How some organisations are using captives to benefit the bottom line

AXA-XL-Head-of-Alternative-Risk,-Canada,-Alonson-Tello

Authored by AXA XL Head of Alternative Risk, Canada, Alonson Tello

It used to be that a captive – most commonly known as a wholly owned and controlled entity whose purpose is to (re)insure its parent and subsidiaries – was considered a risk financing solution used mostly by larger companies whose unique risks were difficult or impossible to fully cover by traditional insurance means. Fortune 500 companies and large commercial accounts were dominating the captive space.

Yet, captive use has evolved, driven by the desire by companies to gain more control over their insurance placements and catalyzed by the current hard market cycle. Smaller organizations are now tapping into the captive market to manage some of their risks. These companies are increasingly buying into the concept of captives and can access these risk management mechanisms through different avenues.

Traditionally owned by one company, alternative captive structures that fit the needs of a wider spectrum of organizations are gaining momentum. Even for those who are not as well resourced, there are options in the captive market. For a few decades, cell captives – whereby the owner of a core facility holds the regulatory capital, insurance licenses, as well as managing the day-to-day operations, rents a cell to third-party organizations – have made it possible for small and mid-sized organizations to enter the market. So has the pooling of risks by insureds into a group captive (a single captive entity, in which they share both the risks and the profits from that captive.)

Much has been written about the most common benefits captives offer, particularly in today’s insurance market cycle and with the current rate increases being applied across the industry. However, there are some exciting alternative ways in which organizations are successfully using captives to enhance their risk management program, attract more clientele, or even access other forms of risk transfer.

Use: Access to Insurance Services & as a Risk Incubator for Emerging Risks

A captive can give an organization access to the services that often come with policies, without having to transfer all their risk to the traditional insurance market. For example, an organization using a captive to retain their cyber risks could take advantage of the pre-breach and post-breach services that the fronting carrier may offer, even if they otherwise don’t wish to buy insurance capacity for their cyber risks. The carrier would receive a fronting fee from the organization, which would give that organization full access to those services.

That allows organizations to have access to a host of services for which they otherwise may not have had the internal resources. Pre-breach services that help pinpoint vulnerabilities in a company’s IT systems, or that provide insight on best practices, can strengthen their cyber risk profile and mitigate potential losses. And following an event, the expertise required to properly notify and address the breach can be an invaluable service that the fronting carrier’s cyber proposition often includes.

For some of the more unique coverage options, or for emerging risks that are difficult to place affordably in the traditional market, a captive can also enable a company to ‘incubate’ their risks and build up enough data over time to share with the market, provide greater comfort about the exposures for insurers, and hopefully improve pricing or open up capacity not otherwise available. For example, a growing trend within construction has been the increased use of mass timber. This building material is not easy to obtain coverage for in the admitted market, even though its proponents advocate its safety, sustainability and cost-effectiveness versus other materials. Instead of potentially having to place the coverage for these operations separately (or retain them on the balance sheet), a company can use their captive to retain the risk for this exposure – as a sublimit in the main program, or standalone - and demonstrate its timber loss exposure over time, while maintaining the ability to build up loss reserves and protect the company balance sheet in the event of a loss.

Most fronting carriers would want to retain some of the risk in any structure that they underwrite e.g. 5% or 10%, and the data that is gathered on these risks will allow them to understand the risk better. With a more detailed view of the organization experiences in an exposure or coverage type, underwriters can assess the risk with more certainty, and more accurately price those risks.

With a more accurate premium to reflect the risk assumed, the organization may be better able to find more capacity in the market that fits their budget and compliment the wider business operations.

...for emerging risks, a captive can also enable a company to ‘incubate’ their risks and build up enough data over time to share with the market, provide greater comfort about the exposures for insurers, and hopefully improve pricing or open up capacity not otherwise available.

