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Like any other business sector, captives occasionally have to be sold or wound up. Stephanie Mocatta, CEO, and Tom Hodson, general counsel, SOBC Sandell offer five reasons for failure, and suggest some solutions.
Captives are a very valuable risk management tool used by thousands of companies. When successful, they provide excellent, comprehensive and dedicated insurance cover to sometimes unusual or difficult to rate business risk. But captives sometimes fail. Here are five reasons (mainly light-hearted) for such failures, with some suggested solutions.
- A ‘softening’ insurance market
This is one of the main reasons we are seeing for captives failing in the present climate. One of the primary, and very important, reasons for setting up a captive in the first place is to get value-for-money (generally thought of as cheaper) insurance coverage. Once the open market rates drop consistently below those that the captive would charge itself, the primary reason for the captive disappears.
There is a separate question here as to why an open market insurer believes it can consistently charge less than a captive, when the captive fully understands its own business, but that is a question for another day.
Under these circumstances, if the captive wants to continue, we believe it should take a long-term view. You know the saying “what goes up must come down”. Surely you know your business better than anyone and therefore the rates being charged by the open market are unsustainable? If you do change to external coverage, when (and it will be a ‘when’, not an ‘if’) the market hardens you will be caught with fluctuating and higher rates in the end. By keeping your captive going, you stabilise long-term cash flow.
- The captive ‘diversifies’
This is a less common reason nowadays, but in past years many captives looked to diversify—the classic move being to write London Market reinsurance during the 1990s and 2000s. This diversification, often pushed heavily by the brokers, led to captives writing outside their knowledge base and then, sometimes, receiving poor quality business that brought down the rest of the company.
This trend for diversification was (and sometimes still is) driven by the risk-based capital calculations that, incomprehensibly, give credit for a company writing business it knows nothing about.
A favourite phrase of ours in the run-off business is when a captive says “we are going to diversify into safe long-tail business to improve cash flow”—a recipe for disaster.
The easy solution here is: don’t do it. If ‘don’t’ is not an option, make sure you fully research any lines you are about to begin underwriting. Remember that brokers are not always your friends, and in the memorable words of an old Louisiana lawyer “do not let the sweet smell of the premium hide the stench of the claims”.
- Parent companies merge
This is a genuine set of circumstances where the captive simply becomes redundant. In times of mergers (and mega-mergers) large numbers of companies (eg, in manufacturing, IT, or services) can be amalgamated together and often each individual company had its own captive.
While the combined group may choose to maintain more than one captive—for instance one offshore and one onshore, or perhaps one for certain, more challenging risks alongside their main captive—there often are a number of captives that simply become dormant or unnecessary.
If you are in the position of having several captives, some of which are not needed, then consider:
- Merger, especially within one territory;
- Closure, particularly where the local laws allow finality (generally those with UK-based law, rather than US-based law); or
- Sale to a run-off specialist—this will be at a discount to net assets, but some good deals can be structured.
- The front company demands too much collateral
Where the business has to be fronted for various territories, states or types of coverage, there is (obviously) a front company. Some of these are highly professional, operate well and fully support and work with their captives.
Others, we have seen, are less so—this can range from overly aggressive pricing in terms of fronting costs, reinsurance agreements that are extremely one-sided and (the killer here) where they demand so much collateral based on the losses and the incurred but not reported (IBNR) claims that the captive becomes illiquid.
This means that the captive can no longer run itself properly, cannot pay claims promptly and professionally (sometimes leading to increase in both the claims themselves and claims costs) and ultimately it has to either raise more capital or fail.
Sadly, the only answer to this is not to be in those contracts in the first place. To quote another lawyer friend of ours, this one from the UK: “before you sign any contract, carefully study the ‘divorce’ clause”.
- The underlying business is rubbish
We have seen some captives, particularly those that are an amalgamation of several individual companies, where the good business of many of the members of the captive is completely overshadowed by very poor business of a minority of members.
The particular issue we have seen more than once is in captives whose business is spread across many states in the US. Each state has a different attitude, legal system and method of operating. Some well-known states make it much easier for claimants to co-join all possible parties, meaning that even where there isn’t, ultimately, any liability, the captive has to defend this position at great cost. Construction defect insurance is a classic example of this, where construction wrap-up policies can cause significant difficulties in certain states.
Another scenario is where a group, or business, simply cannot get coverage in the open market and decides to set up a captive to provide coverage. But, why is that coverage not available in the first place? Generally, it is because there is a significant flaw with the underlying business or risk.
Under these circumstances, it is important to understand why coverage is not available, look at the business as a whole and perhaps change practices and products, rather than continue with an essentially uninsurable risk. Forming a captive will not address any fundamental flaws.
A last bit of advice from us: as soon as you start to see something going wrong, act, and act decisively. It is much easier to put a captive back on the right path while there is premium flowing, liquidity and good will. And, if sale or closure is the chosen course, the sooner you do this, the more of your original investment you are likely to get back.
SOBC Sandell specialises in the purchase, management, consultancy for and purchase of legacy liabilities and distressed insurance entities, including captives. We like to get to them as soon as possible, so we can help turn them around and avoid future problems, including insolvency.
Stephanie Mocatta can be contacted at: firstname.lastname@example.org
Tom Hodson can be contacted at: email@example.com
SOBC Sandell, Stephanie Mocatta, Tom Hodson, Captives, Run-off, Risk management, Reinsurance, North America