28 November 2013Analysis

Parental control

Whereas 20 or 30 years ago captive formations and premium growth closely followed the cycle, nowadays there is greater emphasis on the value captives can deliver in risk management, with growth and utilisation increasingly decoupled from the market cycle. That is the view of Steve Chirico, assistant vice president at AM Best and head of the captive rating team who said that there has been “no interruption” in the formation of captives or their deployment in the current soft commercial cycle.

He agreed that for certain lines of business there would be a “trade-off” between running the line through the captive and buying coverage in the commercial market, but he said that captives continue to prove their value to parent companies. John Andre, group vice president at AM Best said that companies are growing increasingly sophisticated in their insurance buying behaviour and that captives form an integral part of their buying calculus. “It may sound trite, but the captive as a tool concept is more and more evident. Captives provide companies with flexibility. They aren’t beholden to the commercial markets any more”.

Chirico said that AM Best had seen exactly this kind of behaviour among the single parent captives it rates, with parents exploring options in the commercial market, but continuing to keep “skin in the game” through their captive. He said that the rating agency fully expects such companies to increase their captive limits post-event, but for the moment they were able to benefit from mixed source coverage. As Chirico explained, “they can buy what they need and judge that based on the cost of the commercial market”.

Chirico said that the single most important reason parents establish a captive is “control”. It affords companies “an extraordinary amount of flexibility” in their risk management, “while control can in turn lead to a competitive advantage”. And it is recognition of this control that motivates some captives to seek ratings, he explained, as an affirmation of the work they are doing in enterprise risk management (ERM).

Andre added that the increasingly prominent role corporate risk managers are playing within companies has also helped to raise the profile of captives. “ERM was pretty perfunctory as it existed at the corporate level—if it existed at all—a few of years ago, but now it’s day to day.” Captives form an integral part of this process.

This increased recognition regarding the value of captives and the strengthened role of risk managers within the wider parent company, has also helped to shield captives from unwanted overtures from the parent company. Andre said that this was unlikely to happen with the larger single parent captives, as “frankly what they have in the captive is a drop in the bucket of what they have at the corporate level”. However, Chirico did admit that among those companies that aggressively pursue return on equity there might be a temptation to take capital from the captive. Among the captives AM Best rates however, he said there had been little evidence of parents stripping out capital from their captive. Evidently, the value of their captive is well understood.

Increased interest in ratings

Chirico said that there is an increased interest in corporates pursuing a rating for their captives. He states that much of this increased interest in ratings has been due to greater regulatory oversight following the financial crisis and the desire among parent companies to be seen to be attending to compliance issues more proactively. Chirico said that most of the new entrants are captives that have been active for a decade or more, but that their orientation towards compliance has been strengthened in recent years.

The US Affordable Care Act is helping to encourage captives further to consider ratings, “although not directly”, said Chirico. “Rather it is the general sense that we are in a whole new world.” Andre said that changes in the healthcare landscape were encouraging a change of attitude among healthcare organisations. “They are saying, ‘let me be transparent, let me be open, let me have my best resources in front with a rating’.”

AM Best has experienced a particular rise in interest from risk retention groups that provide medical malpractice coverage. As Chirico explained, whenever there is an element of uncertainty or the potential for increased volatility, “ratings tend to lend a kind of stability”. Ratings lend credibility to your underwriting and operations, he said, bringing in an “independent party to comment on where you are compared to everybody else”. The changing ground in US healthcare provision is likely to encourage still greater interest in the ‘stability’ afforded by ratings.

Domicile excellence

Addressing the increasingly competitive domicile environment, particularly in light of the rising number of US states with captive legislation on their books, Andre said that circumstances “have encouraged the more established domiciles to up their game”. But he said there are only a few US domiciles can really compete with offshore leaders such as Cayman and Bermuda.

Chirico said that there had been “no material change” in the domicile choice of US firms or a marked move onshore. Rather, parents continue to seek out the best captives domiciles regardless of geography, he said. He added that some of the new captive domiciles had nevertheless achieved success in building their franchise. Highlighting Montana as a case in point, Chirico said that with a solid infrastructure and robust auditing work, the state has achieved solid, steady growth. He cautioned against overly rapid growth however, adding that “frankly we become concerned when we see a domicile adding a ton of captives too quickly, because we understand that you have to have the infrastructure in place to be able to handle them. That doesn’t happen overnight. That’s the strength of established domiciles like Cayman.”

Andre said that experience and reputation are extremely important within the captive space, adding that jurisdictions such as Cayman and Vermont are in a strong position to benefit from the interest of new entrants. As he explained: “If I’m running a captive I want consistency from my domicile and among its service providers.”

Considering Cayman’s evident strengths and experience in captive insurance, Chirico warned that the domicile could do more to promote its proposition internationally. He said that one of the major issues that has been brought up recently was regarding Cayman’s decision not to opt for Solvency II equivalence, which has left question marks regarding its position—at least in the eyes of the general public. While its decision to opt for a wait and see approach with regard to Solvency II is appropriate given the significance of its captive sector, Chirico said that the public perception is that “Bermuda is upping its regulatory game”, while Cayman is not. However, as Chirico explained, some have stated in the Cayman market that Pillars 2 and 3 are not fully appropriate to captives and there is some doubt that these components will be applied to captives facing equivalency. As such, Cayman’s position makes sense; it is just in the press it is portrayed as though Cayman’s regulatory position has weakened vis-a-vis Bermuda, said Chirico.

“Cayman has a robust regulatory process, but that isn’t what is getting out, instead it is the big question mark regarding why they are not pursuing equivalence”. Chirico said that by addressing this question, Cayman would be able to compete more effectively with the onshore competition, particularly in the healthcare area which has been a particular strength of the domicile.

Tough in the middle

Many captive managers regard the SME market as the next frontier for captive insurance, but it is apparent that cracking that particular nut won’t be without challenges. As Andre explained, pricing on commercial lines remains attractive, creating “little impetus to enter into some kind of captive arrangement”.

Andre added that there is also the cost element and the “fear of the unknown”. He said that cell captive solutions were seeking to overcome some of the cost hurdles for the middle market, but explained that middle market companies tend to lack the depth of financial knowledge that is typical in a company. Rather than being considered as a risk management tool, captives are regarded more as a commodity by such companies, said Andre.

Chirico said that in order to sell to the middle market captive managers need to change their approach: developing business, rather than simply acting as service providers. Captive managers need to “up their game” when selling to the SME market he said, helping SME companies “get comfortable” with the captive concept. He suggested that companies can bring their captive programme on over time, adding in additional premium and lines as they gain knowledge of captive operations. He admitted that savings might not be substantial immediately, but that when hit by a catastrophe event, the benefits could be significant.

Chirico said that among the 54 single parent captives that AM Best rates at present, the average combined ratio is 80 percent. “If owners are able to save 20 cents on the dollar in their insurance spend that number might start out small when you have a $10 million captive, but when the captive grows to $50 million the amount saved is not a small number any more.” He concluded that with captives increasingly decoupled from the commercial cycle, middle market parents would do well to consider their captive options.

John Andre is group vice president at AM Best. He can be contacted at:

Steve Chirico is assistant vice president at AM best. He can be contacted at: