Jirsak /
26 April 2017Actuarial & underwriting

Group captives: the inner workings and obstacles

There are more than 900 group captives with North American owners, but only a handful in Europe and elsewhere. This series intends to explore some of their inner workings and show readers why there are good reasons to consider this captive alternative by addressing the main points of resistance I have encountered. I will use a not-so-hypothetical example to illustrate these points.

It starts with an insurance crisis
Many group captives were initiated by a number of insurance buyers getting together to bemoan the high prices and restrictive coverage of the commercial insurance they were able to buy. Sometimes rates skyrocketed from one renewal to the next. Sometimes coverage was restricted in the same way. For some insureds, capacity dried up or was just not offered.

These insurance “crises” started in property insurance, spread to liability insurance, and were observed even in marine and automobile insurance. The best example was the well-known origin of OIL, a large mutual of energy companies. Their insurance crisis originated in a lack of sufficient pollution liability coverage for oil and gas exposures.

“To start such a group captive initiative every example I have seen needs a convinced ‘champion’ from among the original group of potential insureds.”

The absence of this sense of urgency, or an insurance crisis, for the last few years is one reason for there to be few group captive formations outside North America. The soft insurance market, which means lower premium rates, and the availability of capacity from commercial insurers and reinsurers, discourage all captive insurance initiatives.

The meetings
The meetings I refer to took place at gatherings of insurance buyers (also known as risk managers) or industry special interest groups. The common theme and driving interest was the same sense of frustration and mistreatment that was the reason for the formation of single-owner captives.

But this time the participants were not all large multinationals, they were medium-sized entities, often with an industry similarity, or a regional location interest. I observed the fact that many of the participants’ companies were competitors for the same business in their areas. Cooperation at the insurance buyer level was able to transcend the competitiveness. This theme of cooperation will return throughout my series of articles.

I am talking here about the “do-it-yourself” aspect of group captives, in which the insureds themselves initiated, developed and got the process started—and then went out to find service providers to carry them through. Much later the service providers became promoters of group captives, a development that encouraged more formations, raised their expense ratios and downplayed the original do-it-yourself initiatives.

Example step 1
Here’s the first part of my not-so-hypothetical example: the financial consequences of one aspect of cyber risk, ie, the expense following a recognised intrusion, or hacking, of a customer database resulting in extra expense and legal expenses.

This is not the whole spectrum of cyber risk—it addresses two of the exposures that are of serious concern to all users, and against which some risk management defences and underwriting protocols might mitigate the exposure.

The insurance markets are offering capacity excess of very high deductibles and restrictive conditions in their broader cyber coverages, and where prices are quoted they are very high.

What if we brought retailers and other non-financial businesses together to write their own conditions to cover the first $1 million above suitable local deductibles?

To start such a group captive initiative every example I have seen needs a convinced “champion” from among the original group of potential insureds. One who will lead by example: “I’m in—you should be, too”.

Once we have one, the next hurdles are the minimum numbers with which it could get started. There are two: the capital required and the expected annual premium.

The two main numbers
The most successful startup group captives begin with the notion that they will share the cost of losses up to an amount—let’s say, $5 million over three years. Notice the starting point is an estimation of what losses we want to cover, not how much premium there might be.

This starting point then indicates what annual premium is needed to cover $5 million—it’s that plus expenses plus reinsurance. Why reinsurance? Well, the potential members might want protection against early exhaustion of the original $5 million in the form of a reinstatement, or additional capacity above the $1 million.

To simplify, the annual premium for the first three years is estimated to be $2.2 million. Instead of seeing how many members we might have had to start with (always an arduous and thankless task) we now know how many we ought to have—enough willing to pay a reasonable rate on line as well as a rate based on their risk (of which more later).

Obviously, only five members sharing $2.2 million a year will be paying a high rate on line, and probably won’t get off the ground. Nine to 12 starting members would work better.

