6 March 2014Analysis

A powerful ally

EMEA Captive: What kind of captive is the typical purchaser of reinsurance?

Urs Neukomm: Gross retention captives are the main buyers, those which write more business than they ultimately keep on a net retention basis. Of that group, larger captives are the biggest participants, either because they want to reduce their excess capital by paying out dividends, for instance, and then need to protect the remaining capital— mainly captives in offshore domiciles and with loan-back arrangements— or because they want to further grow without injecting additional equity capital.

Then there are smaller captives that come to the point where they need to decide how to position a captive re/insurance company for the future. Either they exit the captive concept altogether and sell or close down the company, or otherwise use such a vehicle in a more meaningful way and increase the captive gross retention significantly to better align the captive retention with the corporate risk profile and risk tolerance. Typically, financially strong captive owners go down that route. The buying pattern definitively changes, away from the traditional motivations for a captive.

How do you see buying patterns changing?

There’s a paradigm shift happening largely unnoticed. In the past, to put it bluntly, a number of captives were being used to store cash for bad times. They were being used as tax efficient vehicles and for smoothing rate changes in the market. Post financial crisis, the cost pressure on captives has increased. The captive route is expensive to begin with, and with imminent Solvency II capital requirements, increasing fronting and administration costs and an added tax burden due to the OECD Action Plan on Base Erosion and Profit Shifting as well as increasing insurance premium tax rates, parents are now thinking about captives in a different way.

A captive should be used as a capital management tool for risk management purposes— that's the flip side of capital management— and not just as an insurance tool. That is the right place to put the captive in an overall corporate environment because it should be used to manage the corporate risk retention— the capital that you earmark for paying losses you know you will suffer.

Instead of just having a captive, captive owners  see such companies more and more in a strategic context and consequently exit the captive, or do exactly the opposite, by asking themselves how they can use the captive in a (more) meaningful way. Reinsurers can play a role in that, for example, by participating in such a dialogue from the beginning and in the end by protecting the difference between the external gross retention and the internal net retention of a captive.

What are the key drivers of reinsurance buying at present?

Definitively reduction of costs: If you want to reduce underwriting risk volatility in order to lower the solvency capital requirements you may want to think about reinsurance because of the diversification it offers.

Sometimes it’s the efficient use of available capital so that captive owners with the intention to grow their company do not need to inject more equity capital or can extract capital while continuing to use their captive in a meaningful way. In this case, reinsurance helps to calibrate the exposures with the available capital or the other way around.

In the context of Solvency II—if it ever becomes reality—the anticipated solvency capital required (SCR) may encourage you to think about reinsurance to protect the captive. And then there are other risk management reasons, for example access to the net risk carrier or access to specific know how. Simple insurance reasons (such as independence from market cycles and market conditions) are still valid, but play less and less a key role. These are all drivers as to why people look into reinsurance.

What are some of the benefits that captives can expect from accessing the reinsurance market?

Reinsurance as a substitute for equity capital is a key element, without any doubt. In addition, there's access to know-how and access to the real net capacity provider. This is true at least in our case, as we leave in our balance sheet what we write.  As part of the paradigm shift I discussed earlier, people are more concerned with who, in the end, will pay. So access to the real capacity provider is certainly a crucial element.

In another sense it’s also access to the latest market developments. If you think about tackling exotic risks like cyber, non-physical damage business interruption, reputational risk, even fronting companies and direct insurance carriers need support from reinsurers. People are seeking access to the people who really have an overview of solutions. We try to have an open dialogue about new exposures. But we try to put a proper perspective around it, and say what can be done and transferred and what is not eligible for risk transfer in the first place, and what is more of a risk management topic rather than an insurance issue.

And then, we can also provide guidance on enterprise risk management in the context of the Solvency II discussion—what works best or is most efficient. We don’t provide the capital calculations or the models—that’s not our turf—but we can give captives guidance on how to keep capital efficient. That's all part of designing optimal reinsurance protection. We can also advise on how to use a captive more meaningfully, for example to increase net retention. We look at the whole risk landscape of a corporation and provide guidance on how to best use capital in terms of what lines of business should flow into a captive and what shouldn’t, or in which lines of business reinsurance is better than using your own capital, how to free up capital, and for what valid reasons.

When should captives consider buying reinsurance, and what are the key considerations?

Captives should consider purchasing reinsurance when they want a substitute for equity capital and to keep exposures at a certain level. That is when a captive should consider reinsurance, because reinsurance is essentially a substitute for equity.

However, there are some other considerations. I mentioned before that a reinsurer can provide access to new developments. Let's take an example to illustrate what I mean by this: Typically, fronting insurance carriers for captives ask for collateral to mitigate the captive credit default risk. There's nothing wrong with this and quite reasonable to do if you are not the last risk carrier in the chain. But with a highly-rated reinsurer behind the captive and a security assignment or any other form such a "cut-through" mechanism, you may be able to avoid putting up that collateral or bring down the overall risk transfer costs.

Are there any lines that fit particularly well into a reinsurance solution?

There is no straightforward answer. More important even than lines of business is the loss history. Definitely what you should avoid—at least from a Solvency II perspective—are higher excess layers for peak exposures that happen every fifth to tenth year; or low frequency and high severity exposures. Those are all exposures for which you are punished in terms of Solvency II capital requirements. If you’re punished you should look at the alternatives, and one of those alternatives is reinsurance because it’s a substitute for your own capital.

On the other hand, such a decision also depends on the risk landscape of the company and on the stage of the captive. If you  establish a new captive you want to start with a line of business for which a lot of data is available and which is relatively simple— for example property damage and maybe business interruption. However, if you are a bit more advanced, you may also want to look at liability business or even more exotic risks. And as a mature captive you probably can afford it to free up capital by protecting the more traditional lines of business with reinsurance and concentrate the underwriting on new lines of business, including exotic risk classes.

The overarching concern is how to most beneficially use the capital of a captive. It’s not only the lines of business. It really depends on the stage of maturity.

What should captives be looking for in their reinsurance partner?

There are only three factors: financial strength; a reinsurer who is willing to act as a long-term partner, which means they are not going to walk away when something extraordinary happens; and experience.

Urs Neukomm is Swiss Re.