10 March 2020ArticleAnalysis

New problems, new solutions: expect more innovations

Captives were created to solve problems with traditional commercial insurance carriers. They have evolved into effective financial tools that are used not only to manage issues with traditional companies but also to provide innovative new risk financing solutions.

This is evident in the current economic and insurance environment. Captives continue to assist their parent companies to manage a hardening insurance cycle through providing increased primary capacity and facilitating direct access to the reinsurance market. They have been much more responsive in interpreting unprecedented COVID-19 exposures and are leading the insurance industry in designing customized responsive cyber coverage.

Impact of the pandemic

The predominant factor influencing businesses the past two years has been the unprecedented impact of the COVID-19 pandemic. At the start, government-mandated shutdowns caused many businesses to urgently adapt and innovate. Those who tried to recoup lost revenues by filing business interruption claims typically had their claims denied by their carrier.

Claims were rejected due to explicit exclusions against the actions of government authorities or broad exclusions due to the impact of communicable disease. In cases where there was no exclusion, carriers argued that shutdowns did not constitute the “physical loss or damage” necessary to trigger coverage. Attempts to contest these denials have to date been unsuccessful.

According the Covid Coverage Litigation Tracker maintained by the University of Pennsylvania there have been more than 2,000 COVID-19-related claim lawsuits filed by policyholders in federal and state courts combined. Of the over 700 cases with information publicly available, the policyholder has lost more than 90 percent of the time in the pre-trial phase.

Businesses who insured their business interruption risks in their captives were able manage the impact and provide much-needed funds to the insureds. As captives, they applied a more liberal and responsive interpretation of what constituted a valid claim.

Many captive owners are now adding specific coverages to their captives to supplement coverage deficiencies in their traditional insurance policies. In addition to enhancing business interruption coverage, they are responding to supply chain problems with contingent business interruption coverage.

In addition to commercial coverage, captives are adding specific employee COVID-19 coverage such as additional indemnity coverage to healthcare professionals and additional counseling and supplemental health benefits to essential workers.

In addition to paying claims, captives were used as a source of liquidity during the pandemic, providing cashflow to their insureds in a variety of different ways. Captives that had built up excess surplus over the years were able to pay dividends or offer inter-company loans to their parents. Some captives and risk retention groups (RRGs) were able to defer premiums or allow flexible payment terms, effectively providing free premium financing to align with the insured’s cash flow or ability to pay.

Impact of a hard market

Before the pandemic, the traditional market was hardening across the entire coverage spectrum. The increased frequency and severity of natural disasters such as floods, hurricanes and wildfires has led to losses for property and excess lines. In some liability lines such as medical professional liability the industry was being hit by the trend of increasing severity due to social inflation and more frequent “nuclear” verdicts.

A significant increase in fee litigation, often from employee benefits or class action suits, led to increased D&O losses. Carriers struggled achieve profitability in cyber exposures due to the exponential growth and severity of cyber-related attacks. These increases in losses were exacerbated by reduced investment income due to prolonged historically low interest rates.

The traditional commercial market responded with its predictable countermeasures: increasing premium rates, more stringent underwriting standards, and a reduction in coverage combined with restrictive policy terms and larger deductibles. Reinsurance markets saw capacity shrink significantly as investment capital was withdrawn.

As these factors started to impact the market, more business owners realized that a captive was vital in order for them to design and expand the necessary coverage to control their overall risk-financing costs.

Hard markets are typically a time for captives to thrive and new formations are a testament to their application. At the time of this writing, preliminary reports from virtually all domiciles are indicating significant numbers of new captive formations in 2021. It appears that there are increases in all captive segments such as cells, pure captives, group captives and RRGs.

The impact of cyber risk

Cyber insurance has been severely impacted by the hard market with premium increases in excess of 50 percent. Historically, businesses which implemented sophisticated cybersecurity practices would expect a significant premium discount. Currently, those same practices are mandatory for acceptance by the underwriter.

Coverage is narrowing rapidly with carriers working hard to remove their problem of “silent” cyber—historically many property and casualty policies have neither expressly covered nor excluded cyber risks. This ambiguity has left carriers exposed to cyber risks they did not price and has left insureds thinking they had coverage when they may not. Now most carriers are routinely excluding cyber from all coverages and then adding coverage by endorsement—for significant additional premium.

The obvious solution for captive owners faced with large price increases and reduced capacity is to insure their cyber risks with their captives. However, the magnitude of the exposure requires significant increases of capital in order to provide the necessary limits. Furthermore, captives do not provide any risk mitigation services.

For small to mid-sized captives it may make more sense to take a hybrid approach with the captive acting as a reinsurer under a fronted policy and sharing in various levels of risk negotiated with the carrier. This approach should allow for some cost savings while still allowing the insured access to the front company’s resources in terms of pre-breach services such as IT system reviews and ongoing training that may be offered. After a breach the front carrier would assist in the required notifications to regulators and affected parties as well as advise on preventing the next attack.

The increasing size of the cyber insurance market and the increasing size and sophistication of the cybersecurity market is attracting significant interest and capital from insurtech investors. An increasing number of cyber insurance companies are being formed by insurtech private equity firms. These insurtech companies utilize sophisticated computer models that employ artificial intelligence (AI) in their underwriting models to provide insureds with highly customized coverage solutions.

In addition to streamlining the process of buying insurance, insurtech companies are looking to benefit from the application of technology in other aspects of the operations of an insurance company. AI can be used to automatically determine premiums and can adjust those premiums as additional data is received. Other firms are using AI to automatically process and settle claims often with limited human involvement. Settling claims faster often leads to lower total loss costs. An insurtech firm may choose to set up a captive insurer to act as an incubator for its technology to allow it to prove that it works before its wider adoption on a wider scale.

Another technology-based use of captives is in the potential of parametric insurance. Parametric coverage is non-traditional insurance where a payout occurs if a pre-specified trigger event or limit occurs. As the coverage triggers are simply defined and not open to dispute an insurance payment can be made very quickly after the claim is triggered.

Parametric insurance can be used as a hedge to reduce other insurance risks and as an alternative to purchasing reinsurance. For example, a captive that provides crop insurance to a Florida-based orange grower might purchase a parametric policy that pays a predetermined amount if the temperature drops below a certain level in the region. This policy would pay out whether or not there was any crop damage, provided the parametric trigger was breached.

Parametrics may also assist businesses in their sales efforts. A vacation resort could provide a parametric version of “trip insurance” to its guests by offering them a refund or discount if there were a certain number of rainy days during their vacation. The resort could in turn insure this risk in their captive.

Businesses with existing captives have the ability to immediately trigger their utilization to manage the hard market. Captives can offer coverages no longer provided by the market by, for example, buying back exclusions in the traditional policy. They can also offer various layers of coverage as needed from insuring higher retentions/deductibles to offering excess layers of coverage to ensure the business is fully protected.

Conversely, businesses looking to form a captive may find that due to the increased number of formation applications they do not have the immediate financial ability to respond to negative economic and insurance consequences. A formation that would take 30 days in a soft cycle may take 90 days in a hard cycle.

The recent growth experienced by captives is bringing significant additional capital and many new participants into the industry. These new participants may bring with them new ideas as well as new problems that need to be solved. If the past is any guide, it would be reasonable to expect a period of significant innovation in the captive insurance industry over the next few years.

Les Boughner is chairman of Advantage Insurance. He can be contacted at: l.boughner@aihusa.com

Simon Kilpatrick is a senior vice president at Advantage Insurance. He can be contacted at: s.kilpatrick@aihusa.com