The other main number is the starting capital. To keep things simple, the proposed group captive will write direct, not reinsurance, and be based in a jurisdiction which follows Solvency II requirements, even if it is not under them.

Capital required for this kind of uncertain exposure ought to be fairly high, in this case as much as $5 million (and maybe a bit more, just in case). Why not more? Because the group captive’s bylaws and policy wordings will specify no coverage after the group annual aggregate losses reach $5 million.

In some domiciles the starting capital can be partially paid in, with the rest promised in case it has to be called. Using the 100 percent capital needed as a starting point, the most logical way of assessing it is as a function of first year’s premium.

Proportional parity—initial
The notion of proportional parity is one that works in most group captives, although it is seldom called that. It means insureds participate in initial capital, in underwriting, and in entitlement to profits (or losses) in proportion to their size, experience, or risk, and that these proportions are not absolute, but relative.

For our cyber group captive, the initial capital contribution is set at 2.5 times initial premium (remember we estimated $2 million premium the first year). So those paying higher premiums will pay in more initial capital. There is some logic to this, since as the group captive ages, those who put in more capital may, in the absence of losses, be entitled to a higher share of the profits.

What about voting and control? Here the opinions among group captive owners have always been split. Some want voting to have the same weight as capital, others want one vote per member, to balance the large and the small. There are many different kinds of “A and B” share systems to work this out.

What about real or perceived risk differences? This obstacle is the one biggest one that has prevented most European group captive initiatives from getting off the ground. “You are doing what kind of clinical trials? We wouldn’t do that kind.”

“You’re building what in South Africa? We wouldn’t go there if you paid us.” And, for our cyber case, we might hear “Your systems have what kind of controls? Ours are much better.”

As a result, rating differences are worked out in two ways. The simplest way is to appoint an impartial underwriter, such as a retired Lloyd’s underwriter, with whom all members can agree. The other way, if a number of members have exposures that the others don’t, is to create sub-pools, separately rated.

Both of these methods, with or without sub-pools, can be simplified down to categories, such as category 1, category 2, etc, up to category 5 (or higher). The proportional parity system allocates annual premium on the basis of the risk assessment underwriting that says, for instance: “Most of us are in category 3. That’s 100 percent. Some have higher-risk activities, so category 4 is +10 percent and category 5 is +20 percent. Some have better protections or less activity, and warrant a category 2, or -10 percent.”

Note that the system of proportional parity requires that at the end of these allocation of categories and percentages, the total has to equal $2 million. If it doesn’t, the underwriter simply slides the scale up or down until it does.

Example step 2
So much for the first year. We managed to find 10 members, some large, some small, in the same jurisdiction, who were able to raise $3 million in cash capital (and promise $2.5 million more) and willing to start out under the proportional parity calculation, thanks to underwriting standards and protocols, that collected $2.2 million annually for the first three years.

Along the way they decided what kind of triggers, what kind of claim, and what proof of loss—subjects that take a lot of group discussion, as well as the local deductible before the captive’s coverage. The initial obstacles of large versus small members, high risk versus low risk members have been addressed.

Experienced readers will have already detected the necessity for agreement and understanding among the founding members. These are often hard to attain unless there is a driving force in the form of an insurance crisis urging them all to do something. And they would have asked whether standards and risk management for cyber risks were being addressed.

These non-financial advantages of a group captive are often the real keys to success in limiting or mitigating losses and sharing best practices. These, too, require some cooperation and understanding among the members.

In the next article I will go into what happens next. If agreement and understanding at the outset can be reached, the next phase, and the application of proportional parity, will be easier.

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More on this story

31 July 2017   Hugh Rosenbaum, captive consultant and retired principal of Willis Towers Watson, addresses the entitlement to profits—the third and sometimes most difficult of obstacles to overcome in the design stages of a group captive.

More on this story

31 July 2017   Hugh Rosenbaum, captive consultant and retired principal of Willis Towers Watson, addresses the entitlement to profits—the third and sometimes most difficult of obstacles to overcome in the design stages of a group captive.