Be a part of the future

Organisations must learn to manage risk in a volatile, uncertain, complex, and ambiguous (VUCA) world. Organisations must prepare for the disruptions of a changing climate, future pandemics in the near term, digital security, and the failure to create an inclusive and safe work environment, among other risk management challenges.

Empathetic college graduates who can understand a captive’s risk challenges will find themselves in the centre of the risk management universe, assisting firms in meeting their strategic and operational objectives.

The captive insurance company is the organisation’s risk financing laboratory to develop innovative strategies to underwrite risk and drive risk control initiatives. And a captive laboratory requires inputs to design and deliver innovative solutions.

The organisation’s enterprise risk management (ERM) process feeds exposure, peril, and impact data needed by the captive to develop a broad spectrum of property, liability, employee benefit, operational, financial, and strategic risk solutions.

This line of communication connects the captive to its member insureds’ board, ERM oversight committee, and its risk owners.

The ERM innovation lab

Captive insurance is a niche industry and it does not provide the college graduate with the experience to develop a meaningful risk management and insurance career. Right? Wrong.

Why not work where the future is happening today? The VUCA world is disrupting operations across all industries. Digital security, supply chain, and human capital management, among others, must address evolving and mutating perils and threats. The VUCA world has challenged the global commercial insurance marketplace, and the stress is evidenced by the recent difficult property and casualty insurance market.

To be clear, the captive does not replace the commercial insurance market. The captive is a vehicle that develops risk financing innovations by integrating commercial insurance, reinsurance, and capital market capacity into its solutions.

The captive’s ability to ally with these vast financial resources enables the member insureds to comply with local insurance regulations, contractual obligations, and loan/bond covenants. Access to this financial capacity allows programme liquidity and financial security. And the captive provides the member insureds with control over underwriting, coverage, claims management, risk control, and the total cost of risk.

Captives are complex ventures requiring capital, resources, and intelligent input from ERM practitioners, actuaries, underwriters, claims managers, risk control experts, insurance and reinsurance brokers and consultants, lawyers, auditors, insurance regulators, and captive insurance company managers. It sounds as though captives are the centre of the risk management and insurance universe.

A history of success

The captive insurance industry has a long history of being proactive when addressing emerging and evolving risks. I contend that Zachariah Allen founded the first group captive based on environmental, social and corporate governance (ESG) principles in 1838 because he was willing to share his fire loss prevention and mitigation technology with other mill owners.

Allen made improvements to his mill to increase its resilience and decrease the likelihood and impact of a fire. When his property insurance company declined to credit his risk management improvements, he formed a mutual property insurance company with other mill owners who shared his risk management vision and mission. That benefited the local and the regional economy.

Allen could have looked inward, treating his risk control inventions as proprietary to gain a competitive advantage over the other mill owners. Instead, he was willing to share his inventions to the benefit of society.

A group captive insurance programme was central to this initiative. Allen’s group captive grew into FM Global, a major mutual property insurer. Its solutions are driven by research, data, and evidence-based loss prevention and mitigation strategies to build business resilience.

More recently, the developing cannabis industry has found it exceptionally difficult to secure general and products liability and directors and officers insurance. This time the uncertainty is not created by a new technology, but by a conflict in the regulatory landscape.

According to Hugh Rosenbaum in his article “A new cannabis group captive” for Captive International, a patchwork of 33 states (plus Washington, DC) have legalised the use of cannabis for medical purposes. Some, including California, have eased the permission to sell and commercialise it for recreational purposes, but technically, across the US, cannabis is a federally prohibited schedule 1 narcotic in the same class as heroin.

This creates a grey area that means that most traditional carriers will not insure cannabis producers for fear of falling foul of federal regulation, and those that do will do so only at eye-watering premiums. What to do if you are an aspiring cannabis producer looking to gain early entry to this potential multi-billion dollar industry?

In the summer of 2020, CLIC, a cannabis risk retention group, was created to serve struggling cannabis producers in the Nevada area and will now cover general and product liability insurance at half the rates offered by those carriers.

A combination of very high premiums and extremely low capacity has created the conditions that prompted innovators to organise a number of a cannabis producers into their own insurance company.

A strategic risk management tool

The building blocks for any risk financing programme are compliance, capacity and control. Is the captive owner in compliance with all local insurance regulations, contracts, and loan covenants?

Does the captive owner have sufficient risk capital to pay its losses as they come due? And is the captive owner controlling those aspects of its risk management programme from loss prevention, loss mitigation, claims management, control of loss engineering data, and its total cost of risk to the extent needed to achieve both its ERM and risk financing goals? Only a captive-based programme is agile enough to address all three issues.

Captives do require resources, but they can generate capital from underwriting and investment income. Captive insurance companies do employ partnerships such as commercial insurance fronting companies and reinsurers to address compliance and capacity needs. But a captive’s flexibility, agility, and utility are fuelled by these relationships.

The more we expand the captive’s scope, the more it becomes a magnet for data, which makes it an effective platform for designing and modelling risk financing solutions. Expanding the captive’s role will therefore enhance the organisation’s ability to prepare for future disruptive events.

Effective captive insurance company boards must include skilled senior managers from operations, finance, compliance, law, and risk management. This board structure creates the perfect platform for senior managers to discuss uncertainty that matters to their organisations, suppliers, customers, employees, shareholders, and other important stakeholders and develop risk management solutions.

What specific risks should organisations be funding in their captives? The captive is a laboratory for the captive owner to study this question. The ERM process identifies, assesses, and prioritises risks or exposures, and the organisation’s risk registers represent opportunities for the captive.

