Need to know: understanding the benefits of captives

Buying reinsurance is like building a house, brick by brick. The first brick sits on top of any self-insured retention and you keep buying bricks until you tower up to the total limits you’re looking for. But, the hardening market has made building a reinsurance tower a much more difficult affair.

The last renewals were tough—with reinsurers reluctant to deploy capital, we’ve had to fill layers and gaps in the University of California’s (UC) reinsurance tower with our captive insurance companies.

“As a general rule universities are risk-averse, and some regard setting up a captive as being risky. To me, this is very unfortunate as the benefits of risk financing via captive insurance companies is so very clear.” Courtney Claflin, University of California

This is probably not going to change in the next few years. There are no indications that the reinsurance market will recover that quickly from expected cat events coupled with the aftermath of the COVID-19 pandemic. And now, after being hit with COVID-19 losses, the industry will have to face the repercussions of the March 2021 Suez Canal blockage and its impact on the supply chain. And all of this just before what is being predicted as an active hurricane season.

This all means that, as a captive insurance platform, we have to continue to step up and provide cover and risk financing solutions to our parent.

A new idea

Once reinsurers have taken coverage away from you, it can be very difficult to get back to the types of limits or direct coverages you’re used to. With that in mind, we’re considering taking these excluded lines of coverage and forming a cell captive that can segregate these exposures and provide their own dedicated limits.

These particular liabilities are seen as volatile (eg, cat losses) so instead of having them blended with a balance of risks in another captive, we can house them elsewhere. Housing them separately also means we can undertake research and discover different ways of financing the risk from a premium, coverage/capital standpoint.

We’ve put together a blueprint but we’re still very much in the discovery stage right now. As we’d have to prepare for a claim happening tomorrow, the captive would take a very unique structure, in which there’s a large premium payment upfront, followed by very small incremental yearly payments. This allows the captive to immediately fund for a worst case scenario up front, while maintaining limits long term in the event the claim does not occur immediately.

From my perspective as the architect of this project, it’s extremely rewarding and satisfying. One of the reasons you form a captive is to help the parent company during hard times by building up surpluses and providing coverages that would normally either go to insurers or be excluded entirely, and that’s exactly what we’re doing.

Where we can, we issue direct captive (no reinsurance backstop) policies to UC with substantial limits. We provide direct coverage and provide rate stabilisation to our 10 campuses and five medical centres, absorbing the big actuarial and reinsurance rate increases.

Popularity and risk

April 2021 marked my sixth year at UC’s captive insurance programme and it’s come a long way. When I started, we had one company with around $18 million of assets. Now, we have five companies with $2 billion assets, and a potential sixth on the way. Back in 2015, we had one line of coverage, now we have around 45 to 50 lines. Having a supportive boss and board of directors has been critical to this growth as they are as excited as I am to constantly look for more efficient ways to finance our organisational risks.

However, captives have not proved as popular with other university systems, which I am rather perplexed by. I’ve talked to many university systems around the country about forming captives, but they haven’t yet made the jump.

As a general rule universities are risk-averse, and some regard setting up a captive as being risky. To me, this is very unfortunate as the benefits of risk financing via captive insurance companies is so very clear.

I try to teach that it is the same risk, the same premium, and the same self-insured retentions as any non-captive risk financing arrangement. But, by utilising an insurance company construct to finance the risk, we are realising many financial efficiencies only available if you have (captive) insurance company status.

When speaking on a cyber panel at the Vermont Captive Insurance Association annual conference a few years ago, I talked through some of things we were doing at UC. Someone in the audience asked “isn’t it financially irresponsible to take on emerging risk like Cyber where it could be so volatile?”.

The problem is sometimes what you think is happening in the captive insurance process is not really what is actually happening. At the time, we had a $5 million retention on cyber so all I was doing was buying reinsurance for the captive, at a wholesale price point, that attached to the same $5 million self-insured retention. We also enjoy more capacity (limits) and earn interest income on premiums paid to the captive set aside for actuarially derived expected claims. In the aggregate, we finance the same risk through the captive but save 7-10 percent net due to these captive advantages.

I’m not taking on any more risk, I’m just financing the risk more efficiently. It’s a misunderstanding that captives provide all the coverage and take all the risk—captives write all the policies to their parents but in most instances they buy reinsurance for claims in excess of the self-insured retentions.

An education

However, the captive insurance industry and insurance brokers are getting much better at communicating and educating on the relative simplicity of these arrangements, instead of making them seem more complicated than they are.

Currently, in this hardening market, every captive manager will tell you they’re busier than they’ve ever been. From a broker standpoint, we’re seeing a lot of activity to support captive insurance operations, from formation to growth.

I’ve been in the captive industry since 1998 and the insurance industry since 1984, there wasn’t a lot of captive specific information out there at the time, but it’s a completely different story now. Associations, consulting firms and brokers are doing a great job of publicising the benefits of captives and so many more consumers are now going down the captive route.

One of the biggest obstructions to growth in the past was the brokers themselves. They would look at captives as something they didn’t know anything about and think that if a client decided to form a captive or participate in a group captive, they would lose revenue or worse yet, their client.

A lot of that broker resistance is gone now. These days, any broker who tries to throw out the standard captive myths that brokers used to to fight against captives, they will expose themselves to potentially losing their client.

Hard markets make consumers look for alternatives and captives are a wonderful risk-financing mechanism. Properly done, they can provide tremendous benefits to organisations. I just hope more companies, and in particular university systems, continue to explore captives and the financial efficiencies they can deliver back to the parent organisation.

Courtney Claflin is executive director of captive programmes at the University of California. He can be contacted at:  courtney.claflin@ucop.edu