Michael Zuckerman, Temple University Fox School of Business
5 January 2021Analysis

Seeking risk management equilibrium in a VUCA world

The pandemic may end in 2021. Nonetheless we will continue to live in a world characterised by volatility, uncertainty, complexity, and ambiguity (VUCA), requiring most organisations to develop new risk management strategies for a changing risk landscape.

Organisations will need to question why they were not better prepared to mitigate the devastating disruption wrought by COVID-19, despite repeated warnings that a pandemic was coming. Furthermore, organisations must ask whether they are prepared to address the dynamic nature of risk in the 21st century?

In 2020, many organisations were managing multiple crises at the same time. Record-setting wildfires, typhoons, earthquakes, hurricanes, thunderstorms, terrorism, water and food insecurity, threats of future pandemics, and emerging cyber risk trends, among others, characterise the dynamic nature of our risk landscape. And as many risk managers acknowledge, the complex nature of risk presents an opportunity for captive insurance companies.

“Organisations must do more to fully understand their exposures and better detect weakness in their current approach to managing risk.”

McKinsey & Company, in an article titled “Meeting the future: Dynamic risk management for uncertain times”, published by its risk practice in November 2020, argued that “beyond the profound health and economic uncertainty of the current moment, catastrophic events are expected to occur more frequently in the future”.

McKinsey’s article cites the growing digitisation of the global economy, changing climate, growing stakeholder interest in environmental, social, and corporate governance (ESG) factors, and an uncertain geopolitical future as trends that require dynamic and flexible risk management.

The role of the captive

McKinsey believes most organisations need to refresh and strengthen their approach to risk management. Its article provides important insights into developing a dynamic risk management process required to address a VUCA world’s challenges. But it does not talk about the role of the captive within this initiative.

The risk management equilibrium represents the optimal balance between risk financing and risk control (loss prevention and mitigation) needed to ensure the organisation can attain its strategic goals and the underlying operational objectives. This equilibrium has been upset by the VUCA environment.

The pandemic demonstrated that organisations must do more to fully understand their exposures and better detect weakness in their current approach to managing risk, for example residual risk within the context of their risk appetite and tolerance. A captive’s board must therefore govern it as a strategic risk management tool to enhance the organisation’s strategic and enterprise risk management (SERM) process.

The definition and purpose of a strategic captive was discussed in my Captive International article, “ Getting creative with risk management: put captives front and centre”. In summary, it is the captive that can enable the organisation to improve its risk management programme across the enterprise.

The use of well-designed self-insurance is a proper response to an increasing imbalance between the cost of risk transfer and what risk managers are willing to pay for coverage that imposes increased retentions, limited coverage terms, and less in/reinsurance capacity. But many still believe that a captive has limited application as an alternative risk financing vehicle, best used for underwriting traditional hazard exposures with predictable impacts such as workers’ compensation, third-party liability, and first-party property among other predictable insurable exposures.

However, captive insurance programmes should also be designed to manage the emerging and evolving exposures arising from a VUCA world. Cyber, climate-driven, and pandemic-related perils will continue to disrupt business operations and supply chains globally.

Organisations seeking the appropriate balance between risk control and risk financing to address a VUCA world need to use captives to improve risk identification, drive risk control, as well as fund risk. Therefore, a captive, if properly used, can become a more effective risk management vehicle for volatile and ambiguous exposures.

Well signposted

What is predictable or foreseeable? As I wrote my previous article, scientists had evidence that the current pandemic was coming for more than a decade. The role of poor governance as a root cause of devastating plagues has been written about since before the 3rd century BC. We have been studying climate change since the early 19th century.

Why, then, are we are not focusing more attention on risk identification and assessment, and analysing the residual risk of dynamic perils such as a pandemic, climate change, and cyber that cause operational and supply chain disruption?

If we accept that captives are a strategic risk management tool, not just a checkbook, then why not use them proactively to seek to correct the current risk management imbalance? What would the world look like today if organisations had begun developing risk financing and mitigation strategies for the current pandemic in 2010 or 1918?

What specific risks should organisations be funding in their captives? The captive becomes a laboratory for the SERM process to answer this question. The SERM process identifies, assesses, and prioritises risks or exposures, while the risk register represents opportunities for the captive. There must be open communication between the SERM group and the captive insurance company board and management.

The role of the SERM process is to put the VUCA world into context for the organisation. Captive board meetings are a perfect platform for senior managers to discuss uncertainty that matters to their organisation’s suppliers, customers, employees, shareholders, and other stakeholders. This integration of SERM and the captive will enable the implementation of risk financing and data-driven risk control strategies that help calm the impact of VUCA disruption.

The captive programme design process requires structure within a controlled environment to properly study new captive insurance programmes’ feasibility. And this begins with an analysis of the risk financing building blocks, including compliance, capacity, and control. This process must also address any disconnect between the organisation’s strategic goals, risk control strategy, and risk financing strategy.

The open line of communication between SERM and the captive can repair this disconnect. A well-crafted captive based risk financing design plan will focus on identifying critical risk issues to fuel the brainstorming of solutions and developing cost assumptions to enable the creation of a programme structure required for appropriate modelling.

