Understanding your risks
What are the key concerns that captives need to attend to in today’s environment?
Solvency II remains the key concern for the industry, because there is so much uncertainty about how it will be applied. Most UK captives are located offshore, raising questions regarding what their attitude to the new regime will be. Offshore domiciles have already indicated that they are not going to be driven by Solvency II, but what does that mean? Is that going to threaten issues such as fronting costs?
The second concern relates to proportionality. Everyone talks about proportionality, but I don’t see too much evidence of its being applied, and it’s an area where the offshore jurisdictions are probably a bit more constructive in their approach. The most interesting dynamic will concern what happens in Bermuda. Bermuda is applying for equivalence, but the industry is watching to see whether they will apply the ruling to their captive sector. If they do, then they will lose a lot of business because it will go back to the mainland US.
An adjunct to Solvency II, but not only an adjunct, is diversification. People are increasingly looking to use their captives on a broader basis, with how exactly they are going to do this a topic of some debate.
Another issue is the question of capital coming under threat from within the company. Some firms are questioning why they should have £20 million tied up in Guernsey, particularly in such troubling economic times. My view, however, is that for the larger companies, and in fact for almost all companies, a captive is actually quite a good investment ofcapital because their operations save the parent money and any profits are consolidated into the parent company. Captives are, after all, a constructive way to purchase your insurance programme.
Finally, because the market has been soft for a number of years and there are some expectations of a turn in 2012, companies are looking at how they can more constructively use their captives, particularly for things such as employee benefits and health risk. I would have to say that companies with serious US exposures would be mad if they weren’t considering deploying captives in these areas.
How can captives work to overcome threats posed by captive immaturity and data scarcity?
In the case of newly formed captives, if they don’t know what they are doing, they shouldn’t be doing it. Sometimes, however, captives are formed for exactly that reason, because the information is not being collected, or it is being diversified into many different areas, and the parent needs a focal point and you don’t necessarily want to give it to an outside entity. The main benefit of employing a captive is in areas where the parent either has frequency of loss or medium sized losses that don’t make financial sense to transfer into the commercial market.
What about the threats posed by uniqueness of exposures?
Unique exposures present a considerable challenge, but writing them within a captive is also quite a good idea. There is a risk there, but by being owned by their parent company and insuring their risks there is some justification for taking on unique risks. However, the captive owners need to be sure that they have quantified to themselves what their exposures are. I think it can be a good idea to write the risk, set the pattern and then establish the history, but just to make sure you don’t kill yourself in the process.
And the threats posed by concentration of risk?
I think that’s a big area. On the whole, I see the captive benefit actually being in the consolidation of risk. Captives have a real role to play in dealing with concentrations of risk because they can, probably, best negotiate and interpret risk information and use it sensibly in the market. Despite being penalised under Solvency II, firms that are only writing primary lines of insurance know exactly what they are doing because they have the history.
How should captives and their parents be approaching enterprise risk management (ERM)?
I have always believed that the chief risk officer is the chief executive of any corporation: at the end of the day company-wide ERM is his responsibility. ERM should, ideally, be led by someone on the board, although in my opinion what has worked quite well is a risk committee, which involves the insurance people, the audit people, the treasury and security people and even the IT people these days, as this can potentially be a big risk. Together they can get a good handle on the demands of ERM.
Captives, for their part, are a very positive aspect of risk management because they provide a lot of centralised information, particularly for multinationals that may not get such risk insights from another source.
For those corporations with considerable international spread, the reality is that overseas subsidiaries and joint ventures can be influenced by local market practices. By involving captives in the primary layers, valuable risk management information can be obtained relating to trends and specific problem areas. In the event of a serious loss, the involvement of the captive ensures there is some parental influence in negotiating both the response and the settlement.
There is also the opportunity to encourage risk improvement through incentives and/or penalties applied to the cost of local maturities. If some territories are being more risk aware than others you can influence the pricing. Finally, the review of captive business at a senior level within the company can provide a perspective to the senior management team about local subsidiary issues that they might not otherwise be aware of.