Ciarán Healy, director of client solutions for EMEA at Aon
16 September 2019

The importance of challenging the captive

We live in an era of unprecedented change and volatility. The transition to a highly connected and digitised global economy in recent years, in which data is quickly becoming the most valuable asset, has fundamentally altered the risk profile of many multinational organisations.

“Captive owners should challenge their position on the captive’s location, and its ability to meet the expectations of the BEPS initiative.”

In concert with this, the signals visible across many risk classes and across most geographies suggest that the insurance market may no longer be as generous as it has been for the last number of years.

These ‘macro level’ phenomena must be considered in terms of the evolution of individual organisations. The low interest rate environment which has prevailed in recent times has led to a reaction in the form of increased merger and acquisition activity globally, impacting to some extent a significant proportion of captive owners.

Meanwhile, it is unlikely that strategic priorities or the risk financing needs of any multinational organisation have remained static.
A captive-based strategy can make an effective risk financing approach, providing a cost-efficient basis for the retention of risk as well as acting as promoting enhanced risk management visibility and accountability.

However, a captive’s effectiveness always depends on how well aligned it is to the organisation’s risk management priorities, and its relationship with the insurance market. As each variable evolves, so too should the captive, which should be challenged regularly as part of its established periodical protocol.

Is the captive’s programme optimal?
A captive should periodically assess whether its programme is optimally efficient. Material changes in an organisation’s risk profile, or its relationship with the insurance market, can directly affect the relative efficiency of the captive programme.

The current trend of insurance rate increases suggests that, for many organisations, the next renewal will be more expensive than that of previous years. A material increase in rates will inevitably impact risk finance equilibrium, placing increased emphasis on risk retention.

The captive programme should adjust in line with this dynamic. Failure to do so would result in a sub-optimally efficient programme and a higher total cost of risk.

Is the captive’s location still the best?
The macroeconomic, political and regulatory landscape in which multinational organisations operate has been subject to significant change in recent times. There are some obvious developments that could potentially influence the location of a captive, including the UK’s departure from the EU and the introduction of new regulatory frameworks such as Solvency II. Other factors linked to brand reputation are arguably the most influential forces that have emerged.

Organisation for Economic Co-operation and Development-led anti-tax avoidance initiatives, including Base erosion and profit shifting (BEPS), have placed significant emphasis on the location and operation of subsidiary companies located in jurisdictions with lower rates of corporate tax, a criterion that many captives meet. These anti-tax avoidance initiatives coincide with a general shift in the attitudes around what is ‘acceptable’ from a tax probity perspective.

Many captives were established before this new sentiment towards tax probity and the reputational risks associated with newly perceived tax ‘havens’. This can introduce increased scrutiny from internal and external stakeholders. Captive owners should challenge their position on the captive’s location, and its ability to meet the expectations of the BEPS initiative.

This at a minimum should take the form of a BEPS-themed assessment or challenge to ensure that the captive is not introducing unnecessary tax or reputational risk to the organisation. It is important to emphasise that this does not imply that having a domicile with a lower corporate tax rate should be thought of necessarily as problematic.

At the same time, it is important that the captive is tested and maintains appropriate documentation of its position and arrangements around transfer pricing, substance and economic rationale.

Is the captive evolving in line with the organisation’s risk profile?
The majority of multinational organisations are experiencing a rapid evolution of their risk profile. The onset of digitisation and emergence of a data-reliant digital economy has introduced a new generation of risks. The increase in cyber risk is the most obvious consequence of this development, but it also extends to a range of other risks related to intangibles.

Organisations should be challenging the use of the captive to respond to these emerging risks. As the relative relevance of the risks that have traditionally been the mainstay of captive programmes reduces, it is crucial that the captive is used as a risk financing solution of the organisation’s most pressing risks.
This is a challenge for the entire insurance industry, as the ratio of insurable vs. uninsurable for the top risks facing organisations shifts. The insurable portion looks set to be overtaken by risks that the industry has not yet fully got to grips with.

This could however be an opportunity for the captive to act as an incubator for these new, currently uninsurable risks. Captives have regularly been used effectively in this regard, collecting data, enabling quantification and forecasting through modelling which in turn can lead to transfer discussions with the market.

Organisations therefore need continually to map the usage of their captives against their risk registers to ensure that they are maintaining relevance and maximising their captives’ ability to generate flexible solutions.

The three challenges suggested above all reference the fact that a captive will risk becoming inefficient, or less relevant, unless it is continually measured against internal and external dynamics. It is essential that the captive reacts and adjusts to the forces which influence the risk profile of the organisation.

This requires effective and regular challenge to guarantee that the captive does not remain static in times of change.

Ciarán Healy is director of client solutions for EMEA at Aon. He can be contacted at:  ciaran.healy1@aon.ie