Keeping up with Captives

Captives

Authored by AIG Head of Multinational Stephen Morton

The past two decades have shown that captive formations occur during all phases of the insurance cycle and throughout varying economic climates. Traditional reasons – including a hardening commercial market like the one that we are currently experiencing – remain key drivers.

Indeed, despite an overall decline in the number of wholly-owned captives worldwide and fewer formations in 2020 compared to 2019, we are seeing a continued increase in the use and diversification of existing captives. Captives are playing a larger, more important role in clients’ risk strategies, largely via increased participation – for example, a captive doubling a retention is not uncommon – and filling gaps in coverage, particularly in the energy and property space where capacity is a challenge.

We are seeing companies expand the use of existing captives to encompass additional geographies and different lines of business such as cyber, A&H, trade credit and marine. In addition, we are seeing an increase in third-party coverages, such as warranty and tenants’ liability, as companies look at their captives as a separate business unit and source of revenue.

Expanded risk management strategies

Although risk managers are likely to expand the use of their captives during a hard insurance market, particularly for difficult-to-place coverages, alternative risk transfer has also developed into a longer-term strategy for sophisticated companies to leverage financial and coverage benefits over time.

The most successful insurance programmes maintain a balance of risk retention, traditional and alternative risk transfer, with a strategy that adapts to changing market cycles and risks.  The benefits of self-insurance, including having greater control over risk financing and risk management, as well as customisation of loss control and claims mitigation strategies, remain relevant when prices soften again.

This has rarely been as relevant as in today’s changing risk landscape.

Global supply chain risk impacted by the current environment plus an accelerated move towards digital transformation is high on the risk management agenda.  Captives are certainly a high value potential candidate to manage these risks. 

Other emerging and intangible risks, such as cyber, reputation and non-damage business interruption continue to underscore the need for new and innovative risk managed solutions. While traditional lines such as general/ professional liability, auto and property are still driving most captive participation, there is also interest in evolving lines, particularly cyber.

Growing interest in cell captives

While the captive market is more mature for large multinationals, there are thousands of organisations operating in slightly smaller footprints that may not have considered or needed to consider a risk retention mechanism in the past. For those companies that are not ready to justify the commitments involved with forming their own captive or simply do not have the time, a cell captive structure may provide a simpler, more cost-effective alternative. Cell captives have lower barriers to entry and so provide an attractive option for a wider pool of organisations.

Available for virtually any line of business, there has been growing interest in captive cell programmes as smaller and mid-sized companies seek to capitalise on the advantages that this solution provides. In 2020for the first time there were more cells formed in Vermont (50) than stand-alone captives (38).

Generally requiring a considerably smaller investment from a time, resource and capital perspective, a captive cell is a relatively simple and inexpensive way for a company new to captives to gain experience and enjoy many of the benefits of retaining risk in a captive structure. Despite a relatively long history, the cell captive market is still poised for growth — both for new regions and new types of companies in existing markets.

No one-size fits-all

However, at the end of the day there is no one-fits-all solution. Different clients will have different needs and the onus is on all parties, including captive managers, fronting insurers, brokers and risk managers to sit down and talk through the solutions available.

There are a number of creative and innovative options to be considered, including alternative risk transfer solutions and joint, scalable captive solutions, such as a multi-captive ‘mutual’ approach. For clients concerned about the impact of higher deductibles and how this may cause greater volatility on their balance sheets, loss portfolio transfer, for instance, can spread out of the cost of a severe claims year over, say, three to five years, offering capital relief and smoothing out the impact of a loss.

In this current hard market environment, even companies in countries which have not been at the forefront of captive formation to date, such as France, appear to be increasingly motivated to do so. 

This is an exciting time for the insurance industry and one for innovation in how we use existing and develop new tools to manage a rapidly evolving risk landscape. 

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