Captive parents are increasingly considering adding additional and more complex lines to the roster. What lines can they potentially add and what are the benefits of doing so?
The employment of captive insurance entities continues to gain ground, with statistics from Europe showing that 46 percent of European firms employed captives in 2011—up from 42 percent in 2010—according to the Federation of European Risk Managers Association (FERMA). This is despite soft commercial market conditions and a decidedly troubled investment environment, with captive entities continuing to prove their worth. They are employed to write a wide variety of lines of business, and although there is a preponderance of workers’ compensation, healthcare and employee benefits globally, there are significant opportunities to develop the scope of lines written—particularly as experience and knowledge of captive management deepens.
Initial lines of business written through a captive very much depend upon the nature of the parent’s business, but as Kevin Poole, manager at Kane (Cayman) indicated, statistics from the Cayman Islands Monetary Authority (CIMA) provide an indication of the most commonly written lines of business in Cayman. They break down as: medical malpractice (34.61 percent), workers’ compensation (21.61 percent), property (12.04 percent), general liability (9.99 percent) and professional liability (8.89 percent), with Cayman’s position as a home for US risks evident in the make-up of lines.
Economics and stability
What are the drivers behind opting to run lines of business through your captive, rather than having it insured or reinsured by the commercial markets? They appear to be two-fold. “As surplus grows, a captive owner will typically seek to ascertain which lines of business might make economic sense to include in the structure,” said Poole. James Rawcliffe, vice president, Sagicor Insurance Managers, spoke in a similar vein, arguing that if the “parent feels the insurance market is charging an unjustified premium for the level of losses the parent is incurring”, then it will opt for captive insurance. Simple economics will dictate the use (or not) of a captive entity and remains the leading driver of lines deployed.
Captives also like stability. Difficult risks prefer a home in the commercial markets. As Nicholas Leighton, group managing director at Atlas Insurance Management made clear, “risks that are predictable and controllable are placed in a captive”. Rawcliffe echoed his sentiments, with captives preferring steady, understandable risks; lines written through them will need to reflect these realities: economics and predictability.
In the face of soft commercial market conditions, however, it has at times proved more difficult to justify the economic benefits of opting for a captive. That said, captive numbers and their use have remained buoyant in recent years—evidence of their continuing utility and economic viability. On the predictability side of the coin, certain lines will remain safer bets than others, but self-insurance has nevertheless grown increasingly innovative in its provision of credible risk solutions to a host of insurable risks.
Scale and sense
While captives are generally established to write specific lines of business for the parent, adding additional lines can bring benefits. Such considerations will increasingly come to the fore as the captive grows and after rate-changing events in the commercial market, bringing both benefits and challenges to the parent. As Poole indicated, “the primary advantage is that the more lines of business you place into the captive, the greater the amount of premium this generates and the broader the spread of risk it provides”. This speaks to the notion of stability—a primary driver of captive business.
Rawcliffe added that larger captives also help to create economies of scale, “for example through letters of credit or aggregate stop loss when a captive participates in multiple lines”. He said that for “accounting purposes premium written in the captive—a subsidiary of the parent— is eliminated on consolidation, and the more premium written in the captive, the greater the reported profit to the group”, an issue that can provide significant economic benefit.
So what does one need to consider when looking to add new lines to a captive? “First, does it make sense, and second, is it achievable?,” said Rawcliffe. “Captives are always in demand, but there are some risks that never make it into the captive because of regulatory issues or market demand. A classic example is workers’ compensation for professional employers organisations (PEO), where there are only a few US insurers willing to front the business, and if they do, they take the risk in their own captive, not that of the PEO.” Certain risks will only ever find a home in the commercial market due to accumulation, regulation, size or volatility, but captives nevertheless have the potential to take on significant risks.
"As rates harden in lines such as workers' compensation and general liability, captive programmes become more attractive in comparison to the guaranteed-cost approach."
