Creative uses for captives in a hard market

The global insurance and reinsurance market has been battered over the last 18 months by a series of events that have caused it to recalibrate its risk tolerance appetite and pricing outlook. We firmly believe that captives and their parents should see this as an opportunity to do the same.

The headwinds in the global re/insurance market were clear over a year ago. In a survey we undertook in June 2019, 90 percent of our respondents at that time, which included underwriters, brokers and risk managers, concluded that premium rates would increase for businesses that had enjoyed a loss-free record; 60 percent also expected to see deductibles increase or come under severe pressure (Table 1).

Table 1: Expectations of re/insurance market in 2019

Source: RISCS market survey June 2019

These dynamics have driven the reintroduction of two tried and tested captive approaches:

Cross-class aggregate stop loss reinsurance programmes: the portfolio approach

It is a given that captives offer their parents flexible solutions to manage the impacts of a changing market. What is perhaps not so clearly understood is how captives can ensure that their reinsurance protection is purchased in the most efficient manner.

At this stage of the market cycle, we expect captives to be put to work as hard as they can to:

Following the above approach will of course increase a captive’s gross retention. It is here that a carefully structured portfolio reinsurance programme can reduce the financial impact of such a changed captive structure.

Traditional insurance companies have used portfolio reinsurance structures for many years to bring overall pricing stability and loss quantum certainty to their underwriting activities. Captives can and should look to benefit from the same capacity structures to support their growing underwriting operations.

Cross-class aggregate stop loss reinsurance programmes: example

Table 2: Example of a client’s expiring and renewal programme

The expiring captive programme benefited from the excess markets’ dropping down to replace the captive’s per-occurrence retentions on exhaustion of the captive’s annual aggregate retentions. The renewal structure removes the excess market drop-down and therefore these markets now attach their capacity excess of unaggregated captive retentions, which along with the increased captive per-occurrence retentions enables these excess insurers to offer a lower renewal premium as their risk has been reduced accordingly.

All well and good—except, of course, that the captive has increased its retention from £2 million annual aggregate to an unaggregated position in return for the reduced renewal premium of £5.5 million, down from £7 million. This will be too rich a proposition for most, if not all captives, hence the need for a tailored portfolio captive reinsurance programme to cap the captive’s overall net retention to an acceptable level.

To achieve this, the captive purchases a multi-line stop loss reinsurance programme to kick in after the captive has incurred £2 million of losses—thereby bringing the captive net annual aggregate retention back to the same level as in the expiring programme.

The £2 million attachment point for the multi-line stop loss reinsurance programme can be eroded only by the individual captive per-occurrence retentions of £500,000 (liability) and £500,000 (property) so there is no way ever that the multi-line stop loss reinsurance programme could be called to pay the first loss.

The captive would have to have four total losses before the stop loss programme is called on to pay and then only for any subsequent losses.

The captive buys as much reinsurance limit as is available for 65 percent of the £1.5 million saving, so perhaps an aggregate stop loss limit of £7.5 million. The remaining 35 percent of the premium (£525,000) remains in the captive to (a) cover the captive’s increased per occurrence limits; and (b) build more of a financial fighting fund to cover unexpected further instabilities in the traditional excess market at next year’s renewal.

Were the £10 million aggregate reinsurance limit to be exhausted then any future losses would revert to the captive, but this is unlikely to happen given this captive has never experienced losses greater than £150,000 per claim, and never more than £1.5 million annual aggregate.

Table 3: Benefits and considerations of cross class aggregate stop loss reinsurance programmes

Producer-owned insurance/reinsurance captives

A producer-owned insurance company (POIC) can also be referred to as a producer’s own reinsurance company (PORC), or simply a direct writer – all these options are referred to as POIC below. A POIC is a third-party insurance company owned by an insurance agent or broker that insures only the risks of policies that are placed by, or through, such agency or brokerage.

A POIC differs from a traditional captive in that it is not owned by the party or parties to which it issues cover, but a POIC brings the agency or brokerage similar advantages. As a direct writer, the POIC receives a share of the premiums written and is obliged to pay its share of claims.

There is a growing trend amongst the broking community in establishing their own vehicles to manage the risks of their client base. Many brokers already have their own managing general agents (MGAs) or managing general underwriters (MGUs), so taking the next step of establishing their own offshore insurer (whether a captive, cell or even their own cell company), is a natural progression.

We have also seen (and assisted in establishing) the trend for Lloyd’s syndicates in setting up these structures in order to allow them to offer non-admitted policies to their client base, such as political violence, kidnap and ransom, or trade credit.

For a broker or agency, the POIC structure allows them to provide direct capacity support to their MGA/broking business in serving the needs of their clients. The POIC also allows them to interact directly with the reinsurance market, as the POIC acts as the regulated and licensed direct writer.

POICs have demonstrated a range of significant advantages that can be gained by brokers/agencies:

Will Asia be the next growth engine?

The 6,500 captives that make up the global captive insurance market wrote global premiums of circa $150 billion in 2018, and had assets under management of circa $256 billion. Captives have always demonstrated that they have a key role to play in the world of traditional insurance, but especially in times of catastrophic loss and subsequent economic downturn.

If we cast our minds back, whether it be to post-Katrina, Rita, Wilma in 2005, 9/11, or even further back to the 1980s global liability insurance crisis, captives have repeatedly shown their resilience, stepping up to bring cover and pricing stability to their parents.

The use of captives in Asia has not been as pronounced as elsewhere in the world but currently we are seeing increased demand for new captives and for more creative uses of existing captives from this region.

As cover contracts, retentions and premium rates increase, and capacity dwindles, Asian buyers are pushing ahead with a clear captive insurance agenda designed to protect themselves from market instabilities and to drive the best risk transfer price they can. We expect a significant growth of captives in the Asian region accordingly and the leading regulators in the region have embarked on a charm offensive to position their domiciles as leading destinations for Asian and non-Asian parents looking to establish a captive vehicle.

The future for captives

2020 will prove yet again, and perhaps more convincingly than in any previous market crisis, that using a captive creatively will bring stability and certainty to corporate insureds in a hard market.

At RISCS, we firmly believe that this current market, along with the expected market reaction to the severity of COVID-19 claims, presents another golden opportunity for businesses to make more use of their existing captives, or indeed to establish a captive for the first time.

Oliver Schofield is managing partner at captive insurance consultancy RISCS. He can be contacted at: oliver.schofield@riscs.org

Damian McNamara is a partner at RISCS. He can be contacted at: damian.mcnamara@riscs.org