Equipped for risk - the captive choice

What role can captives play in identifying and mitigating risk for their parents?

I view a captive as a risk management tool mostly on the fi nancing part of the risk, not so much involved in the early stages of the risk management process. The risk management process includes identifying, quantifying, mitigating and fi nally fi nancing risk. A captive normally enters this process in the fi nal stages, to fi nance risks that have already been identified and considered as a potential threat to the corporation.

Obviously a lot of risks are emerging now—there is a lot of talk regarding cyber risk and issues such as environmental liability—and there is work being done to identify, quantify and mitigate their impact. Captives have a role to play in this area as they are extremely useful in providing a way to fi nance these new emerging risks, where there is no financial market to provide coverage and where the insurers are reluctant to get involved. During this initial period, important statistics on loss experience can be gathered which will help with the risk management process.

Captives can also be helpful in leading research and developing best practice as companies work to mitigate emerging risks. Damage to biodiversity is just such an example, with captives able to work closely with third party consultants in order to carry out a thorough study of the impact such threats can have on their parents and the wider industry, and what steps can be taken to identify and reduce risk. Together with consultants they are able to explore technical and fi nancial solutions to emerging threats.

Are there any specific risks that captives are particularly good at writing or helping their parent company understand?

Captives traditionally excel with risks that have a high probability and low severity. That said, captives are also strong when it comes to providing coverage for new risks, risks that are outside the scope of traditional insurers. They can be very good funding mechanisms for these risks, risks that often occur infrequently and which are diffi cult to gauge. Cyber risk is just such an example—in many instances it is unclear what kind of damage such risks can cause. However, by running those risks through your captive you can at least start to fund and prepare for them.

How important is management buy-in when considering managing risks through a captive?

It’s fundamental. If you don’t have management buy-in it is going to be very diffi cult to get the captive to function properly. Management should understand the purpose of a captive, should understand the limits of what the captive can and cannot do, and should understand the reason why the captive has been established. We’re talking about communication—all of these items should be clearly communicated to the top management and accepted. The upper management team has to understand how important it is for the company to have this tool and to use it properly.

Too often there are misconceptions regarding what captives do—for example, that a captive is a means to evade tax—and those involved in the captive need to elucidate what captives are really about and for. Captives are there to help manage risks effi ciently, and management buy-in is essential to their success.

"The actuarial capabilities that captive employ to quanitfy the probability and severity of an event or risks help to create credible standards in risk management."

For example, when there are claims or losses, management have to understand the captive’s objectives. When it comes to claims settlement for instance, is management aware of the level of risk transferred into the captive, how claims are being settled and how much capital may have to be returned to the captive to repair its balance sheet? There has to be an intimate understanding of what the captive is doing and what it can do. So it’s important that management clearly understands everything about the captive.

Have risk reporting standards increased as a result of the recent fi nancial crisis?

There is not really a risk reporting standard, as such. It’s moreregarding obligations to disclose and report upon risks taken by the captive. Obviously there has been increased scrutiny as a result of the fi nancial crisis. If you look at legislation such as Solvency II—particularly for captives under Pillar II and Pillar III—a complete governance system is being put in place that requires greater transparency regarding the risks being written. The level of information that is now required has increased substantially since the fi nancial crisis. These standards did not exist before 2008–2009, but with the legislator now putting them into effect, captives can expect to face far greater scrutiny and more stringent reporting standards.

Despite the efforts of the European Captive Insurance and Reinsurance Owners Association (ECIROA) and FERMA— associations that have consistently lobbied for the simplifi cation of regulation concerning the captive sector—we have been unable to reduce the amount of information captives now have to disclose under Solvency II.

What does this mean for parents and for the benefits of owning a captive?

It can be dangerous. If you are obliged to disclose such a high level of information, it can prove detrimental to the parent and the captive itself. It could, for example, be detrimental to disclose publicly the type of risks which are being run through your captive, as it would reveal which risks are, or are not, being insured and which are being retained by the captive.

If you started running employee benefits through your captive, being obliged to disclose the amount of coverage the captive is extending and the way in which the funds are being calculated can be something that the parent simply doesn’t want to become public knowledge. It forces the parent to communicate its risk profile and requires transparency where it’s not required and where it doesn’t bring anything to the table.

What role can the captive sector play in helping to build global standards to measure and respond to risk?

There is a broad range of international risk management methodologies, with a number of new standards that are emerging as a result of the global financial crisis. These have resulted ininternational efforts to normalise the way risk should be handled within a corporation. The problem remains however that no single methodology has emerged. At present, it is not possible to apply a single risk management methodology, rather there are a variety of solutions that can be—and often need to be—applied in order to deal with risk.

Captives can provide a level of flexibility in mitigating risk that standards in risk management simply don’t have. The captive sector can help to make standards more flexible and more adaptable to the actual risks that companies face. The actuarial capabilities that captives employ to quantify the probability and severity of an event or risks help to create credible standards in risk management, while providing finance for specific risks.

It is worth emphasising just how important captives can be in the risk management function of companies, particularly when it comes to emerging risk. Commercial insurers are increasingly reluctant to take on such coverage and so, in many instances, captives will lead the way in understanding and responding to their parents’ emerging long-term liabilities.