19 August 2013Actuarial & underwriting

Captives and reinsurance: teaming up

Captives are increasingly exploring their reinsurance options—particularly as pricing in that part of the market has grown increasingly competitive—with reinsurance offering the potential to smooth fluctuations in lines of business and provide the stability needed to enter new lines. Reinsurers have the potential to lend invaluable support to new captives as they start out and often stay with them through their life cycle, extending capacity, capital and analytics as they develop.

As Dan Meyer, senior vice president at Guy Carpenter explained: “Reinsurance brings stability, surplus and capital protection, benefits that are particularly important when a captive first starts.” Without the levels of surplus capital associated with more mature entities, new captives can reduce the threat posed by large losses in early years through reinsurance relationships, with such coverage “serving as a backstop to pay that loss and continue functioning”, said Meyer.

Steve Bauman, senior vice president and head of captive services for Zurich’s Global Corporate in North America business spoke in a similar vein, stating that reinsurance helps to bring additional capacity to take on exposures. “Reinsurance can also bring with it cost efficiencies, particularly if there is additional capacity in the market,” added Bauman. Arthur Koritzinsky, managing director in the captive solutions group at Marsh, also spoke of pricing being an attraction. “Where single parent captives do buy reinsurance, it is often to fill in a buffer layer, where it may be more attractively priced in the reinsurance than the direct market.”

Reinsurance can also help to smooth out some of the severity claims that tend to trouble captives. As Meyer detailed: “Captives typically retain the high frequency-low severity coverage layers, with the high severity losses being what can throw them off their operations and threaten their ability to operate.” Reinsurers can play a valuable role in reducing this volatility, through buffer layer and umbrella placements, that can offer considerable protection to the captive, knocking out those bits of volatility that can endanger the captive.

Building close relationships with reinsurers brings with it still further value. As Meyer explained, reinsurers can extend significant underwriting expertise to captive partners. They may be able to share with the captive their experience on how particular lines of coverage perform in the market, informing captives about the progress of existing and potential lines of business. “They can also deliver market intelligence and an insight into what other folks are doing in the market,” said Meyer, thus helping captives to adjust their insurance operations where appropriate.

Bauman added that reinsurance also helps captives establish long-term relationships with the market that, due to the cyclical nature of the insurance business, will help them source capacity when it is needed during difficult periods in the captive’s life cycle. He added that reinsurance has the further potential to generate income associated with ceding fees, which can help to pep up the balance sheets of captive insurers.

While a host of single parent captives employ reinsurance to support their operations, the case for group captives doing so is all the more pressing. As Koritzinsky explained; “For group captives, reinsurance is critical, serving as a substitute for capitalisation.” Reinsurance can help to offset the severity of claims for group captives and dilute losses from an aggregate perspective, although he agreed that the benefits of reinsurance “are offset by lower profitability and reward”. Groups will have to consider their options carefully therefore, with the decision being all the more important in the early days when capital buffers are slim.

Big brother

Once they have opted to purchase reinsurance, the first consideration for a captive will be the credit quality and longevity of its reinsurer. “You want to be sure that when you buy reinsurance it will be there when it comes to paying claims,” said Koritzinsky, with such security all the more pressing on long tail lines. Bauman concurred, arguing that captives are looking for financial security above all else, with a lasting relationship helping to create security around the coverage of risk. Meyer added that captives need to be similarly cognisant of not only reinsurers’ ability to pay claims, but also their willingness to do so. Relationships based upon trust and predictability will prove the hallmarks of success.

As for the reinsurers, their main focus when considering captive partners will inevitably be data. “Data is going to be king with any type of captive programme,” said Bauman. And with captives being “depositories of information, reinsurers can at the same time benefit from that information to better evaluate and assess data over time”, he said. This evaluation extends to the parent, with reinsurers considering captives as long-term partners that necessarily need the backing of their parent companies.This will create inevitable challenges for new captives or programmes, which will be “squeezed at the beginning, based on data”.

“When parents are looking to insurance programmes they are challenged to get the best data possible. As such there is always apprehension over the first few years,” said Bauman. Nevertheless, if they can provide the data and the proposition, there is the potential for a lasting reinsurance relationship.

Koritzinsky added that reinsurers are looking for “a sense of the management, leadership and governance at the captive. That will be portrayed in the submission the captive makes”. Captives can help their hand by providing complete and accurate submissions, he said—back to the issue of data quality—and ensuring that the captive has the infrastructure in place to track operations such as claims and reinsurance recoveries. Koritzinsky concluded that captives can strengthen their hand through an active understanding of the reinsurance proposition, enabling them to enter transactions as partners, not simply as buyers.

Building upwards

While of obvious value at a captive’s inception, reinsurance also has the potential to help captives develop in size and by line. Far from shedding reinsurance ties as they mature, many captives retain and develop such relationships. As Meyer outlined, “As the captive grows, it offers either new limits or different coverages and so as the entity grows the need for reinsurance doesn’t diminish, it just adjusts and moves with the company.” Bauman added that while more mature captives might reduce their reinsurance spend on lines they have become comfortable with, when they take on new or emerging lines they will once again seek out reinsurance to protect themselves. Reinsurers also help them to understand new exposures and get a better handle on such risks, he said, particularly if those commercial players have a track record of dealing with those risks.

As they develop their lines of business many captives are exploring the potential of multiline reinsurance coverage that sits on the back end, bundling lines together, Bauman added. “This enables the captive to protect itself on a multiline basis, while it grows into new areas.” Again, attractive options in the commercial reinsurance market can help bolster the position of captives, particularly in the face of parents looking to maximise the value of such entities. It seems that the retention of ties with reinsurers can pay dividends down the line, with the captive-reinsurer partnership helping to strengthen the hand of those captives active in the space further.