1 January 1970

Captive prove vital risk tool

There is a mountain of evidence, including research by the Association of Insurance and Risk Managers (AIRMIC), to show that the recent recession has raised the profile of risk. Many of the recent economic difficulties were caused to a large extent by a failure of risk management, particularly in the banking sector. Large corporations in all sectors accept the need to take additional steps to make their organisations robust and are planning to recruit the relevant risk professionals once financial restraints have eased.

There is also a growing appreciation that risk in all aspects is an issue to be addressed at board level, although not necessarily by just one director. Traditionally, health and safety has been the responsibility of the human resources director, while financial risk has been the preserve of the finance director. Business continuity and brand/reputation risk have been more difficult to categorise.

A number of companies have appointed a chief risk officer (CRO) to the board. This makes sense, particularly for financial institutions, but there is also a strong argument that the chief executive should really think of himself as the CRO. For any risk management culture to take hold, there needs to be an active interest and commitment at the most senior level.

It is equally important that all aspects and units of the business are risk-aware, because that is where day-to-day decisions are taken and where there is the greatest understanding of the detailed issues. It is crucial that managers understand how their activities relate to the business as a whole and that they appreciate the knock-on effects if things go wrong in their own particular areas.Risk is related to reward and some risk-taking is essential if the firm is to flourish. However, the parameters must be controlled and understood.

Insurance is a risk management tool. It continues to be a significant consideration in risk management, and captives are an increasingly important part of the equation.

Not only is insurance important in its own right, notably for risks such as natural and man-made catastrophes and liability, but the very process of buying cover also adds value. Insurers may, for example, give advice on risk control in areas such as fire protection and business continuity; they ensure that experience can be shared to mutual advantage. With underwriters increasingly favouring firms that demonstrate strong risk management frameworks, and sometimes asking awkward questions, insurance-buying encourages a level of discipline that might once have been lacking.

Those involved with risk profiling will agree that the risk assessment process lies at its heart, identifying loss exposures and interrelationships, and tracking these on a continuing basis. This is effectively what insurance underwriters do all the time, as they need to have confidence in the information on which they are making their judgements.

Over the last decade, the insurance market has become more professional and sophisticated in its underwriting analysis, helped by information technology. Insurers understand better the risks of their customers and also their own exposures. It is only recently that many major insurance and reinsurance companies have been able to assess their exposures to events, such as natural catastrophes, with confidence.

Captive increase

Captives are one area where insurance has contributed significantly to the risk management process. Their use continues to increase, even in soft markets, but their role has evolved rapidly.

"The continuing, and indeed expanding, attraction of captives is their value to enterprise-wide risk management."

There are still some taxation benefits to owning a captive, but government attempts to restrict offshore revenues have made them less compelling. There also continue to be obvious insurance advantages, especially when there is a hard market. In these circumstances, captives can use variable risk retentions structured in a strategic way to reduce insurance spend in the conventional market. Generally, the ability of the captive to access the professional reinsurance market has been a key competitive advantage.

For all that, the main reason for the continuing, and indeed expanding, attraction of captives is their value to enterprise-wide risk management.

Some major corporations have turned their backs on the traditional insurance market and taken the view that their business is more financially sound than the entities to which they would transfer the risk. These companies, however, continue to have an insurance interest through their own captive companies. This is partly to participate in classes of insurance risk where they have a statutory commitment to provide documented cover and partly to enable them to obtain insurance for joint ventures, but also because the captive is a useful tool in the management of their own insurancetype exposures.

A well-run captive will collect data throughout the business in relation to exposures and record losses at a greater level of detail than would be the case with most mainstream insurers. The information acquired will help to identify weaknesses and trends. An increasing number of small incidents can, for example, highlight those areas where more significant losses could occur so that the problems are addressed.

In the early days of captive insurance, the direct market was opposed to the whole concept, seeing it as unwelcome competition. Reinsurers, by contrast, welcomed it. They avoided the expenses involved in frequent modest claims, yet they obtained a reasonable price for the more significant exposures, resulting in a mutually satisfactory arrangement. Over time, the direct insurance market realised the expense factor implications, and now an important role of the captive is to manage all incidents with a significant loss frequency. This allows them to collect information across all areas of the business, which in turn helps the wider risk management.

Among other advantages of using captives is that doing so can assist multinational companies whose overseas subsidiaries prefer to purchase local insurance because their executive bonus system is related to financial performance. The use of a captive smoothes the local results but retains the risk and the premium in the corporation as a whole.

Partly driven by market pricing considerations, some corporates have carried large self-insured deductibles for risks such as workers’compensation and product liability. The background information in these circumstances is retained in a number of specific areas of the business without the bigger picture being realised. This has created major problems with some disposals and merger and acquisition deals. Captive involvement significantly helps with these issues and retains funds within the business that can be used for financial or capital investment. Captives can also assist with greater certainty in the budgetary process.

Innovation and growth

The captive sector is among the most creative parts of insurance, with some very clever people working on new uses and better ways to bring business advantage.

One of the biggest developments has been the creation of protected/segregated cell companies. The management costs of these entities are significantly lower than for full-blown captives, opening them up to businesses and professional organisations that increasingly find themselves having to manage very large self-insured retentions in areas such as professional liability. A cell captive in these circumstances is a very useful facility and can be fiscally efficient.

Captives have come a long way, becoming increasingly professional and technical, driven by the changing needs of their owners and growing regulatory pressures. Expect them to become even more prevalent and wide-ranging in their applications as they confirm their place at the heart of integrated risk management strategy.

Alan Fleming chairs the captives group of the Association of Insurance and Risk Managers. Its website is: www.airmic.com