Optimising your risk portfolio can make captives more attractive under Solvency II, argues Dr Paul Wöhrmann of Zurich Global Corporate.
Captives are a unique vehicle by which their parent companies and affiliates can manage their global risk portfolio, finance retained risk and transfer remaining risk to reinsurance carriers. However, many captive owners will need to cope with the stringent new requirements that will be imposed by Solvency II when it is implemented in 2013 and 2014.
Over many years, the role and use of captives have been growing steadily—Zurich estimates that around half of the world’s largest companies run captives. Its global corporate unit alone fronts more than €1 billion in written premiums allocated to more than 200 captives.
Zurich’s experience is that companies which run captives take a sophisticated approach to risk management and exhibit strategic buying behaviour for insurance or reinsurance.
Change is imminent
Traditionally, captives write less diversified portfolios than mainstream insurers. They also lack the same levels of governance, infrastructure and expertise. However, that is set to change with the imminent impact of Solvency II, which will place additional pressure and costs on parent companies to run their captives more efficiently and structure insurance programmes so they comply with the new requirements.
Solvency II requires companies with captives in Europe to show they have robust, transparent risk portfolio management practices and maintain appropriate capital levels to support possible losses across the risk portfolio. The new rules will reward captives by imposing lower capital demands, if captives diversify their risk portfolio and so reduce total portfolio volatility. This is why Zurich believes the strategic role of captives will be extended as multinational companies realise the potential benefits of running a captive in a Solvency II environment.
Assess the potential of captives
A captive owner needs to assess and understand the quality of the captive portfolio as well as its performance and decide how best to reduce volatility by introducing risks with lower volatility, such as life insurance elements or trade credit insurance.
For managers of captives, Solvency II is an opportunity to collaborate with and support parent company chief financial officers, whose eyes are firmly on balance sheet capital requirements, and encourage them to view captives in a new light. While most companies are familiar with the details of Solvency II, many appear less certain on what is the best strategy for using their captives to optimise risk management.
It is relatively straightforward to assess how changes can be made to improve risk quality, for example, by effective loss prevention to reduce the frequency and severity of claims or by bringing together different, uncorrelated lines of business, particularly life and non-life insurance elements.
Focus on reducing volatility
Why aren’t many more multinational companies doing this? Too often, combining volatile and non-volatile insurance in a captive portfolio is not pursued because it requires understanding, collaboration and strategic alignment between the corporate functions that govern corporate life insurance and the ones that manage non-life insurance. But if, for example, the human resources department were to team up with risk management to develop a joint captive approach, a company could unlock lucrative benefits in the form of capital requirements and premium savings, even under Solvency II.
On the other hand, such solutions also require an experienced insurance carrier, in which cross-functional expertise in underwriting life and non-life insurance as well as captive management services are brought together. At Zurich, this expertise is pooled in a global centre of excellence for the benefit of captive customers.
"The new rules will reward captives by imposing lower capital demands, if captives diversify their riks portfolio and so reduce total portfolio volatility."
Working closely with an insurance provider that has extensive experience on a global scale is a good starting point so that when Solvency II arrives, an optimal captive strategy is in place to ensure capital requirements are as low as possible. In the last year, for example, Zurich has worked with customers to assess the positive impact of greater risk diversification and to determine ways of adding life and non-life elements into their captives’ programmes.
CRISS alternative to captives
Captives aren’t the only way to finance or reinsure a corporate risk portfolio. Following the arrival of Solvency II, Zurich expects increased interest in its Corporate Risk Insurance Sharing System (CRISS) concept as an alternative to running and managing a captive. In a similar way to a rent-a-captive arrangement, where the policyholder takes on a share of his own risk, the CRISS account is integrated into the insurance policy and into the insurer’s balance sheet.
This alternative offers companies greater flexibility with no need for capitalisation. Companies also benefit from limited costs of running this instrument and avoid the added cost of reporting under Solvency II. Any earned investment income is directly credited to the CRISS account, where it can be used to offset losses resulting from the payment of claims.
Fine-tuning insurance structures
Solvency II requires a re-think on strategy for captives to enable companies to create a more efficient insurance structure based around its appetite for risk and its use of corporate capital. Companies need to comply with the captive capital requirements of Solvency II, while deciding upon the level of exposure to risk they want or can take. Making the right decisions on risk retention, greater diversification in the captive and how to minimise the cost of risk financing in the parent can be supported by Zurich’s Quantitative Risk Analysis. It helps companies to:
• Determine the optimal retention level, including tailored cross-class aggregates;
• Understand their insurance risks;
• Forecast expected losses and quantify volatility at various confidence levels;
• Deal with uncertainty of potential loss scenarios;
• Conduct scenario testing using alternative captive structures, such as per occurrence limits and aggregates; and
• Decide the feasibility of a captive as a risk-financing vehicle.
Dr Paul Wöhrmann is head of captive services at Zurich Global Corporate. He can be contacted at: firstname.lastname@example.org
Solvency II: questions for captives
When deciding the best way to tackle future requirements under Solvency II, companies with captives need to answer several key questions:
• Should I move the domicile of my captive to a country where Solvency II does not apply?
• What is the impact of adopting Solvency II in terms of operational costs and the need for any additional capital?
• Does my captive meet the Solvency II requirements?
• Do I need to change my approach to running my captive, for example, in areas such as inter-company loans of assets and retention of historic liabilities?
• Who can prepare reliable actuarial studies across life and non-life risk portfolios?
• Have I allowed enough time to revise the business case for having a captive and are any changes needed?
EMEA, Zurich, Solvency II, regulation, captive, insurance