Captive solutions as a risk management tool in the 21st century
The principle of insurance has its roots in ancient times. In those days, traders and business people made up what were known as “risk communities”. They helped each other with material losses (eg, piracy, accident, or theft) and the group paid jointly for damage caused to the individual—the principle of risk assumption by the collective was created.
The first maritime insurance originated in Italy in the 14th century in order to make the risks of maritime transport calculable. Ship operators and shipping companies had the opportunity to take out maritime loans for their daily operations. They had to pay these back—with interest—only if they returned unharmed to their port of destination. Under the terms of this hedging option, shipping grew into a prosperous industry.
Companies helped each other in cases of material loss. These developments paved the way for a multibillion-dollar industry—the insurance industry. If one focuses on the taxonomy presented, insurance is a new market innovation; a totally new market, or rather a totally new sector, was founded (see Figure 1).
Figure 1: New market Innovation
Even in modern times, the insurance industry retains its importance for industrial companies because the option of transferring risks to third parties is still hugely relevant. In fact the necessity for a customised hedging concept is becoming increasingly important because companies are exposed to a constantly increasing and diverse number of risks. This is where, for a variety of reasons, the insurance risk management tool often reaches its limits.
The number of uninsured, or rather uninsurable, risks is constantly increasing. In recent decades, products on the alternative risk transfer (ART) market have thus increasingly emerged as real alternatives to the traditional insurance business. This step forward can be seen as a radical innovation in the hedging risk market—it is referred to as a disruptive innovation, because the ART market satisfies all the framework conditions to replace the traditional insurance market (see Figure2).
Post 9/11 innovation
A practical example of how flexible and innovative the elaborate strategies of ART providers are can be illustrated in the context of the 2001 terrorist attacks on the World Trade Center. A German insurance company issued terrorism insurance for the aviation industry. This insurance solution was innovative in that, in the wake of the 9/11 attacks, aviation insurers initially cancelled third party liability cover for losses arising from terrorism entirely, and later reintroduced it—but with severe restrictions. Because of these decisions, airlines and airports did not have adequate insurance cover.
Based on these circumstances, many governments were forced to give their national airlines and airports the necessary cover with state guarantees. In the event of a claim, this could have significant consequences for the taxpayer. The insurance company therefore developed a solution with limited liability and claims-based premium mechanisms, which was classed by the European Commission as a viable insurance solution and led to the termination of the state guarantees. These customised product solutions can of course be difficult or even impossible to design in a portfolio—and thus following traditional insurance approaches.
Figure 2: The alternative risk transfer market
What is more, the captive establishments in New York City—especially in Manhattan—skyrocketed after the 9/11 terrorist attack. A notable reason for this was that insurance companies no longer provided cover for these risks, or only with very high excesses and significantly reduced cover.
Other causes are mega trends (eg, globalisation, industry 4.0, digitisation, new political world orders, and newly developed markets) which to some extent present unforeseen risks for companies. Especially in modern times, companies are forced to act on the quote from Peter F. Drucker: “Innovate or die”. Companies must keep launching innovations on to the market place in order to stay competitive and to survive against global competition.
This pressure to innovate—due to increased competition—determines the strategies of industrial and service companies, and as a result creates new risks that may be covered only at great expense, or not at all, on the traditional insurance market. In this case, the captive solution—the company’s own piggy bank—emerges as a contemporary approach to risk management for hedging risks that are difficult to calculate. As the figures show, this type of protection is already established worldwide in multinational corporations.
Taking a look, for example, at one of the world’s most important industries—the automotive industry—it is striking that only 22 percent of innovations are produced by the original equipment manufacturer (OEM). The significantly larger proportion of 78 percent is generated by suppliers—and this trend is rising. An increasing pressure on suppliers to innovate—the laws of the automotive industry are certainly applicable to other industries—ensures a growing and ever-changing risk portfolio.
Due to the increasingly influential individualisation of products and markets, traditional insurance concepts (the balance of risks within a portfolio using the law of large numbers) are more often reaching their limits. The suppliers of ART solutions (eg, captive providers) are now taking advantage of this situation.
However, the forecast penetration has not yet been completely achieved. Products such as finite risk, insurance-linked securities (ILS) or weather derivatives—which are also included in the ART market—have little market share and are often unknown, in particular to medium-sized companies.