The feasibility process must begin with understanding any compliance issues that may require the use of a commercial insurance front. A front adds cost, but it can be a valuable partner providing needed capacity as well as compliance. A thorough review of the organisation’s regulations, contracts, and loan documents will identify risk management and insurance compliance issues.

Where will the organisation find the financial capacity to retain risk without impairing its solvency? Does the organisation understand its risk appetite and ability to tolerate the inevitable variability between expected and actual losses financially? In other words, how much risk does the organisation want to retain, as opposed to how much can it afford to keep? Will access to the reinsurance and capital markets provide the needed capacity to move forward?

Over what aspects of its risk management process does the organisation either want or need to gain additional control? What effect does the organisation want to have on its risk management programme? Control is required to regain risk management equilibrium. For example, centralising the risk management programme to address the needs of a complex or diversified organisation can increase risk management control.

A magnet for data

The captive is a magnet for data, which makes it an effective platform for centralising risk management. Expanding the captive’s role will therefore enhance the organisation’s ability to prepare for future disruptive events.

What does control over the cost of risk look like for the organisation? The research required for a captive feasibility study improves risk financing decision-making. The improved understanding of operational and strategic risks will provide multiple risk financing opportunities for the captive to research and consider. Moreover, improved risk financing decision-making will increase the likelihood that an organisation will successfully achieve its strategic goals, increasing its value.

The captive will also increase control over the cost of risk by reducing risk financing transaction costs and enhancing cash flows by improving loss reserving to maintain the liquidity to meet loss payout patterns. Reducing the impact of adverse events by improving the organisation’s focus on its residual operational risk will also reduce the cost of risk and protect its credit rating over time.

Suppose the captive is used to begin funding volatile and ambiguous cyber, climate, or pandemic-related perils. The captive increases its parent’s control over its access to the global reinsurance and capital markets, which as previously noted is critical to building the captive’s financial strength to address these VUCA related issues. However, the challenge is whether access to the reinsurance markets will provide the desired capacity, rate arbitrage, and improved coverage terms (sans current market conditions).

“This integration of SERM and the captive will enable the implementation of risk financing and data-driven risk control strategies.”

Will the captive’s access to the capital markets provide the capacity needed to supplement reinsurance coverage or address a specific catastrophic peril using a parametric coverage trigger such as the models used by Amtrak and the New York Metropolitan Transit Authority? These issues must be explored and defined within the programme design and feasibility study process to answer these important questions.

What does greater control over claims management look like for the organisation and its stakeholders? Retention brings more control over claims management. The captive board must monitor how an organisation manages claims to ensure that it improves reserving, resolves loss development anomalies, addresses consent to settle issues, improves litigation management, and funds the development of information technology needed for a productive SERM process, including claims management.

Furthermore, greater control over claims management provides risk management data for operational, financial, and strategic SERM analyses to improve risk management and the overall efficacy of the organisation’s operations.

How can a multidisciplinary and diverse captive board increase its control over or affect the risk management equilibrium? As noted earlier, more control means more data. Through its risk management committees, a captive board with more control over loss prevention, mitigation, and claims data can act as an incubator for the design of evidenced-based loss prevention and mitigation strategies. This includes improved business continuity, crisis management, resilience, and sustainability needed to reduce volatility, uncertainty, and ambiguity.

The captive may also be a funding source for these projects. The US Harvard medical community’s CRICO captive case is a stand-bearer for this proposition. Using this data to reduce frequency, velocity, and severity of adverse events will generate additional capital to enable value creation and fund value protection, including organisational reputation. Furthermore, this return on risk management investment goes to the very heart of improving ESG scoring, which will enhance the organisation’s access to capital needed to fund operations and growth, not to mention its reinsurance submission.

More risk control data also means improved exposure analysis and modelling for reinsurance marketing submissions.

What about control over the cost of residual uncertainty? Clarifying compliance, capacity, and control will improve the efficacy of risk financing programme design and the feasibility study process, ensuring that we are appropriately employing the captive. Effectively managing the captive’s underwriting, credit, and investment risks will generate retained earnings that provides additional retention capacity.

This capacity is also a source of capital for the organisation to meet short term cash needs created by VUCA disruption of earnings before interest, taxes, depreciation, and amortisation (EBITDA), which if not effectively managed could impair the organisation’s credit rating and increase its cost of capital, triggering a liquidity crisis. If we lower the organisation’s residual risk, we can reduce the volatility and uncertainty that matter to its operations, global trade, and supply chain management, reducing the cost of residual uncertainty.

A well-governed captive insurance programme integrated into the organisation’s SERM process can help steer risk control and financing into balance. Reducing residual risk enables the organisation to meet its strategic goals and the underlying operational objectives increasing its value. Isn’t this the ultimate test of captive’s economic value?

Michael Zuckerman is an associate professor at Temple University’s Fox School of Business, in the department of risk, insurance and healthcare management. He can be contacted at:  zuckerm@temple.edu