Business theory dictates that firms must be prepared to innovate or go out of business and the theory holds true for captives also, as Matthew Latham, head of captive programmes at XL Catlin explains.
What would you think of a financial services company that had not significantly changed how they used technology over the past 10 years? What about a fashion designer that was selling the same clothes as five years ago?
You might imagine that these companies would struggle to be successful. After all, technology has dramatically changed how companies create and distribute their products. A fashion house that didn’t look to change its designs continually would be obsolete within a year, let alone five years. Although in the insurance sector there’s much less speed of change, the evidence is all around us that innovation is increasingly necessary, if not essential.
Many captives were established in the 1980s and 1990s and the rationale for establishing them at that time may have been very different from now. So have owners significantly reviewed how they use their captives during that time?
Reviewing captive strategy
There have certainly been changes in captive retention levels and improvements in how decisions are made, but what about the risks that the captive insures, particularly new and emerging risks that may not have been as relevant when the captive was established?
Surveys indicate that captives are still heavily focused on property and casualty risks. But with a host of emerging risks on the horizon and with significant changes to how captives will be regulated and capitalised under Solvency II (or other enhanced solvency rules in offshore domiciles) there’s never been a better time for captive owners to review their arrangements.
"FOR THE BETTER-UNDERSTOOD RISKS SUCH AS CYBER AND EMPLOYEE BENEFITS IT IS ABOUT GETTING MANAGEMENT SUPPORT AND COLLECTING THE RIGHT DATA THAT GIVES CONFIDENCE THAT THE RISK IS UNDERSTOOD."
Key questions need to be asked when reviewing the captive strategy.
Is the captive writing risks that create a diversified portfolio that delivers capital efficiency? With increased running costs, is the captive sufficiently utilised to make it sustainable? Does the captive play a role in delivering the company’s strategy?
Diversification benefits and delivering value
A diversified captive portfolio offers stability and flexibility. Big insurers can offer economy of scale and lower premiums on standard line coverage, especially in soft markets. Not so for captives, which use a single premium pool to pay claims, and only deal with one bottom line. Therefore it is important that if claims are high in one line of business there is premium from other lines that will offset the financial impact.
Solvency II and other new solvency regimes are increasing the amount of capital that a captive is required to hold on an industry-wide basis. Writing just two lines of business will not deliver significant diversification benefits or capital efficiencies. Adding uncorrelated new lines of business will bring a better spread of risk and increase capital efficiency.
In the recent 2014 Federation of European Risk Management Associations (FERMA) Benchmarking Survey, risk managers said they were not satisfied with the level of mitigation for six of the top 10 risks “that keep their CEO awake at night”. How might it increase the profile and the value of the risk and insurance team if they could provide a solution for one of these risks by utilising a combination of captive capacity and excess capacity from the traditional market?
Adding new lines of business
This all contributes to an environment that is encouraging captives to consider writing new lines of business that they have not previously participated in. This could be for classes of business where there is market capacity, but captives have not frequently participated, like trade credit, environmental, cyber or employee benefits. More excitingly though it could be for emerging risks where there is no traditionally available cover, such as non-damage business interruption, cost overrun or long-term product warranties.
There is evidence that the benefits of adding new lines of business, particularly non-traditional risks, have been recognised by clients. Another finding that came from the 2014 FERMA benchmarking report was that the use of captives is continuing to grow. They found that 39 percent of the respondents who own or use a captive expect to use it more over the next two years.
This was even more emphatically underlined when XL Catlin surveyed UK risk managers attending the captive workshop at this year’s Airmic Conference in June. The survey highlighted that 21 percent of respondents had written new lines of business into their captives in the last two years. When the same people were asked if they were considering writing new lines in the next 18 months, a much higher 71 percent said they were thinking about adding new lines. The results also showed that 67 percent of respondents said that they would consider adding emerging risks, such as reputational damage, cost overrun, or weather-related risks in the captive. This is a clear signal for insurers and brokers to engage captive owners to help them provide innovative and valuable solutions.
Turning words into reality
It does highlight, however, that there is a big gap between those that are considering new lines and those that have actually included new lines in their captive. So what is holding people back? For the better-understood risks such as cyber and employee benefits it is about getting management support and collecting the right data that gives confidence that the risk is understood and properly priced. In the current soft market it may also be about securing the right discounts from the insurance market for the layer that will be written through the captive. In such a competitive market there is a danger that the premium saving is not sufficient to cover the exposure.
With emerging risks where there is no cover in the traditional market there are the same issues but some additional complexity. Does the data exist? Can the risk be clearly defined so the exposure is understood? Can risk and premium be quantified in order to support losses over time?
If those questions can be answered then manuscript policy wordings will also be required and consideration needs to be given to whether meaningful limits can be provided. If the exposure to the company runs into hundreds of millions and the captive can offer a limit of only a few million then does this make any impact?
It is likely that to get to meaningful limits reinsurance will be required from the insurance market. Given that these are risks that the market has not typically been able to provide solutions for, then this will require flexibility and a long-term commitment from insurers to partner with the client and its captive.
Typically underwriters like to underwrite a portfolio of business as this gives access to a bigger pool of data with more statistical significance, which should be a more reliable reflection of the risk. It also means there is a portfolio of premium to use when paying the losses of the few. Underwriters won’t get this comfort when first providing a solution to a new risk so this is why an insurer who takes a long-term view is required. Over time as better loss data is gathered and confidence grows in the risk profile, this support should pay dividends as underwriters will get to understand a new risk class which will give access to new premium income and they will be able to build a bigger portfolio and offer higher policy limits.
It’s not easy to underwrite new and emerging risks, but is it worth the considerable effort that is required? If it helps the parent to deliver its corporate goals then the answer has to be ‘yes’.
Imagine a printer manufacturer. Its strategy is to produce high-end machines, but it has a difficult time selling them when so many companies are cutting costs. Why buy a €1 million printer, when a €500,000 printer offers less quality but similar functionality? What if the first printer includes a five-year warranty, no exclusions, against repair costs and business interruption? It’s the kind of bespoke warranty that only a captive can supply, and it gives the manufacturer a competitive advantage, even against cheap producers.
Innovation was a key driver in the development of the first captive structure. As captive owners seek to address challenges and create value this is every bit as important today. The insurance market needs to be innovative and prove its relevance to the needs of corporations, particularly in the light of new and emerging risks. Owners of captives should not forget the role their captive can play.
Matthew Latham is head of captive programmes at XL Catlin. He can be contacted at: firstname.lastname@example.org
Matthew Latham, XL Catlin, Europe