Use: Captives to Attract and Retain More Clients

While not new, cell phone damage coverage, flight cancellation insurance for travelers, and other affinity insurance products are just a few examples of how some organizations are using captives to attract new customers and retain business. A cell phone provider that offers phone damage insurance with a purchase of a new phone can give buyers that additional incentive to purchase from that company and generate more premium for the captive. The same can be true for an airline wanting to give buyers an incentive to travel with them; with the aim of removing a potential buyer concern and therefore generate increased sales for the company. In fact, many airlines are currently using these solutions to address customer concerns related to the pandemic – though it is unclear if a captive is being used to assist with implementation.

How it works: Because the organization, such as a cell phone provider, will most likely have large pools of loss data on the products they sell and repair, the loss frequency and severity are more predictable. The claim history can show trends and can be actuarially calculated with a greater degree of confidence. Rather than paying 100% of these premiums to a traditional insurer, a portion of those losses can be offset through a captive. Likewise, if the losses are lower than expected, the organization can realize some profit on paid premiums ceded to the captive.

Such products are beginning to show up in the cryptocurrency market, as well. Cryptocurrency storage companies are starting to offer breach coverage to their customers to remediate in the event of a security breach of the company’s platform. That gives customers an additional incentive to use their services, while also providing peace of mind. The first step is to identify a potential hurdle in the customer journey that can be addressed through insurance, and the next is to leverage the organization’s captive to tailor coverage and potentially capture underwriting profit.

Use: Greater Use of the Capital Markets to Transfer Risk

For larger and more complex placements, captives have often been a way to access reinsurance directly. Direct access to reinsurance typically allows captive users access to lower cost coverage than what the primary insurance market offers and can provide companies the ability to package their risks in different ways. The ability to access reinsurance directly can be an important benefit when organizations have a desire to retain greater control of how their program is placed and priced.

However, a less utilized, but growing area for captive utilization is leveraging a captive to access other forms of capital, outside of the traditional (re)insurance realm – capital markets. This can be considered an alternative form of reinsurance, and the captive can be used as the conduit for accessing this third-party capital.

For example, a technology company that has a large concentration of their IT infrastructure located in areas with high catastrophe exposures, such as earthquake or flood-prone areas, can often times be left underinsured in the event of a CAT event, due to the lack of sufficient capacity in the traditional marketplace to cover their full exposure. A company in this situation could use a captive as a special purpose vehicle, to transfer these exposures to the capital markets, who like the diversification and return these risks provide to their portfolio. When the CAT loss exposure is high, and the traditional marketplace is not able to cover those exposures, companies can turn to the captive market to find relief and new avenues for transferring their risks.

Use: Rerouting Surplus Capital into Risk Management

Captives can also give a company the chance to develop the capital they need for risk management initiatives. When loss history is better than predicted, those funds can remain in the captive and build equity over time. Those funds can then be directed toward preventative equipment, such as water detection systems, telematics wearables, or technology that improves safety.

That can be a more impactful use of excess capital and can shift companies into a more strategic approach to managing their losses. Instead of adding more risk to the captive portfolio to use that capital, that capital can be used to improve risk profiles in a more tangible manner; especially when operating budgets continue to challenge everyone to do “more with less”.

The Captive Appeal

In the current market, as in any hard market, even risks that are performing well are going to be swept up in the hardening rate environment. That is where captives and other retention vehicles can help insulate an organization from those higher rates and tighter coverage terms in a few ways: by aligning interests with the carrier via higher insured retentions, and by enhancing coverage where required. That can give an organization more influence on its program pricing and terms.

Captives enable users to take on more risk in a structured way that allows the organization to smoothen market cycles, and potentially deliver some profit from better than expected loss experience. Even in a soft market, a captive can bring stability to the risk portfolio, and help an organization improve its overall approach to risk.

CLICK HERE TO SIGN UP FOR OUR
FREE BI-WEEKLY NEWSLETTER

Latest video

AXA XL video: The world’s first risk innovation incubator. Welcome to Cube

Cube, the first of its kind, is a six-week programme designed to enable risk managers to work alongside AXA XL risk and innovation experts to develop innovative risk... click here for more