The role of the ERM process, therefore, is to put the VUCA world into context for the organisation. Captive board meetings are a perfect platform for senior managers to discuss uncertainty that matters to their organisation’s suppliers, customers, employees, shareholders, and other stakeholders.

This integration of ERM and the captive will enable the brainstorming of ideas, programme design, modelling, and implementation of risk financing and data-driven risk control strategies that will help calm the impact of VUCA disruption and allow organisations to succeed.

Captives, true to their history, still fund traditional property, liability, and employee benefit insurance programmes. Today, however, captives are also used to fund voluntary benefits, warranties, cyber risks, medical stop loss, and offer third-party insurance coverage to stakeholders.

The third-party captive insurance programme creates a new profit centre for the captive owner and addresses the strategic risk management needs of its stakeholders.

Driving improvement

An enduring example of captive insurance driving evidence-based risk control to improve operations is the Controlled Risk Insurance Company (CRICO). The Harvard Medical Institutions (HMI) licensed CRICO, the first medical professional liability captive in the Cayman Islands in 1976.

The CRICO board and subcommittees are made up of experienced physician leaders including chief medical officers, hospital executives (including operations, quality, and safety skills), finance and investment professionals, and academics.

This skilled board drove the ERM practices which resulted in data-driven improvements in patient safety, medical outcomes, and reduced HMI’s cost of risk. CRICO’s claims data analysis process led to the development of patient safety best practices and specific risk management initiatives to reduce frequency and severity.

CRICO is an example of how captive insurance company programmes can use data and risk management incentives to advance patient safety. Moreover, many healthcare provider owned captives do provide risk management grants funded from the captive’s retained earnings.

Other organisations are using captives strategically to serve their stakeholder needs. For example, a tool manufacturer uses its captive to offer needed property and liability insurance coverage to its franchisees, thereby securing its supply chain. Some organisations use their captives to insure warranty programmes, improving customer loyalty.

The organisation can use the captive as a risk management tool, offer stakeholders’ access to affordable coverage, create a profit centre, and improve the likelihood that the captive owner will meet its strategic and operational objectives.

With the world still struggling to cope with fallout from the ongoing global COVID-19 pandemic and the spectre of climate change now becoming a short-to-medium term risk, now is the time for organisations to form a captive to improve organisational resilience and stakeholder value before the next global event.

The challenge going forward is to develop creative captive insurance programmes to fund the design of business disruption, recovery, and resilience solutions to increase preparedness.

This will help reduce the overall economic loss caused by dynamic risk issues such as a changing climate and pandemics allowing the captive owners to successfully respond, recover, and continue operations following a catastrophic event.

How can a captive be used to anticipate future risks? Simply put, more control over risk financing means more data. Therefore, the captive can act as an incubator for the design of evidenced-based loss prevention and mitigation strategies.

This includes improved business continuity, crisis management, resilience, and sustainability needed to reduce volatility, uncertainty, and ambiguity.

Furthermore, the captive-driven risk management programme that minimises residual risk can balance the investment in risk financing and risk control reducing the overall total cost of risk.

Well-designed captive programmes can reduce the economic losses from a catastrophic event, reducing the reliance on government for funding. Captives can be part of the private-public partnership needed to address the economic impact from catastrophic events.

Solutions for an uncertain world

The COVID-19 pandemic may end in 2022 but we will continue to live in a VUCA world, requiring most organisations to develop new risk management strategies for a changing risk landscape.

Risk management will also be called upon to improve an organisation’s access to affordable capital needed to grow its business. ESG is a framework for investors to evaluate responsible behaviour and predict sustainable future financial performance. ESG reports and ratings are based on an organisation’s:

1. Environmental performance;
2. Social performance; and
3. Governance standards.

ESG can therefore be used as a tool to identify risks, giving further importance to ERM. ESG ratings will impact access to and cost of capital. And how organisations manage ESG factors arising from their operation may also dictate the way they are underwritten by in/reinsurers.

The traditional view is that a captive has limited application as an alternative risk financing vehicle, best used for underwriting traditional hazard exposures with predictable impacts such as workers’ compensation, general liability, and first-party property among other predictable insurable exposures, but this view is changing.

Organisations must ask whether they are prepared to address the dynamic nature of risk in the 21st century? Many have had to manage several crises at the same time such as the pandemic, wildfires, and cyber attacks; or the pandemic and hurricanes, including flooding.

Cyber, human capital, climate-driven, and pandemic-related perils will continue to disrupt business operations and supply chains globally. Captive insurance programmes are a vital ERM tool to manage these emerging and evolving risks.

How well an organisation manages the complex risks of a VUCA world including the demands of an ESG environment, will determine its long-term sustainability. Captive insurance companies offer an opportunity to drive the risk management creativity needed to meet this challenge, drive down the cost of risk, and improve access the capital.

As risks endlessly evolve into new and unexpected forms, the ways in which a captive may be used to respond might open the door to new innovations. Innovations that may, in the spirit of Zachariah Allen, help benefit not just captive owners, but society too. And that is a good place to be in the ESG age.

If you want to get started in the captive insurance industry, I suggest two routes:

Obtain the Associate in Captive Insurance professional designation from the International Center for Captive Insurance Education.

Consider joining the Captive Insurance Company Association’s NEXTGen initiative, dedicated to developing the next generation of captive insurance professionals.

Michael Zuckerman is an associate professor (instruction) of risk and insurance management at Temple University’s Fox School of Business. He can be contacted at: zuckerm@temple.edu