The captive value proposition
Not everyone understands captive insurance. It is perhaps surprising considering the size of the sector and the number of major corporations globally that employ a captive entity, but impediments remain to the creation and growth of captive entities. They can at times prove a hard sell to the parent. That said, there is plenty of ammunition for those looking to put forward the case. As James Rawcliffe, vice president at Sagicor Insurance Managers indicated, “a captive’s key value proposition to its parent is stability”. Captives help reduce the volatility associated with insurance rates. Rawcliffe highlighted early November’s landfall of Superstorm Sandy as a case in point, saying “Major events create volatility in pricing, but by having a captive it is possible to set what level of premium you will be paying beyond that event.” This helps to simplify insurance budgeting and spares the parent any rate shocks.
Conor Jennings, managing director of Captiva Insurance Managers, similarly spoke of the “stabilisation of pricing” that comes with owning a captive, with entities helping to reduce the threat of nasty rate hikes that often follow major events. Captives also help to “reduce reliance on the commercial markets, with less chance of being bullied by insurance companies at renewal”, said Jennings. Being able to set rates themselves, captives are no longer slave to the whims and vagaries of the market.
Kevin Poole, manager at Kane (Cayman) also spoke of the cost savings associated with owning a captive. “Its value proposition ultimately boils down to the captive helping the parent drive down the overall cost of risk,” he said. And it isn’t only driving down pricing volatility that comes with owning a captive. As Jennings explained, a captive also brings with it underwriting advantages, with captives “an excellent vehicle through which to manage and control your own claims”.
During a soft commercial market cycle, however, a captive’s value proposition can be blunted by rates in the wider market—at least in the eyes of those who don’t understand the nature of captive insurance. Competitive rates may encourage some parents to consider the commercial market, but retaining risks within a captive continues to make sense even through a protracted soft cycle, said Poole. “In a soft market, it’s possible a captive’s premium could be set higher than the commercial market’s. However, if good risk management practicescontinue to be employed, then profits in the form of dividends can be returned to the parent at a later date, which are likely to offset any shortterm cost variances.”
Rawcliffe added that establishing a captive during a soft period of the cycle can in fact be the best time to do so. “You can take advantage of the soft market to use your captive to leverage rates. If you go to the market as a customer your premium will include all the associated costs and profit margin of the insurer in addition to the basic cost of pricing the risk. If you approach reinsurers as an insurance company, you get wholesale rates.” Market participation brings with it considerable benefits.
Having a captive also enables the parent to build beneficial relationships in the reinsurance market. As Poole explained, “If the captive purchases reinsurance, then it may well be possible to reduce captive retentions or expand coverage for minimal premium changes. It may also be possible to negotiate long-term reinsurance placements, the benefits of which accrue to the parent and/or policyholders.”
Again, being in on the ground floor of the market has its advantages. Rawcliffe said that all too often as a consumer of insurance you get lumped in with other firms in your risk class. “Reinsurers don’t go into such detail on individual loss experience. Instead you suffer the same rates as everybody else in your risk group. By setting up your own captive you can receive the benefits of your own carefulness.” Captives can help both to instil that care and to enable their parent to gain benefit from it when it comes to rates. Captives can also help by bringing in improved cash flow benefits, said Jennings, and can—during the good times—act as a profit centre for the parent.
The advantages of captive ownership are not limited to pricing. As Rawcliffe explained, captive entities can play a key role in “shaping divisional attitude to risk”. With multinationals having operations all over the globe it can at times prove a challenge understanding risk exposures and working to improve risk behaviour. By having a captive, parents have a better view and understanding of their own risks, said Rawcliffe and can use this to “impose discipline and safety measures that will actually reduce their overall losses”. As globalisation deepens, the ability to gain insights into international risks, exposures and behaviour are likely to prove increasingly valuable.
"CAPTIVES CAN ALSO HELP BY BRINGING IN IMPROVED CASH FLOW BENEFITS, AND CAN-- DURING THE GOOD TIMES-- ACT AS A PROFIT CENTRE FOR THE PARENT."
Jennings added that captives should form an integral part of any ERM programme. At times, however, proving the value of a successful ERM policy can be difficult. “How can you easily measure the effect of having a good supply-chain, a prudent investment policy or a hard hat policy?” This is where a captive comes in. “The only real measure of ERM’s success is through the captive, where the profits generated on the premiums paid over time are a clear reflection of the impact of a good risk management culture.”Captives can also play an invaluable role in strengthening the enterprise risk management (ERM) capabilities of their parents. As Poole explained, “ERM provides a framework for risk management which typically involves identifying particular events or circumstances relevant to the organisation’s objectives, assessing them in terms of likelihood and magnitude of impact, determining a response strategy, and monitoring progress. By helping companies to identify and proactively address their risks and opportunities, the ownership and use of a captive can help to protect and create value for the parent, its employees and also, potentially, customers.”
Despite all the advantages accrued by the parent, obstacles nevertheless remain to asserting the value proposition of captive insurance. As Jennings indicated, the “major obstacles are generally due to internal politics or ignorance”, rather than any notion that a captive cannot add value to the parent. The fact that risk managers do not tend to generate the kind of income that other department heads might, means that sometimes there is “a tendency for them not to be taken seriously”, said Jennings. As a result, issues “such as the treasury division insisting on dividends being paid as soon as any funds have been built up in the captive, which restricts the captive’s ability to grow its balance sheet and thus take on more risk”, can arise. As can suggestions that profits generated by the captive be deployed elsewhere, rather than seeking to “improve risk management within the group”, said Jennings. Again, this relates to ignorance of a captive’s value proposition. Educating key members of the board at the parent about its role in driving down costs and providing pricing stability should help to change matters.
Rawcliffe also spoke of the role that lack of knowledge can play in dissuading companies from setting up or considering captives. “There is a fear factor, because captives can be regarded as an unknown quantity by some companies, particularly if senior members of the board do not have exposure to insurance.” He said that domiciles such as Cayman have a part to play in dispelling some of the myths surrounding captives—particularly those that are offshore—that help to create negative perceptions about the industry.
Much of this relates to notions that captives are created for tax avoidance purposes, but on a list of reasons to set up a captive insurance vehicle, tax benefits sit very low down on a long list, said Rawcliffe. “It’s just a matter of taking time to hear the captive story.” Jennings echoed his sentiments, arguing that for the captive to be successful it needs the “full personal support of the group’s chief executive officer and for the captive to be treated as a real benefit to the group, rather than just another head office department that contributes nothing”. Much of this will hinge on education and explaining the longterm value of the captive.
“It’s important at the formation stage that the captive sponsor understands that the captive shouldn’t be viewed as a short-term fix,” said Poole. “If the parent has had a captive for a while, it should be easy to demonstrate the value, not only in terms of ultimate premium savings when compared to the insurance market, but also through cash-flow advantages, including the earning of any investment income and the ability to use the captive as a bargaining tool in market negotiations.” Jennings likewise argued that the value of owning a captive is not evident to the parent until after at least five years, by which time “real advantage and savings are accrued”. Captives are not simply shortterm fixes, rather they are long-term risk vehicles.
Over time the value of a captive will only strengthen for its parent. The captive will build up surplus and reduce its reliance on the commercial market, said Poole, while increased surplus will enable the captive to “expand existing coverage and retentions, or write new lines of business”. It can also enable its parent company to take on risks that are not easily placed in the commercial market, said Rawcliffe, with lines such as environmental liability and medical malpractice an excellent fit for such entities. Finally a captive can “assist the parent in some of its strategic goals such as helping to fund risk management programmes or safety initiatives that help reduce the cost of risk”, said Poole.