Derek Bridgeman, Marsh
With insurance renewals becoming more challenging for brokers and risk managers, formalised risk retention can improve negotiating strength with commercial insurers and secure improvements in price, terms, and conditions, says Marsh’s Derek Bridgeman.
Throughout 2019, market conditions were described with terms such as harshening, transitioning, hardening, or state of flux. According to Marsh’s Q3 2019 Global Insurance Market Index, average commercial insurance pricing increased 8 percent in that quarter. It was the largest increase since the survey began in 2012, and the eighth consecutive quarter of average price increases.
As a result of these conditions, potential issues at renewal time now include policy exclusions, reduced capacity, higher deductible levels and premium increases. This is encouraging many to consider formalised risk retention.
“We believe it is vital that the OECD fully understands the commercial rationale as to why so many multinational companies use captives.”
Increased risk retention can strengthen overall risk management processes and improve loss experience. This contributes to a potentially more profitable and sustainable risk for both the insurer and insured. The expectation is that as brokers strive to provide value and options to the client, demand for alternative risk transfer (ART) offerings, including captives, will continue to increase.
In the past, captives have been required to generate a financial benefit if the risk manager is to sell the captive concept internally. In general, there appears to be a shift, with more and more captives being implemented and expanded to derive a strategic or operational value—sometimes with a view on long-term, rather than short-term, financial benefits.
Let’s take the example of a multinational group with a global property programme consisting of subsidiaries of varying size and tolerance who retain risk on their local P&Ls. Until now, manageable deductible levels have been available, so smaller entities have been protected from volatility.
We have seen instances where insurers are now imposing five-fold increases in deductible levels, leaving them in excess of the local unit’s risk tolerance. The captive provides a formalised and transparent mechanism to bridge the gap between local and group risk tolerance.
Although there may be an opportunity to capture underwriting profit currently leaked to the commercial market, the decision to retain risk in the captive is based primarily on the strategic value and the ability to insulate the local units from volatility.
For clients that have captives or are considering implementing one, our advice is to constantly challenge the status quo and strive for a more optimised insurance programme.
Areas to consider include:
Are there discounts available from the market for retaining a layer of risk?
Identifying the financially efficient level or layer involves pinpointing the “sweet spot”, ie, where the premium reduction will outweigh the cost of retaining the additional risk. There are other variables, naturally, such as whether these levels of retained risk fit within the group’s overall risk tolerance/appetite, but we feel it is essential that groups are aware of this sweet spot in any case.
In a more challenging market clients have more appetite to retain the predictable level of losses at the lower levels, so as to avoid dollar-swapping with the market. This removes the insurer profit margin which could be 30 to 40 percent in certain cases.
Is there sufficient capacity and coverage within the current commercial markets?
Where capacity and coverage are either insufficient or shrinking there may be value in exploring alternative markets. These include commercial reinsurance markets, insurance-linked securities (ILS) and index-based parametric markets, all of which provide an alternative, more sophisticated offering to clients.
We are certainly seeing increased interest in multi-line/year reinsurance offerings to provide aggregate protection across different and often uncorrelated lines of business within a captive programme. These allow the client to aggregate its risks and avail of a single reinsurance agreement, limiting its overall exposure to an amount aligned to risk appetite.
To date, captive ILS structures have been used to provide cat reinsurance for risks such as earthquake and windstorm events, primarily in the US and Asian markets. Capacity at these higher limits has certainly reduced within the Australian markets, for example, and the current wildfires will undoubtedly result in further challenges in obtaining sufficient property and business interruption coverage.
Should this capacity diminish as expected then it is logical to assume that there is an important role to play for alternative or structured reinsurance offerings such as ILS, parametric or index-based insurance solutions, which to date have been designed to complement, and not to replace, traditional insurance programmes.
Although these structures can quite often incur more time and cost at implementation, once the programme is set up then the renewal process should be straightforward. The guaranteed and timely settlement following an event, together with the ability to customise (ie, multi-line, multi-trigger), are obvious differentiators when compared to the traditional settlement process.
Can captives be used to cover uninsured or potentially uninsurable risks?
Trends are indicating utilisation of captives to insure “uninsurable” risks or risks which companies find so expensive to cover it makes no commercial sense but to self-insure.
Cyber captive programmes have increased substantially in recent years and this is likely due to various factors. Companies are facing more restrictive exclusions in respect of cyber coverage within their property and casualty insurance policies.
With cyber exposures generally increasing in recent years, coupled with a transitioning market, some insurers are seeking to limit or even remove cyber-related coverage outside their standalone policies. Risk managers are keen to explore the possibility of including such risk within the captive.
Again, this is an instance whereby the motivation for including the risk is more strategic than financial. Certainly, outside the US market it could be argued that there has been minimal opportunity to attain a financial benefit through retention of cyber risk to date.
Why are captive cyber programmes growing at such a rate? Risk managers are striving to understand their risk. The data collection and risk quantification exercises, in particular, should mean that clients are better prepared to retain significant risk should the markets dictate this going forward.
The expansion of cryptocurrencies and tokenised assets adds a further level of complexity to the emerging technology, cyber, and financial risks that companies must manage daily. We have worked with a number of financial institutions with cryptocurrency and other tokenised asset risks, where the commercial insurance coverage available contains too many exclusions or gaps within the cover and the market price is simply unaffordable. These clients are being left with no viable option other than self-insurance.
The captive’s ability to provide a formalised funding vehicle with ability to prove this insurance to customers and third parties is a key driver. Other important considerations are the ability to tailor the policy coverage and access specialty reinsurance.
Similar to the way supply chain-type risks were included within captive programmes post 9/11 due to a lack of commercial alternatives, it is likely the captives will continue to implement, evolve and diversify, so as to provide a mechanism to insure these so-called “uninsurable” risks.
The captive will provide an ability to incubate the risk until such time as risk transfer is available, and to allow access to capacity in non-traditional markets.
Could changes in regulation impact the way captives are structured and operate?
Many within the industry reacted with apprehension with the introduction of the OECD’s base erosion and profit shifting (BEPS) recommendations. It has certainly resulted in an increased focus on the captive insurance arrangements from group internal tax departments and, more recently, national tax authorities.
Captive owners are being challenged to demonstrate the economic rationale, together with the appropriateness of the substance and governance and transfer pricing arrangements. Many have undertaken detailed reviews in these areas, resulting in an increased confidence around the value and robustness of the captive.
We believe it is vital that the OECD fully understands the commercial rationale as to why so many multinational companies use captives. We are engaging with risk management and industry groups to help educate the OECD through dialogue and thus assist with the creation of guidelines for national tax authorities with respect to captive insurance arrangements.
By doing this we aim to deliver a more proportionate and consistent implementation of BEPS for captives.
Once clients have confirmed that the captive provides value and is structured correctly, the logical next step is to consider how use of the captive might increase.
Many of these captives have built up capital reserves over the years, reserves which are deriving little or no investment return. This gives them an opportunity to use this capital to diversify, expand and optimise their overall insurance programmes.
Multinational groups’ enterprise risk management (ERM) is increasing in sophistication, which continues to drive the evolution of the market offerings available. Risk managers desire flexibility and options in order to demonstrate to the market their commitment and confidence in their ERM structures, as well as presenting an alternative to traditional insurance.
All indications are that ART and captive structures, as they have done historically, will play a prominent role.
Derek Bridgeman is a senior vice president at Marsh Captive Solutions. He can be contacted at: firstname.lastname@example.org
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