23 June 2014Actuarial & underwriting

Property risk: an unrealised opportunity?

In the past many parent companies have considered property insurance risk an unlikely fit for their captive entities. With a short duration, property affords limited investment opportunities compared with longer tail and more popular lines such as workers’ compensation and medical malpractice, while losses can be abrupt and significant.

As Jason Flaxbeard, senior managing director at Beecher Carlson, explained: “With no tail, there are no reserves set up at the end of the year, meaning that if you are an insurance company you don’t get to accelerate the deduction on those reserves. Captive owners have usually regarded property risk as a poor fit.”

Tony Bibbings, senior vice president at Artex Risk Solutions, said that as a result most captives do not contain property risk, with the impression being that “with short tail business you are often trading dollars with the insured”. He said that while property risk was a popular addition for captives domiciled in Europe, it has tended not to be favoured by entities in North America and Bermuda.

“There are good reasons to put property risk in a captive, but a number of those factors are often overlooked,” said Bibbings. One of the leading reasons to employ your captive to write property risk is to fill out a layer that would otherwise prove costly in the commercial market.

As he explained: “If you have a substantial portion of a layer filled at an acceptable price, but you can’t fill that whole layer at that price; rather than raise the price of the whole layer to get it filled, you put a piece in your captive. That will have a knock-on effect on the layers beyond that and hopefully keep the price of the whole placement down.”

A captive can also play a role in evening out deductible losses, explained Flaxbeard. Citing the example of a real estate company facing commercial market deductibles across its entire property portfolio, he said that similarly, a captive offers the opportunity to spread the deductibles across the whole portfolio, rather than their falling on just one property.

“Captives help to smooth the experience layer and allow allocations back to specific properties. Going forward you can change that allocation based on loss history.” Captives can deliver considerable flexibility to their owners.

Property risk can also help to create a “portfolio effect” if parents choose to add the line into an existing captive, said Bibbings, which in turn can help to strengthen annual results. “Having a mix of risks in your portfolio is a positive. You include predictable long tail risks alongside short tail property risk, with the long tail business helping to deliver steady annual cashflow, complemented by more volatile property premium.”

With regulators pushing for diversification by line and geography, developing the scope of the captive is likely to be beneficial from a capital perspective.

However, portfolio diversification needs to be weighed against a changed investment dynamic. As Flaxbeard explained: “With property, at the end of the year you have either wiped out all your premium or you have all of it left. This means you tend to be taking on significant underwriting risk and, as such, you tend to marry such risks with cash.” This requires a change of investment focus from those longer tail lines that have tended to find a home in captive entities. Due to its volatility, property coverage will generally require complementary lines within the captive.

TRIA and the market

One of the major impediments to the proliferation of Bermuda-based property captives is the federal backstop offered by the Terrorism Risk Insurance Act (TRIA). As Bibbings explained: “Any insured with a terrorism-exposed property should put that through a US-based captive in order to benefit from TRIA.” This has discouraged those with property risk and terrorism exposure from opting for offshore options, while the competitiveness of the commercial terrorism market has generally reduced the role of captives in the property space.

Some have responded by setting up onshore branches of existing offshore captives in order to access TRIA, but the issue is muting interest in offshore options.

Not that captives are excluded from TRIA. As Flaxbeard explained, captives are eligible to access the federal backstop, “providing coverage for their parents, while accessing the federal backstop and potentially buying reinsurance for the deductible layer”. In fact TRIA has boosted property take-up, said Flaxbeard, with parents recognising the long-term value of TRIA backing. With offshore captives unable to access such coverage, it is proving a “significant differentiator” in the space.

Further complicating matters is the fact that TRIA is due to expire at the end of 2014. Until matters settle, the development of captives with any terrorism component “is on hold right now”, said Les Boughner, executive vice president and managing director at Willis Global Captive and Consulting Practice. A handful remain in the wings waiting for a resolution of the current situation, said Boughner, but uncertainty about TRIA’s renewal represents a headwind facing those considering developing property coverage.

Commercial market conditions are presenting another significant impediment to the growth of property insurance captives. Bibbings said that the industry needs to continue to demonstrate the value of captives that can respond to market hardening—either industry or location-specific—but admits that this can prove a challenge during soft market conditions.

Flaxbeard added that with the low number of catastrophe events hitting the property market in 2013, captives will face stiff competition from the commercial market. However, he was circumspect about the situation. “I would expect captives to be exploring the property market vigorously and using the captive only where there are underwriting reasons to do so, such as the smoothing out of allocations, or enjoying access to TRIA.”

Until market conditions change, property captives—and captives generally—will be challenged by commercial conditions, but there are opportunities inherent in the cycle. As Boughner explained, Bermuda has traditionally performed best in response to severe restrictions in capacity and, while conditions might not be conducive to the formation of property captives at the moment, the Island’s captive sector will inevitably be poised to deliver capacity when hard market conditions return.

Latin America: a major opportunity

It is apparent that the captive sector in Bermuda sees considerable potential in Latin America, with many South American parent companies looking to insure property risk. Bermuda has made a significant push to secure Latin American interest in the past few years and Bibbings believes that this may help to encourage a re-examination of the potential of property captives.

“Property is the most significant risk being insured by Latin American captives at present,” he said, and many are considering Bermuda as their domicile of choice. Bermuda would do well to seize upon the opportunity and re-examine the potential of running property risk through a captive.