The global insurance market has been hard for some time and that shows no immediate signs of changing. Market conditions are being driven by the increasingly complex and challenging regulatory environments within which companies are operating, higher levels of community scrutiny, a rise in the prevalence of regulatory investigations and class actions, an increase in significant claim events and, of course, the impacts of the COVID-19 pandemic on businesses and economies across the world.
The desire on the part of insurers to manage their exposure has resulted in higher premiums (sometimes drastically so) and deductibles, less generous terms, tougher underwriting measures and in many instances, limited coverage capacity in the market. As a result, businesses are increasingly choosing to utilise captive insurance arrangements as an alternative to engaging with commercial insurers.
This article outlines the key features of captive insurance arrangements and considers how they can be used to mitigate the current market conditions.
What is a captive insurance arrangement?
Captive insurance offers a means by which a company can effectively self-insure against certain risks. It is essentially an insurance entity within the corporate group structure. Captives operate to provide a primary layer of cover for the relevant risk(s) and enable companies to customise the coverage required. Often, the whole or a portion of the relevant risk is ceded to the reinsurance market (and in so doing the Insured can take advantage of reinsurance pricing benefits).
Given the complex insurance regulatory landscape in Australia, companies seeking to establish a captive insurer often look to do so in offshore jurisdictions such as Bermuda, Vermont or Singapore, where the regulatory requirements are considered less onerous and the process of establishing an insurer is typically less expensive. Depending on applicable regulatory requirements and other internal company considerations, captives in such jurisdictions can be established in as little as five to six weeks (depending on the structure adopted).
Captive insurance arrangements are typically structured in one of two ways:
- by establishing a captive insurer which is wholly-owned (either directly or indirectly) by its insureds; or
- by participating in a sponsored (or “rental”) captive arrangement which is already established and is conducted through a third-party captive insurer.
The use of sponsored captives is particularly popular with companies that want to take advantage of the benefits offered by captive insurance arrangements, without having to provide capital up-front or deal with the requirements and obligations associated with the ownership and management of an insurer offshore. In other words, “try it and see”.
How do captives differ from traditional self-insurance solutions?
Traditional self-insurance involves a company setting aside capital specifically to fund potential future losses. However, a captive insurance arrangement does not necessarily require a company to set aside capital up-front.
In addition, when used over a long period of time as part of a long-term insurance strategy, captive insurance arrangements offer a range of potential advantages. These advantages range from improved and customised coverage terms (our experience is the terms offered by captives and their reinsurers are generally broader than through the direct insurance market) to greater financial flexibility (including increased liquidity). For example, the use of a captive insurance arrangement allows a company a degree of flexibility in the manner in which it may look to capitalise a captive insurer. One such method of capitalisation may involve the payment by the company of a premium to the captive entity. Over time, the premium paid can be used to capitalise the captive entity and in turn, pay any claims which may arise. In addition, any surplus funds which are accumulated by the captive entity over time can be used for a number of purposes, such as the payment of dividends from the captive entity to its parent[1]. Different structuring with reinsurance arrangements can also mean that return reinsurance premiums can be used to capitalise the captive and provide other financial benefits.
Which industries utilise captive insurance arrangements, and for what types of risk?
In September 2020, Marsh reported a notable increase in the number of organisations turning to captives in response to the hardening insurance landscape[2]. Indeed, Marsh cited an increase of over 200% in the number of captives established in the first half of 2020 when compared to the number of captives established for the same period in 2019[3].
The financial services and health care industries are the most popular industries globally in terms of the number of captives and premium volume[4]. However, industries such as manufacturing, retail/wholesale, construction and energy are also increasingly exploring the benefits which captive insurance arrangements can offer[5]. Interestingly, midsized captives with premiums between $5-20 million have shown the most growth over the past five years[6].
Risks commonly written by captive insurers include all-risks property, general/public liability, workers’ compensation/employer’s liability, marine/cargo, directors’ and officers’ liability and professional indemnity risks[7]. Cyber risks top the list of new areas that regulators see captives insuring more frequently, closely followed by employee benefits and professional indemnity[8].
How can captives be utilised to mitigate the current difficulties in the D&O and PI insurance markets?
The aforementioned benefits of captive insurance arrangements can equally be used to mitigate some of the difficulties currently faced in the directors’ and officers’ (D&O) and professional indemnity (PI) insurance markets.
However, it is important to note that the use of captive insurance arrangements is not without its limitations. For example, while the practice of reinsuring the whole or a portion of an insured risk within a captive has historically allowed insureds of captive arrangements to take advantage of the often more favourable insurance terms on offer from the reinsurance market, the current conditions in the market are beginning to have a corresponding impact on the reinsurance market. As a result, the terms offered by the reinsurance and commercial insurance markets are becoming increasingly comparable.
In addition, for D&O liabilities, the utility of captive insurance arrangements is offset by the fact that they can only be used to provide cover to a company for securities claims (which are traditionally covered under “Side C” of a company’s D&O insurance policy).
That is because companies and their related bodies corporate are prohibited by statute from indemnifying their officers, either directly or through an interposed entity, against certain liabilities and costs. In practice, the relevant statutory prohibitions operate to preclude a company from using a captive insurance arrangement to provide cover for such liabilities and costs. Therefore, companies remain dependant on arms-length insurers to provide such cover. Otherwise, officers may be left exposed without the ability to seek indemnity from either the company or under an insurance policy.
Conclusion
Whilst captive arrangements are not a silver bullet for the difficulties many companies are currently facing as a result of the conditions in the insurance market, they do provide an alternative structure within which to insure against various risks. It is certainly an area worth exploring for Australian corporates.
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March 30, 2021 at 06:12PM
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