Driving profits for captives
Captives continue to be one of the most popular risk-financing techniques used by organisations of all sizes and across all industries to self-insure risk. The number of captives operating globally has risen dramatically over a 20-year period, suggesting this growth transcends insurance market cycles.
The reasons businesses start captives have hardly changed in this time, and include:
- Increased programme control;
- Access to coverage not available or cost-prohibitive in the traditional market;
- Lower total overall cost of risk long-term; and
- Access to the reinsurance market.
“The relationship each party has with the captive owner should be reviewed in depth to determine whether entering an insurance agreement would be beneficial to each party.”
Captives as a profit centre
As established captives continued to mature, parent companies often seek new or expanded coverages to further utilise and optimise this valuable risk management tool. According to the most recent captive market study produced by the Captive Insurance Companies Association, using the captive as a profit centre for the parent organisation is one of the top five operational or strategic values a captive brings to its organisation (Figure 1).
But how can a regulated insurance company that was established primarily to finance the self-insured risk of the parent properly transform into a revenue generator?
Many captives are created to take on affiliated party risk, thereby generating underwriting income for the parent company. If this is not the case, a business plan change presented to the domicile regulator is necessary in order to allow the captive to begin underwriting the risk of third parties.
The maths is simple and does not change from the overall premise of writing first-party risk:
(centre) Premium – losses – expenses = Underwriting profit (revenue)
Anything that the captive insures by way of collecting premium that it does not pay out in losses drops to the bottom line as underwriting profit. By electing to insure the risks of uncontrolled third parties, the ultimate parent company will recognise this profit over and above any recaptured revenue generated by first party coverages.
This is true for pure single parent captives and groups, including risk retention groups (RRGs). In a group, a single member will often recognise any unused underwriting revenue as profit for its specific loss account, as well as receive a quota share percentage of the overall group’s performance by way of dividend. For a pure single parent captive to recognise any profit outside of its own loss performance, it must extend coverage to third party risk.
Exploring third party risk
When a captive owner is looking to expand coverages to third parties, particular attention must be paid to whom the coverage will be offered, the relationship between the parent company and the new insured, and what level of risk the captive is comfortable retaining from said third party.
Groups and RRGs are already built upon a foundation of risk-sharing among unrelated parties and have more constraints than a pure single parent captive when it comes to offering additional coverages.
The initial phase of evaluating third party coverages in a captive starts with identifying the sources and benefits associated with the change (Figure 2). Common sources for third party risk include vendors, suppliers, contractors, customers or even employees.
These risks not only offer additional premium to the captive but can also provide additional business efficiencies and leverage for the parent company.
The relationship each party has with the captive owner should be reviewed in depth to determine whether entering an insurance agreement would be beneficial to each party. Common third party coverages include extended warranty, business interruption, theft, casualty (such as auto or certain liability lines), property or voluntary benefits.
Evaluating third party risk
When considering any additional risk to be placed in a captive, thorough examination both actuarial and operational must be carried out. Ensuring that the new risks under consideration fit within the confines of the parent company’s risk tolerance as well as dovetail appropriately to the company’s business needs is as essential as the financial parameters (Figure 3).
In conjunction with this there needs to be an accompanying actuarial analysis completed for each risk being financed through the captive to ensure as much volatility as possible is accounted for and appropriately funded.
Partnering with a qualified captive consultant and actuary will ensure this process is properly structured from the beginning.
Anne Marie Towle is global captive solutions leader at Hylant.
Adam Miholic is senior consultant at Hylant. They can be contacted at: firstname.lastname@example.org