One of the key benefits of owning a captive is the ability to access the reinsurance market as a viable alternative to the commercial insurance market. But relationships are crucial, and new captives must make a clear business case to ensure the reinsurance market is supportive, says Michael Douglas of Aon.
A captive can underwrite almost every line of business that is available from the retail commercial market. Captives are also used to provide specialised coverage for unusual or hard-to-place insurance risks. These non-traditional risks may be mitigated by working with the reinsurance markets that have a broader appetite for such risks when compared to the retail insurers.
“A well-researched business plan for the captive with solid actuarial loss projections, robust capital and realistic premium growth forecasts, is essential.”
As a result, a partnership between captives and reinsurers has developed where unusual risks are insured in a captive, while being supported in large part by the reinsurance industry. A good example of this is the way that insurance for cyber risks has developed.
Initially, cyber was an emerging risk that was excluded by underwriters to such an extent that in many cases self-insurance became the only solution. Captives provided a viable risk-financing solution as well as the ability to incubate the risk. As the risk developed and became better understood, capacity developed initially in the reinsurance market which captives were able to access in a way that non-captive owning corporates were not.
As the insurance marketplace continues to firm, captives are being created and adapted to be the first response for corporates. All forms of organisations are now turning to captives to be the “underwriter of choice” for an increasing range of traditional and non-traditional risks.
However, captives cannot respond to all of these new and developing risks in a vacuum. The need remains for the partnership with reinsurers that has been developed over the last five decades.
Back to the future
According to the Council of Insurance Agents and Brokers, US primary rates have continued to increase during the second quarter of 2019. On average US property, general liability and umbrella premiums increased 8.9 percent, 3.6 percent, and 6.5 percent, respectively, compared to 6.1 percent, 2.1 percent and 3.5 percent in the first quarter of 2019. These premium rate increases are a result of years of losses and the impact they have had on insurer’s balance sheets.
Similar to the commercial insurance market, the reinsurance market has had its fair share of large losses to deal with. As reported in the September 2019 edition of Aon’s Reinsurance Market Outlook, the five costliest years since 1980 for the insurance and reinsurance industry were 2005, 2011, 2012, 2017 and 2018.
However, other than for a short-lived decline in reported capital in the fourth quarter of 2018, the reinsurance market continues to attract capital and has rebounded to a new high of over $610 billion of capital as at the end of the first half of 2019. Reported profits for reinsurers are strengthening.
Not all rainbows and unicorns
The increased confidence in the reinsurance market comes with pros and cons, as reinsurers seek to maintain underwriting discipline and to stick to core lines of risk business.
Existing and well-established captives with a long track record of success are being courted, and supported by, the reinsurance markets. Traditional lines of workers’ compensation, general liability, and (non-catastrophic) property risks, which have been reinsured for years, have given the reinsurers a good understanding of the way that established captives operate.
When such an established captive expands its portfolio to new or unusual risks and seeks support from its reinsurance partners, it can rely on its good track record to at least get the attention of the reinsurers for a discussion and, most likely, a quotation.
Do the maths—and start the conversation early
For new captives, or captives entering a new line of cover, the firming market conditions require more emphasis to support the business case for reinsurance. This translates to an increased investment of time and effort to justify the underlying reasons for using a captive as opposed to the open market or self-insurance.
When first considering the formation of a new captive or a new line for an existing captive, the decision of whether to buy reinsurance is a fundamental question for the captive owner to explore. The firming market means that the time available from reinsurance underwriters to review and understand the need for their capacity might be low, and the competing pressures to maintain underwriting discipline are high. This is especially true for new captives that have no track record.
To succeed in gaining the attention and support of the reinsurance markets, captive owners and their advisors need to understand and work within the constraints of their potential reinsurance partners. A well-researched business plan for the captive with solid actuarial loss projections, robust capital and realistic premium growth forecasts, is essential. Also essential is the way this information is presented.
A succinct executive summary of the business case and the supporting arithmetic should be used for the opening conversations. This can be supported by a full-blown feasibility study and actuarial report later, but the initial conversation and presentation must make sense to the underwriter.
Timing is an important part of the process. It is better to engage with the reinsurance markets early during the planning stage for a new captive or a new line of business to gauge their level of support. This will allow the captive owner to know what pitfalls to avoid and how to structure the captive programme to present it in the best possible light.
Early engagement also allows the reinsurer to provide guidance and advice on such matters as its preference for retention levels for the captive, minimum capital requirements and risk control measures to be instituted.
Few decisions regarding the use of a captive are more important than the structure, quality and collectability of a captive’s reinsurance programme. In a firming insurance market, our reinsurance partners are facing challenges of their own to maintain underwriting discipline and to increase rates and returns. A well thought-out reinsurance strategy that provides stability for the captive and instils confidence in the quality of the risk for the reinsurer is the ultimate objective.
This will mean that captives owners and their advisors will need to take the extra steps needed as part of a captive feasibility or utilisation review process to demonstrate that the captive programme being presented has been fully vetted and is sound from regulatory, accounting, tax, legal and actuarial points of view.
The extra time taken early in the process to engage with reinsurance partners and help them to understand the business case for the placement will be worth it. It may take some added time to prepare the additional information for a good submission, but the investment will go a long way to improving the way the new captive or new line of business is received by the reinsurance markets.
Michael Douglas is director of business development at Aon. He can be contacted at: firstname.lastname@example.org
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