Adapting risk strategies to cope with COVID-19

As insurance companies and insurance purchasers were preparing to do business for 2020, it was widely expected that there would be material rate increases, particularly for liability lines of coverage. Buyers and sellers alike could simply look back to the past few years to get an indication of market trends. Rates for property coverage have been increasing for at least the past couple of years, primarily due to the number of, and costs related to, natural catastrophes.

For liability lines, the severity of claims has continued to rise, so it seemed inevitable that the cost of the related coverages would also increase. These conditions would suggest that 2020 would be a strong year for captive formations and the growth of existing captives, as organisations look to a captive insurance solution as a way to potentially manage and/or smooth their cost of risk.

Four months into 2020, the world looks very different. Captive formations are still moving ahead, but at a seemingly slower pace. Out of necessity, would-be captive owners are spending their time navigating risk, rather than seeking out risk financing alternatives. The COVID-19 pandemic has impacted virtually every individual and business in some significant way. Neither the traditional market nor the alternative risk financing markets have been immune to the impact.

As organisations struggle with their own business interruption, many will be turning to their commercial insurance policies for assistance, expecting—or perhaps hoping—that the policy they purchased will provide the coverage they so desperately need. In some cases, the coverage will be there, and will provide at least some level of assistance. For many others, it won’t be, likely because the policy contained an exclusion specific to losses sustained as a result of a pandemic. The debate about ambiguous policy language will be conducted in the court of public opinion and the traditional court systems through costly litigation in coming years. But is there another option?

Insurers could decide to pay the claims, even if it appears they have a defensible position in declining coverage. Unfortunately, it may not be that simple. Before an insurance company can decide if it will pay pandemic-related claims in situations where there is likely to be no coverage, it must also consider the position their reinsurer(s) will take. The reinsurance agreements probably follow the same policy form, meaning the reinsurance agreements are likely to have the same exclusions. Will the reinsurer be as willing to reimburse the primary insurer for paid losses that did not have to be paid under the terms of the policy?

Let’s consider an extreme example involving a full limits claim. An insurer could wind up with a larger financial payout than it ever intended to make. First, it may not have the reinsurance protection it originally sought to limit its exposure and, since it has already paid a premium to the reinsurer, it has less funds available related to the exposure from which to pay the claim. Another option could see the insurer working with its insured and paying some percentage of a claim, perhaps even up to the attachment point of the reinsurer. In other words, it is an extremely complicated issue.

Implications for captives

There is a little more clarity in the captives market. While 2020 may still see its fair share of captive formations, we should consider the potential impact of COVID-19 on captives formed prior to 2020, many of which are already seeing COVID-19 related claims, for which they may not be prepared.

It is sometimes said that captives—excluding micro captives—are better off retaining predictable risk and transferring unpredictable risk. Pandemic constitutes an unpredictable risk. Perhaps a good way to think about the current pandemic, as widespread as it is, is as a 1-in-a-100-year storm. These events are by definition low frequency, and typically high severity. Such risks are not necessarily an ideal coverage for a captive to insure. The premiums for such low frequency events are likely to be relatively small, and a captive that is writing such coverage would be wise to consider purchasing reinsurance to limit its exposure.

It seems logical that companies with an already established captive would be in a better position to find some insurance coverage. That may or may not be the case. One of the most highly touted benefits of owning and operating a captive is the ability to craft policy language that best suits the needs of the insured: to fill in the holes in coverage the traditional market either doesn’t want, or will take but only at seemingly prohibitive cost. With policy language written broadly enough, a captive could certainly respond in a pandemic situation, providing some coverage, up to policy limits, where needed.

However, just like the traditional insurer, the captive may have to contend with a reinsurer that does not share its view of a covered loss. The captive could choose to pay up to policy limits on a claim, but if its reinsurer denies coverage, the balance sheet of the captive could be impacted. For a less mature captive, a sizeable claim will have a much more significant impact on its financials. Regardless, it becomes clear that proper up-front planning can help eliminate some of the uncertainty. It is vitally important that coverage issues between a captive and its reinsurer are thoroughly considered, understood, and agreed upon, prior to policy issuance—not after a loss occurs.

