Modern-day risk managers are extraordinarily sophisticated. Long gone are the days when their job entailed little more than broker relations over long lunches. These masters of risk have become financial engineers with a critical role to play in the stewardship of corporate balance sheets, and captives have become the number-one tool in their box of tricks.
The sophistication of captives and the financial instruments behind them has evolved in step with the risk managers who run them. The very first captive known was launched in 1901. It was set up to help its sponsor pool risks and hang onto premium.[i] In more recent times, multitudes of additional motivations have driven captive creation. They include capacity shortages, tax advantages, cycle management strategies and an absence of commercial appetite for certain types of risk.
Captives come to the fore when corporations are confident that their risk-management regime is superior to peers, and they pay too much for open-market cover as a consequence. They are invaluable hothouses for the transformation of uninsurable risk into transferable packages. Cyber insurance, for example, was one of the first developed inside captives.
With this many deliverables, captives have moved well beyond their old-fashioned role as the hard-market antidote to the expense of rising insurance premiums. They continue to deliver a flexible range of financial benefits which large and even mid-sized corporations cannot afford to overlook, at any point along the insurance pricing cycle.
Manage your TCOR
An increasing number of in-tune risk managers have come around to the insurance company perspective of risk premium being an asset. Rather than being endured as an inevitable cost, the potential commercial value of risk premium is now acknowledged by many corporate officers, and managed as such.
The current era of captive ownership is often driven by the desire to minimise TCOR, the Total Cost Of Risk. It comes up often in conversations with captive managers. To minimise TCOR, corporations use captives to develop increasingly sophisticated approaches to structuring reinsurance that is designed to dovetail with their risk tolerance and minimise the frictional cost of risk transfer. Many of the more-sophisticated and risk-diverse captive owners use multiple key tactics to achieve this goal.
Chief among these is to gain access through a captive to the diverging appetites of the entire global reinsurance market, where products include an array of multi-class, multi-year structured reinsurance and conventional treaty reinsurance markets. With the support of the capital tools these carriers provide, captive managers can finance frequency losses more efficiently, reduce the frictional costs, and garner the benefits of risk premium as an asset.
Facultative reinsurance still plays a big part in almost any captive strategy, but portfolio trading of less-remote risks may generate substantial savings. That’s down to the diversification benefits gained by using these reinsurance tools to finance non-correlating attritional risks. The benefit can be demonstrated through analytical methodologies more typically reserved for commercial insurance companies, but which allow the risk – and the bulk of the premium – to remain in the hands of the captive.
Seven benefits of captive portfolio reinsurance
Alongside the almost irresistible lure of cash savings, captives’ use of structured and treaty reinsurance may deliver multiple additional benefits. One of these is greater consistency of cost, which removes uncertainty from the impact of risk on the balance sheet and the P&L. By using structured reinsurances to spread losses over time, for example, fluctuations in the commercial cost of risk are flattened.
Another benefit is a reduction in the administrative burden. At the front end of the transactions, all immaterial changes to the risk portfolio may be agreed by the fronting market, and automatically bound. That allows premium to be adjusted at the end of the period, on pre-agreed terms. That light-touch process reduces the cumbersome effort required to attach new risks.
Third, the sponsoring company’s risk tolerance can be very much more closely mapped to the coverage in place, and fourth, tail risk arising from clash between multiple classes can be removed from the balance sheets of the captive and sponsor. That produces greater capital efficiency, and therefore a lower total cost of risk.
Fifth, treaty reinsurance can be used to reduce volatility within structured reinsurance placements, in line with market appetite. Sixth, scenario-testing for multi-class ‘each loss’ coverage can help to focus on existential risk to the captive. Seventh (and in a way most importantly), relationships developed with reinsurance carriers tend to promote the longevity of a mutually beneficial relationship, which will further reduce volatility and the total cost of risk over the medium term and in the long run.
Better than ever
The traditional benefits of captive ownership are enhanced along the way. With greater resources and third-party expertise on tap, they are an improved innovation lab for risk managers to tackle challenging risks and markets. With the support of enormously capitalised counterparties to build a captive’s balance-sheet strength over time through retained earnings, corporations are better able to deal with otherwise uninsurable risks. That makes captives a powerful risk financing tool, a benefit flattered by multi-year reinsurance partners.
Captives remain tax-efficient structures, but the taxation advantages of captive ownership have long since moved out of the foreground. The newer focus on efficiency of risk transfer has forced taxation benefits into retreat. As a result, captive jurisdictions are multiplying as regulators world-wide see the advantages of captive onshoring, and in some cases even actively encourage redomicile into a new, captive-friendly local insurance environment.
In the UK, for example, the option of Lloyd’s as a domicile has a special benefit. The market’s mutually held licences remove the need for stand-alone fronting arrangements in every relevant country, which eliminates a significant frictional cost. Meanwhile, supervisors of the wider UK insurance market, along with others in Europe, are actively developing regulatory frameworks to make local captives attractive.
All that taken together, and despite the easing market cycle, captives are likely to become attractive vehicles to a wider range of companies than ever before. With the right support and advice, risk managers can use them to reduce dramatically the total cost of risk for almost any corporation which enjoys a natural risk diversity. It’s too good an opportunity to overlook.
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[i] Economic Insurance was formed by the shipping magnate Christopher Furness to cover his companies’ vessels. It is now part of Hiscox.