Growth for the middle market
The captive market (the principal activity among ART products) is still relatively unexplored and it is primarily large corporations which opt for such a means of cover. However, the efforts of individual countries and regions—to position themselves in a captive-friendly manner in this jurisprudence—show that the market has not yet exhausted its potential by a long way and that it can keep on expecting many more startups, particularly in the mid-market sector.
At the same time, insurance companies are definitely interested in this very attractive market, and globalisation and the associated mega trends are on the cards. The risks to companies—including and especially small and medium-sized enterprises (SMEs)—are changing. Traditional risks such as fire, interruption of operations, cargo, third party liability and credit no longer represent core risks for companies. Cybercrime, fear of a bull market and, in particular, competitive pressure are becoming the focus of globally operating SMEs.
Product life cycles are shortening, trends such as ‘greening’ and individualisation are driving up the costs of innovation for companies. It is therefore important to have a well-filled war chest for SMEs, which often have insufficient capital cover. This necessity has forced and controlled approaches such as change and lean management in recent years.
Companies are governed by a buyer’s market, which means it is difficult for them to raise prices at their own discretion in order to increase profits. This results in programmes for optimisation and minimisation on the cost side of the business—and this does not stop at insurance programmes. Nevertheless, administrative costs are still very high and premiums are too expensive in relation to claim patterns.
A potential form of optimisation would be to switch to a captive solution which would result, in particular, in a reduction of administrative costs. Since a single parent captive is a separate legal entity, and thus incurs startup costs and capitalisation, this version—at least initially—is counterproductive because for SMEs the issue is the reduction of costs. The advantages of this version of a captive might at first seem prohibitive, since the traditional advantages of a captive solution come into play when insurance premiums are very high (due to the soft market phase, they are often too low).
Captive providers have recognised these problems and expanded their product portfolio to include a rent-a-captive. This was designed to pave the way for SMEs in particular to insure themselves. The fact that a number of companies have grouped together in the guise of a rent-a-captive vehicle has led to a drastic reduction in operating costs by means of economies of scale.
Other modified types of captives such as the group captive followed, although these have not yet had the desired resounding success. The reasons for this are on the side of potential customers (SMEs) and also on the supply side (insurance companies, reinsurers, brokers). Customers are usually not sufficiently informed and often have not yet ventured into looking at the bigger picture, nor dealt with products on the ART market. Nevertheless, they trust their insurer or insurance broker to select and design their insurance programme. Neither of the latter has any particular interest in informing the customer of a potential captive solution.
For SMEs, the broker is paid—in most cases—a commission based on the amount of the premium. Restructuring the portfolio into a captive solution would result in financial losses for the broker, which means they withhold information from customers on this type of hedging. In addition, medium-sized brokerage companies in particular have no specialists in this area. Their focus is not on launching innovative new products but rather on the design of individual wordings, which they consider to be the unique selling point of their company.
Insurance companies themselves earn a lot of money from traditional industrial insurance and do not want to see an erosion in premiums, so they too fail to push the issue of captive solution for SMEs. Thus the aggressive exploitation of this market environment would be more of a diversification than a market development and this is associated with high costs, which might only pay for themselves after a few years—a bold investment in this era of the shareholder value approach from which some top managers shy away, preferring to put money into penetrating the market in core business sectors as a strategy.
Figure 3: The captive solution for the middle market
It must be concluded that SMEs have a need which must be awakened. Similar to the development from the mobile phone to the smartphone market, the development of captives was a disruptive innovation that has lit up for the Fortune corporates of the world (see Figure 3). However, the sustainable success formula of scaling and penetration through the entire insurance industry market has unfortunately so far failed to occur. It can be compared to BlackBerry, which designed its smartphone for the business market, failed to scale it, and is now languishing far behind Samsung, Apple and Huawei as a niche supplier.
In the age of the digital revolution and the associated radical change, innovative solutions such as captives should be exploited considerably more strongly. Great potential for the future exists on both the supply and the demand sides. Mid-market corporates in industrial nations in particular should consider this type of solution.
Marcus Schmalbach is a lecturer in business administration in Fachhochschule des Mittelstands University of Applied Sciences in Germany. He can be contacted at: email@example.com