There may be some additional benefits of having an existing captive in place during this pandemic. For example, captives could see underwriting gains in other lines of coverage as a direct result of the pandemic. Claims in auto liability could be lower due to a combination of fewer miles driven, or fewer other vehicles on the road. Captives would benefit from the reduced claims without having to return premiums.

Also, in situations where a captive has been operating for a number of years and has been able to build up a significant amount of surplus, it is possible that the captive could be available to provide a loan to the parent company. Another source of capital could be extremely helpful during a period when company operations have been significantly impacted. Certainly any discussion regarding a loan to the parent should involve the captive regulator. The primary concern of a regulator is ensuring the captive remains financially viable to pay claims. Regulators are undoubtedly going to take a hard look at any captive and the parent before they allow a loan back to the parent company.

The impact on micro captives

Let’s shift gears and consider the impact a pandemic might have on a micro captive, or enterprise risk captive. Many enterprise risk captives insure a variety of esoteric coverages in addition to, or instead of, some of the more traditional insurance coverages, such as general liability, auto liability and workers’ compensation.

Captives often write from several to many coverages, which could include business interruption, loss of key customer, supply chain, political risk, and others that respond to an unexpected loss of profits. The premium for each of these coverages is typically small, particularly as compared with the policy limits, and may include some type of risk margin, recognising that there is significant uncertainty in trying to derive rates for these coverages. Collectively, the premiums must be no greater than $2.3 million for a single captive to qualify for favourable tax treatment.

Many enterprise risk captives also participate in risk pools with other enterprise risk captives, where a portion of the risk is shared by up to several hundred enterprise risk captives. A typical structure for a risk pool might be a 50 percent quota share agreement between the captive and the risk pool on a first dollar basis. In this example, a participating captive will retain 50 percent of its risk, with the remaining 50 percent being shared among the other pool members.

Any losses a captive assumes back from the pool consist of losses from a broad array of pool members. The losses received from the pool are typically determined using a quota share allocation percentage, usually based on premium. This allows the captive to meet some generally accepted threshold with regard to risk distribution, thus granting it a certain tax treatment. Conceptually, the structure provides for risk distribution and works well within the overall concept of insurance, whereby the many pay for the losses of the few or the one.

The underlying premise here is that the exposures are all independent, and the likelihood of multiple participating members having a full limits claim in the same year is almost zero. However, given the impact of a pandemic across such a high percentage of businesses, these risk pools could see an unexpected amount of claim activity. In an extreme example, if each member of the risk pool has the same premium and policy limit, and each submits a full limits claim, each participating member will be responsible for an amount equal to a full limits claim based on the quota share agreement. The question now becomes, how will the risk pool and the participating captives respond?

For a risk pool that has been in operation for a number of years, it is possible that claim activity has been consistently low due to the nature of the coverages, resulting in significant underwriting gains over that time. The underwriting profits from those prior years, if retained as surplus, could be used to address the volume of full limit pandemic-related claims. However, for a newly formed risk pool, or a newly formed captive entering a mature risk pool, this could prove to be catastrophic. At best, the risk pool and the participating captives are in a much weaker financial position; at worst, some or all of the participating captives could be insolvent.

Thinking about two notional identical risk pools, one mature and one new, both risk pools were set up similarly but one is better positioned to respond, simply because it started writing business a few years before the other. They say timing is everything, and that is certainly the case in these examples. The timing of the pandemic and the timing of when the captive began operations can both play a role in a captive’s success.

As companies look to form captives in 2020 and beyond, and their risk managers consider what coverages to insure in their captive and how much risk to retain, the impact of the COVID-19 pandemic has demonstrated the need to take the analysis a bit further. Organisations need to also think about “what could happen?” and “how will my captive respond in those circumstances?”. When doing so, it can be helpful to look at the successes and failures of those who went before.

It seems reasonable to think that once the dust settles, the COVID-19 pandemic will serve as a learning experience for all of us. It will be important that we take advantage of this knowledge and from it, create opportunity. You can’t plan for every possible scenario. Things happen and sometimes companies fall victim to bad timing and bad luck, but it helps to be as prepared as possible.

The 1-in-a-100-year event occurs approximately every 100 years. The question then becomes, is next year THE year?

Mike Meehan is a consultant at Milliman. He can be contacted at: mike.meehan@milliman.com and  captives@milliman.com