Newly appointed Derek Bridgeman of SRS says the captive industry should consider the hardening market as an opportunity to showcase the suite of benefits a captive can offer irrespective of the status of the insurance cycle
What trends are you currently seeing in the captive insurance market?
Historically, captive utilisation has been a discretionary purchase to further a range of strategic objectives, but with the contraction of capacity and the subsequent increases in prices mean that we are seeing the necessity of large retentions in either the primary or excess markets, in particular around financial lines such as professional liability and directors and officers (D&O) liability.
The use of alternative reinsurance protection products is becoming more widespread as captives look to reduce volatility and downside risk from the increased retentions that they assume.
As market terms harshen and capacity decreases the approach to risk management is becoming more sophisticated with an increased focus on not just insured property and casualty (P&C) and employee benefits exposures but also risks which were historically uninsured (e.g. non-damage business interruption, cyber, reputational and other pandemic related risks).
You have really got a continuation of trends in captive use during a soft market continuing into renewed interest in captives for traditional uses as the commercial market hardens. What we were seeing in the soft market was more strategic and entrepreneurial use of captives – third party use such as warranty or customer-related coverages, as well as medical stop-loss. Traditional P&C lines now getting added back into the mix.
COVID-19 is resulting in increased pressure from parent organisations to access cash thus more focus on surplus reserves in a captive which means it may be time to re-examine and optimise the structure!
How will a hardening market impact the captive space?
The hardening market presents an opportunity for risk managers (and CFO’s) to consider what their insurance needs are and as mentioned earlier, buy limits appropriately. Groups need to ensure that their capital is deployed in line with their needs and demands. There is certainly potential for alternative capital to support the (re)insurance market, however, getting the right risk profile can be problematical. Captives in their simplistic form allow organisations to utilise their own capital and complement capacity available in the traditional market.
History demonstrates the potential for captives to be utilised to access capacity in markets which would otherwise not be accessible. As was the case with terrorism risk in the US post 9/11, captives are being considered as appropriate mechanisms to access government-sponsored pandemic backstop arrangements. The expectation is that captives could be used further to structure reinsurance from capital markets. With a continuing market trend of decreased capacity, there is a strong argument to explore how captives, cells and the mutualisation of risk could sustain retraction of capacity on an industry by industry basis.
What will be the biggest challenges of a hardening market?
If we accept the hardening market as a correction (albeit potentially an overcorrection) then this further justifies the use of a captive as a complementary tool to risk transfer. Two primary challenges with the hardening market are; lack of capacity which manifests with captives stretching their appetite to accommodate gaps in the insurance market; and, stacking of limits and exposures which can drive up collateral and regulatory capital which ultimately can withdraw cash from the parent organisation.
Captive owners should, therefore, consider how to structure their risks to ensure they maximise benefits from diversification whilst limiting exposure to extreme volatility which carries significant risk charges. Often times there can be significant capital and reserves associated with the servicing of historical liabilities within a captive programme. This can impact or limit the captive’s ability to include risks which are uninsurable in the hardening market. Therefore companies are likely to explore ways in which they could remove these historical liabilities so as to recycle capital to enable new risks to be written. We are currently having several discussions with clients to better understand their options to deal with these legacy risks.
Do you think a hardening market represents a big opportunity for the captive industry?
Intuitively yes, opportunities should continue to present themselves, however, there will still exist a need to truly demonstrate how the captive can provide both financial and strategic benefit going forward. Although there has been year-on-year growth in captive numbers through the soft market the key to attaining buy in from C suite has been the ability to demonstrate financial efficiencies of retaining risk in a captive. Higher premiums will increase the opportunities for the captive to mitigate these challenges therefore it is logical to assume growth of new and expansion of existing captives.
In many circumstances, however, we are seeing the decision being driven by strategic factors, particularly for groups with global programmes. The ability of the captive to manage the volatility of smaller business units is relevant at a time when markets are enforcing substantially higher deductible levels. The option of simply retaining this additional risk at local P&< level is not appealing to many groups, as a single large loss would have the potential to bankrupt business units with lower risk tolerances. Simply retaining the higher deductibles through the use of a corporate balance sheet fund can be an effective means to retain frequency risk in a single jurisdiction. However, this model can result in increased tax focus for higher severity risk and particularly around cross border transactions.
The scarcity of capital and rising cost is increasingly making captives and cells a viable option to the mid-tier of organisations that may have historically considered such a structure as uneconomic or inefficient.
What do you expect to see from the captive industry as the hardening market continues?
The captive industry should consider the hardening market as an opportunity to showcase the suite of benefits that a captive can offer irrespective of the status of the insurance cycle. Naturally, it will be important to evaluate whether a captive can provide financial benefit so as a first step we recommend groups ask the question, does it make financial sense to retain risk? Once this is understood then the most efficient way to retain this can be evaluated.
It is a great opportunity to expand captives, utilise surplus capital within captives to ensure that they secure the most economic deals. Optimisation reports can consider how captives can assist in exploring how its capacity can be deployed and more sophisticated products can be structured. There is potential for groups within a single industry to come together to evaluate group captives and mutualise risk. Groups within industries where cover is unavailable at an efficient price are likely to become more open to the idea of sharing risk, perhaps within a captive or cell. The co-mingling of this insurance and credit risk particularly at XS layers may be more palatable particularly if it provides an access point to more efficient capacity.
How will the COVID-19 pandemic affect the decisions of those in the captive market? Do you think the pandemic will have an impact on market conditions?
We are still to see the full extend of the COVID-19 pandemic on the global economies and so we can’t fully understand the pressure on captives, though we are seeing conflicting demands being placed on captives. On the one hand, we expect demands from parent organisations to release cash into the core business to increase. At the same time, we also see greater use of captives to address shrinking capacity in the commercial market and increased pricing.
It is likely that captive owners will pay greater attention to both their overall insurance placement together with the captive structure to ensure its optimised and that the capital is utilised efficiently. Historically there were huge limits being purchased in the market or insured within the captives particularly on lines such as property damage/business interruption, quite often these limits were in excess of probable maximum loss but were only bought or included as the cost was cheap. As the market hardens the appropriateness of such limits will be considered.
How do you expect the next 12 months to play out and do you expect the hardening market to continue?
The hardening market represents opportunity and historically we have seen new organisations grow from such bleak outlooks (i.e. the emergence of the Bermuda class of reinsurers following the US Mainland Hurricanes), the potential to enter hardening markets without legacy is compelling. Nevertheless, we are likely to see the hardening market conditions continue.
Pandemic and/or reputational risks are topical, and we see potential for cells or captives to support the insurance industry and ultimately governmental backstops to create a viable solution.
Although there has been a lull in recent months it is probable that climate change will be high on the risk agenda, and irrespective of how it is viewed from an insurance or a corporate standpoint, businesses will be under pressure to act and a captive structure may allow them to act quickly and efficiently.
It is likely that as the lines of risk within captives increase so too will the demand for structured reinsurance offerings such as multi-line/year programmes. Although structured programmes don’t necessarily need to operate as a reinsurance of the captive, often case it can be a more efficient approach to use the captive as an aggregator of their parent’s global insurable risks.
This enables the group to sell the unwanted and uncorrelated volatility of the risk portfolio to a specialist market. Sophisticated risk managers will likely continue to explore structured captive reinsurance programmes as a mechanism to capture the inherent economic value of risk diversification.
Captive utilisation has been increasing for a while as the market was hardening even before the pandemic. It is logical to assume, therefore, that the additional pressure on the insurance market from COVID-19 will provide more opportunities for captives to respond accordingly
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June 24, 2020 at 02:00PM
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