Alternative solutions for captives in a changing marketplace

The impact of a changing insurance market, exacerbated by the global COVID-19 pandemic, means that insurance and reinsurance buyers are increasingly exploring alternative solutions. Rob Turner, Chief Underwriting Officer and Global Head of Structured Risk Solutions at AXA XL, explains how these solutions can work for captive owners.

There are several strategies and options available to captive owners when considering how best to maximise the potential value of their risk-taking entities in the current market environment. 

A number of factors might prompt insurance buyers to increase the amount of risk that parent companies wish to place in their risk retention vehicles. Those include rate increases, higher retentions and some changes to terms and conditions in the traditional insurance market.

As well as being a way for some companies to offset a potential cost increase caused by rate increases in the traditional market, a captive also offers the potential to grow its revenue while keeping profits within the overall corporate structure.  This can lead to potentially significant growth for a captive in terms of premium and retained risk, as well as the ability to increase diversification as additional lines of business are added to existing captive participations.

Another motivation for captives to write more business is the potential restriction in terms and conditions offered by the traditional market. Previously broad terms and conditions, with low retentions, available at historically attractive prices relative to risk levels, may be less prevalent as the market hardens.  Captives can therefore benefit on a standalone basis from the increased pricing and tighter conditions afforded by the current market and/or offer a parent company a certain level of cost effectiveness and breadth of cover not available from regular insurers.

New exclusions may also prompt insurance buyers to consider whether their captives can perhaps assist in managing certain additional risks over a multi-year period. This could take the form of captives offering parent companies reasonably sized, firstloss limits for risks with significantly increased premiums, or potentially include risks being written by the captive that are not covered by the traditional market.

There are some challenges in taking on more risk. Captives could face issues such as increased capital requirements in order to meet potential tail event losses and also an increase in annual risk volatility. In certain circumstances, these may require even more capital to be injected by the parent, thereby reducing some of the benefit of having a captive take such risks in the first place.  Significant growth, particularly over a short timeframe, could therefore be very challenging for a captive if approached from a regular, annual budgeting perspective.

One potential option for captives to enable more sustainable growth is to enter into multi-year, structured reinsurance or retrocession contracts on an alternative risk transfer basis.  For example, a simple three- to five-year reinsurance contract with a term aggregate limit and premiums that include an element of profit and risk sharing over time with a reinsurer, could enable captives to avoid annual risk spikes from large individual events or aggregated losses.  In addition, it could potentially enable a captive to reduce or redeploy some of the capital it would need to hold without such multi-year, structured reinsurance support.

Structured solutions can also provide captives with the opportunity to offer parent companies with, perhaps initially small, sub limits for risks that are not generally offered by insurers or that are not available at an acceptable price for buyers, such as broad-based, non-damage business interruption or reputational risks.  Initial small sub limits could then grow over time as the captive gains experience and meaningful data related to such risks.

The same could be true for other non-traditional risks. When blended over a multi-year period with more typical property, casualty and financial lines risks, such coverage could potentially be manageable in a way that would not be possible if written by a captive as an annual, standalone risk

There are other mechanisms and solutions available from (re)insurers in the alternative risk transfer market. Going forward, it will be interesting to see to what extent captives, as well as corporate clients, seek to use alternative solutions in combination with regular insurance buying, in order to maximise the benefits and potential profits from risk retention strategies.

Authored by AXA XL