Poole likewise argued that matters need to “make economic sense. Adding new lines has to meet a business need and shouldn’t expose the captive’s balance sheet to significant claims”. “Any new programme therefore needs to be properly structured in a way that takes into account loss forecasts. In addition, regulatory approval is required before the programme is written; it’s up to the captive’s insurance manager to make a reasoned business plan change request to CIMA [or a similar local body] explaining why the changes should be approved,” he added. With regulators paying increasingly close attention to solvency and capital requirements, the justifications behind adding additional lines of business will have to be strong. That said, if they tie in with strong economic reasoning, they should be well placed for approval.
Running additional lines through your captive offers the opportunity to both increase premium generated and broaden the spread of risk, said Poole, with surplus growing as the number of lines written increases. “This can in turn create opportunities to increase retentions or to cut back on the amount of reinsurance purchased,” said Poole. There are also opportunities associated with potentially running third party business through your captive, said Leighton. “It is a major opportunity in terms of risk diversification and additional profit to the parent company—additional costs and exposures are associated with third party business, however,” he said.
Attitudes and pitfalls
A number of drivers will encourage parents to run still greater levels of business through their captives. One factor relates to changing attitudes at the parent—particularly as it relates to those lines that can or cannot be written through a captive. “The attitude of the board and the risk management framework of the parent are two considerations. Some risk managers have a comfort zone that is stuck on casualty deductibles, whereas others are more adventurous,” said Rawcliffe.
The second driver is the increasing range of lines of business that can be written through a captive, particularly as the scope of insurable risks expands. “As new exposures such as systemic loss or common cause coverage arising from issues such as mis-calibrated equipment and unnecessary treatment, billing errors and cyber liability present themselves, captives can often help fill any gaps or provide enhanced coverage to their insureds. In addition, as rates harden in lines such as workers’ compensation and general liability, captive programmes become more attractive in comparison to the guaranteed-cost approach,” explained Poole.
That said, adding new lines of business is not without its challenges. As Rawcliffe outlined: “Understanding the risk is paramount. A few years ago some captives began reinsuring legal expenses, not appreciating the length of the tail on the business and they were badly burnt. Similarly, mortgage lenders reinsured default risks through their captives and did not fully fund for the housing market meltdown. So understanding the risk and the economics are major factors.”
Poole, likewise, said that considering the economics of the decision is key. “Among the main challenges when adding new lines of business is ensuring funding is adequate and that adding the new lines will not expose the captive to unacceptable levels of exposure,” he said. Valuable, if painful, lessons have been gleaned from the recent financial crisis and while captives may be more cautious since 2008 in their view of particular risks, they are also better educated. Such education and the understanding of existing and emerging risks will be central to considerations surrounding adding new lines of business.
Proving their worth
In view of the significance of economic factors in the decision both to write insurance through a captive and to expand its lines of business, it is perhaps surprising that captives have continued to prove their worth, considering the soft commercial market conditions. However, the picture is not universally soft. As Poole indicated: “While the market remains relatively soft for certain lines of business, such as medical malpractice and hospital professional liability, we are seeing some hardening on other lines. For the majority of captives that have been in place for a number of years, the soft market isn’t an issue as underwriting results since the formation of the captive have generally been good. This has led to a similar reduction in premiums in line with market rates.”
Rawcliffe highlighted the potential volatility of the commercial market and the flawed reasoning behind certain parents’ decision to opt to place risks in soft commercial markets, only to see rates harden on the back of major events. “A captive can prove its worth in a soft market by being used by the parent as a shield to reduce premium price volatility in the market. If the market prices harden, the captive can assume a greater level of retention and buy reinsurance ‘higher up’. When the markets soften, the captive can reduce its retentions accordingly.”
Such reasoning is supported by the growing number of companies employing captives globally, with premium levels and captive numbers on a generally upward trajectory. “In addition, using a captive, whether in a hard or a soft market, is generally less costly than using a commercial carrier because of the lower premium rate offered to captives (as opposed to the parent going to the market directly) and the ceding commission received from the reinsurer to assist with the captive’s operational expenses,” said Rawcliffe.
Captives continue to gain ground internationally and the addition of further lines of business can only serve to strengthen their hand and that of the wider captive sector. Economics and stability will continue to dictate which lines are taken on, but new and innovative captive forms and market growth should spur on an increasingly confident captive industry globally.
Cayman, captive, lines, FERMA, Kane, CIMA, Sagicor