5 March 2024Analysis

Captives continue to evolve

Dan Teclaw of AM Best looks at the continued evolution of the captive insurance market over the past quarter of a century.

"The operating performance of rated captives has readily surpassed that of their commercial market peers." Dan Teclaw

The captive insurance segment was created to address periodic availability and affordability crises for certain risks. Captives evolved over time from a simple single parent structure to more complex entities with multiple owners that want to share best practices in loss-sharing and risk management to the economic benefit of policyholders and shareholders alike.

Each structure is unique in its stakeholders, policyholders and the risks they underwrite and how they approach doing so. Their commonality, however, is that they all function as risk transfer vehicles for the policyholders.

Over the past 25 years, AM Best’s rating activity for the captive insurance segment globally has increased in parallel (and, therefore, with periodic surges) with higher usage of existing captives and new formations addressing various insurance segment difficulties for commercial entities requiring coverage.

We have seen surges in formations in the past addressing a medical professional liability (MPL) crisis, commercial auto liability issues and the more recent hard market since 2018 from weather-driven catastrophe coverage issues. This current hard market has encompassed many traditional commercial lines but also came to include cyber and pandemic-related coverages.

AM Best has significant experience in rating many of these structures that run the gamut from large single parent structures that have significant surplus size to cover low frequency, high severity risks, to risk retention group (RRGs) and exchanges comprising small like-minded enterprises, seeking professional insurance risk management and loss control for more affordable risk-sharing. Our ratings activity has grown to include approximately 250 captives globally, which are domiciled in many US individual states, as well as in Europe, the Caribbean (Bermuda, Cayman Islands, Barbados), and Asian domiciles. AM Best’s rating universe includes single parent captives from many different industry types; group captives either in the same industry with similar risks or similar sizes seeking general capacity limits; RRGs from a single industry; and cell captives, which may or may not pool risks.

We have seen formations grow globally with competition among domiciles seeking to draw captives to their regions as industries for their local economies. Various domiciles are tweaking their statutes or regimes to authorise specific captive regulatory environments. Tweaks include capitalisation requirements, licensing, business plan approvals, and permission of certain type cell structures or arrangements.

In the US, we have seen modifications to permit captives to include certain lines such as directors and officers, consideration of an amount of property insurance in RRGs, and permission of specific cell structures. The Canadian province of Alberta has expanded its captive insurance regulatory environment, while France, Italy, and the UK are considering ways to enhance their attractiveness as domiciles for captives.

Knowing the risk

Hard market difficulties drive innovation in captive structures as a check and a balance on traditional market pricing and a means to prudently and responsibly share similar type risks for similar type policyholders. AM Best has recognised that captive owners typically know their own risks better than a generic commercial market policy would cover, affording them the coverage (risk transfer) they need or desire at an actuarially based rate and an objective incentive to efficiently manage their claims as they arise.

A good handle on claims frequency or severity can enable them to save dollars for their respective enterprises that would have gone to the commercial market. Instead, while at least temporarily remaining as capital, the savings can eventually be returned to the owner(s) in the form of stockholder dividends or policyholder dividends.

The savings can be substantial. In our 2023 report on US captives, we found that from 2018 to 2022, our rated companies increased their capital surplus positions by $4.1 billion and returned $5.3 billion in stockholder and policyholder dividends, a $9.4 billion saving that would have gone to the commercial market.

The innovation in structures expanding from single parent to group captives/RRGs and cells has enabled smaller companies to cover unique type risks in a more efficient fashion. Single parent captives often offer fairly high limits against substantial capital bases for their parent/enterprise’s low frequency, high severity exposure risks in property, business interruption, and, more recently, some portion of cyber exposure. When they feel commercial market or reinsurance pricing is not economical, they may plug small portions of their own catastrophe towers temporarily.

Additionally, one of the fastest-growing insurance products offered by this segment is group medical stop-loss coverage due to rising healthcare costs. RRGs may offer reinsured lower limits on top of their own small retentions in order to provide a working layer for some lines of business characterised by higher frequency issues.

The group captives AM Best rates comprise small to medium-sized enterprises (SMEs), colleges and universities, trucking groups and medical professional/doctor groups. These industries are more prone to claims having higher severities due to social inflation components in jury verdicts, especially in MPL and commercial auto liability claims. Colleges and universities face myriad social risks from sexual molestation, pandemic-related claims, traumatic brain injuries in athletics, law enforcement, and many others. Some of these going to jury trials are subject to the recently-added risk of claimants’ litigation finance.

Finally, we have seen several cell company formations or platform expansions as smaller companies can benefit from third party captive managers (ie, insurance professionals) in managing their own unique risks affordably. A recent challenge for small cells has been the rigorous Internal Revenue Service oversight of 831(b) microcaptives to ensure they can demonstrate suitable risk transfer as an insurance transaction.

AM Best has found that the operating performance of rated captives has readily surpassed that of their commercial market peers. Their inherent flexibility and control in managing risk drives profitability and retained earnings, while creating value for their policyholders and stakeholders, regardless of market conditions.

Risk-based capitalisation among the single parent captives is generally excellent, while that of groups is very strong as they seek to be much more capitally efficient. Use of these structures has increased over the past five years for traditional property-catastrophe and other newer risks described above and we expect that to continue for the near to medium term.

Dan Teclaw is a director at AM Best. He can be contacted at: