Marcos Mesa Sam Wordley
30 June 2014Actuarial & underwriting

Bullish on captives

In spite of soft market conditions in the commercial market, captives continue to evidence their worth, regardless of cyclical dynamics. As Martin Scherzer, president of Global Risk Solutions at AIG Property Casualty explained, “While formations have traditionally spiked when conditions are hard—when capacity is restricted, terms and conditions are tight and premiums are high, companies continue to establish captives for reasons other than purely cyclical drivers”.

Firms establish captives when they cannot get insurance, perhaps in particular lines and geographies where it is a challenge to get appropriately priced cover, or where their loss experience or retentions make a compelling case to establish their own captive. But it isn’t only negative factors that encourage their use; the positive benefits of captives can be equally compelling.

Scherzer said that the industry needs to be more proactive and innovative in advocating the benefits of captive insurance. “We need to consider applications beyond simply property and casualty risks”, and encourage parent companies to consider a captive’s potential across the spectrum of risk. Nevertheless, he is bullish about the potential for further captive growth globally. “Captives are time-tested and effective risk management tools that transcend insurance market cycles, and we are seeing growth in formations and rising interest across the globe”.

As he explained, perhaps the best evidence of the success of captives is the fact that few companies abandon the concept. Quite the contrary, many companies that employ captive insurers are in fact expanding the scope and application of such entities, said Scherzer. In doing so, they can expect to unlock considerable synergies and opportunities.

A range of opportunities

Scherzer sees potential for growth within the captive space—for example, AIG has seen considerable growth in the US middle market. He said that US companies have increasingly come to recognise captive insurance companies as effective risk management tools, particularly as the costs associated with formation have come down.

AIG has responded to this increased demand by setting up a segregated cell company in Bermuda that complements its existing cell company based in Vermont. As Scherzer explained, “Such entities make accessing the benefits of captives faster, simpler and easier for midmarket companies”.

He added that there are also opportunities associated with the reforms under the Affordable Care Act, which is encouraging greater use of captives to provide medical stop loss coverage in the US. And interest is only likely to increase, as reforms under Obamacare deepen. Scherzer said that captives were also being applied to emerging risks such as cyber and product recall, particularly in instances where loss experience at the parent is poor or where coverage is restricted.

Captives are being used in creative ways, such as helping companies to drive sales of their core product. As an example, some companies have AIG front policies that provide coverage for the performance of a product, and this risk is reinsured back to their captive. In this example, the end purchaser of the product faces a large well-capitalised insurance company with experienced claims personnel and infrastructure, while the parent company retains the risk, thereby keeping down the cost of such a program.

Outside the US, AIG is seeing opportunities in key emerging markets that are beginning to explore the potential of captives. Scherzer cited China as a case in point, where a number of multi-nationals are evaluating the possibility of setting up a captive. He added that similar opportunities exist in Japan, where companies have traditionally enjoyed a close relationship with the commercial market, but where there is considerable potential to develop the captive concept.

Continuing to speak about growth, Scherzer said, “Latin American companies are also expanding their global reach and are looking at more sophisticated ways to finance their risk. There is increasing realisation in the region that captives can deliver significant benefits. And as their operations grow, the benefits of risk financing will become more relevant and more apparent”.

Scherzer expects the glide path for captive development in these new markets to follow a template similar to that in more developed captive geographies, but believes that the route to development will be accelerated given the fact that there is a model to follow. He added that in the case of midmarket firms, developments around the creation of cell structures will contribute to shortening the path.

Increasingly global

Addressing the multi-national potential of captives, Scherzer said that they are being used to write cross-border risks, and that trends in global trade will only increase their deployment and appetite. “When you consider the benefits of running a captive—risk coordination, a better understanding of your losses and expenses, and greater risk oversight—and you have the ability to bring disparate locations and risks into one place, there are significant benefits to be gained”.

Captives are great tools for managing multi-national risk as companies grow globally—from exports to local manufacturing—with an increasingly diverse international footprint. Scherzer said that this benefit was behind a drive by global firms to use their captives more actively as a tool to manage risk.

Innovative applications

Many parent companies are looking to their captives to add new and complementary risks to their offering. But doing so presents both challenges and opportunities. As Scherzer explained, “When adding in new lines or exposures, there are certain constants you need to deal with. One such constant is to ensure you know what the risk is. Can you gather the data needed to understand the nature of that risk? Can you price and reserve for it? Do you know the infrastructure you need to service that risk? These questions need to be asked and answered, particularly when dealing with new or emerging lines”.

But at the same time, there are also considerable benefits that can be derived from adding new risks into your captive. If for example, you are adding risks into an existing captive, the parent company already recognises the benefits of the structure, and it is not difficult to extrapolate the potential benefits into other lines of business. Adding in new lines also helps to provide greater diversity and stability to a captive programme. “It enables you to spread what is an element of fixed costs over a larger premium base and further inculcates a risk management philosophy into the organisation, extending it right across the fabric of the business”, said Scherzer.

Scherzer explained that captive owners are consistently looking for new and innovative uses for their captives. “Many of our largest clients are very thoughtful and strategic regarding how they use their captives. They consider them for funding not only conventional risk, but also emerging risks.” As Scherzer concluded, “The creative use of captives is bounded only by the imagination of our clients, their brokers and us. We need to truly understand our clients’ needs and in doing so can develop new and innovative captive insurance solutions to address their risks”.