Marcus Schmalbach, RYSKEX
1 September 2022ArticleReinsurance

Challenges for the captive insurance industry: a report from the VCIA conference

Over the past several years, an initiative of experts from Vermont’s Department for Financial Regulations (DFR), as well as Rich Smith, former president of the Vermont Captive Insurance Association (VCIA), and experts from the captive insurance industry worked on a project which has now been passed as a section of Vermont’s captive bill.

The VCIA conference featured a discussion titled “Emerging Risks & Parametrics” led by Thomas M. Dawson and Nir Kossovsky. This article reflects on developments in Vermont, as well as key themes from the discussion.

How much insurance does the world need? A risk or captive manager might glibly answer “as much as possible”. A more considered way of answering the question would be to examine the current value of the assets that require protecting, and the scale of losses that might be expected to occur.

In this way, two indicators can be calculated: the penetration rate and the coverage gap. The first could be a comparison between the total value of assets and the total value of insurance cover. But since it is hard to calculate the total value of all assets that exist in the world, the insurance penetration rate is normally expressed as the ratio of premiums paid to gross domestic product.

For the last decade or so, this has typically been around 3 percent for non-life insurance, according to the Swiss Re Institute. That means that if you viewed the whole world as if it were a single economic entity—Global Inc, if you will—then that company would be spending 3 percent of its revenues on insurance.

What does the truth look like? Let’s go one step further: does the world really have an “all-risks cover” for its balance sheet? The answer is no. On one hand the coverage gap varies quiet markedly by geographic locations. While North America and Europe are mature economies with a reasonable level of cover, other parts of the world are significantly underinsured.

In Asia in 2017 for example, out of total losses of $31 billon, only $5 billion was insured. The developing world is growing faster than the West and this, coupled with the top 4 risks (climate change, cyber, terror/war, pandemic) means that the coverage gap is likely to continue to worsen for the foreseeable future.

Emerging & systemic risks and their impact

Various industry participants publish the top risks of companies every year and these vary with some nuances. In most cases, however, the headings are accompanied by the words “insurable risks”. However, the world has been hit by a risk that was considered almost extinct—a pandemic. This is not insurable.

Another major topic in recent years has been cyber risk. There is no uniform definition and the complexity of the subject is demonstrated by press articles in recent days which state that cyber attacks from Russia fall under the exclusion of war. Furthermore, the umbrella term climate change covers an extremely broad portfolio. Here, too, caution is advised, as not all natural catastrophes are insurable.

In February, one of the world’s largest reinsurers—Hannover Re—issued a press release stating that it had transferred 11 catastrophe bonds with a record volume of $2.7 billion to the capital market.

“The demand from our clients for alternative risk covers was stronger last year than ever before,” said Silke Sehm, whose responsibility as a member of Hannover Re’s executive board includes the insurance-linked securities (ILS) department.

Forgotten risks such as war and pandemics cannot be clearly separated from emerging risks such as cyber and climate change. Risk and captive managers face a volatile, uncertain, complex, and ambiguous (VUCA) situation where insurance is one solution, but not the only one.

After companies had to close their businesses during the COVID-19 pandemic, supply chains were disrupted, and manufacturing was closed, it is now the Russian invasion of Ukraine that is having an impact on the global economy. Traditional insurance lines such as transportation and credit are suspended, and cyber attacks now fall under the wartime exclusion as well.

Even if you have purchased coverage, you are either not compensated or the claim settlement drags on for years. Risks of this kind are declared as “systemic risk”. Systemic risks are undiversifiable—risk that cannot be mitigated through a diversification strategy. These risks have a group-wide, cross-departmental and global impact. They are therefore difficult or impossible to reconcile with the “law of large numbers” approach to underwriting.

Parametric risk transfer

The risk landscape in the VUCA world thus requires a different approach for the top risks of companies that goes beyond the classic insurance concept. This is where parametric risk transfer (PRT) comes in. PRT is as simple as an ‘if x, then y’ statement: if this happens, then pay that. All that is needed is a trigger and a payout mechanism.

The approach is not new and has been used in reinsurance for decades, mostly in the transfer of natural catastrophe risks (see Hanover Re example above). This form of claims settlement is nevertheless somewhat unusual for the traditional insurance market. In most cases, indemnity insurance is used—this approach is in line with the industry’s DNA.

The parametric approach, on the other hand, is used—almost exclusively—in the financial industry, the capital market. Why? Because accounts have to be smoothed very quickly and lengthy regulatory processes would have a negative impact on trading. The global market for derivatives has a notional principal value of $175 trillion, which corresponds to 350 times the capacity of the reinsurance market.

The capital markets, with their long familiarity with the underlying concepts, are a natural fit for parametric concepts. This explains the growth of ILS. The contracts are index-based and therefore cannot be compared with a classic insurance contract. At the same time, capital market portfolios are structured differently.

Risk can be understood here as a kind of commodity. It is difficult for me to write this and it seems cynical, but oil is an example. As a result of the imposed sanctions against Russia, the prices of crude and Brent oil go up. Hedging mechanisms are therefore possible in real time and investors can react quickly even to the impact of systemic risks.

This form of hedging has little or nothing in common with the classic insurance approach. Although there are companies working on parametric solutions, especially in the world’s startup centres such as Berlin, London, Silicon Valley, and Tel Aviv, these are linked to traditional insurers and therefore do not increase market capacity at all.

The Vermont development

The team led by Michael S. Pieciak, commissioner of the Vermont DFR, went a step further and Vermont-based captives now have the ability to purchase capacity outside the traditional reinsurance industry.

Deputy commissioner David Provost said: “Our proposed legislation makes it explicit that a captive insurance company may accept or transfer risk by means of a parametric contract, and that any captive that does so must comply with all applicable state and federal laws and regulations.”

According to Provost, the objective is “to best support our captives and their parent companies in being able to find risk capacity, not only in the traditional insurance market, but also in the capital markets”.

Smith, the now departed president of the VCIA, led the project with a great deal of heart over the past few years and provided the following statement: “Parametric risk exchanges are just another advanced tool captive insurance can utilise to meet the risk challenges of organisations big and small.

“Vermont is keen on working with innovators as we modernise our captive laws to meet the ever-evolving needs of the captive industry.”

Various insurance commissioners from other states have already declared their intention to adapt the concept or to pass a similar law with the same basic idea for their captive insurance laws. Others have stated that they saw no reason to do so, since parametric insurance was allowed anyway and there was no reason to enact it in a law.

However, there was agreement at the conference that parametric solutions will play a major role in the future. All innovations in the insurance industry, from customer-centric underwriting to process optimisation, digitisation of the industry, fast claim payment and the need to buy capacity from the capital market, can be united under the parametric solution approach.

The topic of parametric and the multiple options for its design will continue to be driving topics for the captive insurance industry in the coming months and years.

Marcus Schmalbach is the chief executive officer of Ryskex. He can be contacted at: