Captive sustainability in difficult market conditions

Key emerging risks

Each captive entity will have its own risk profile depending on the insurance risks retained, organisational risk and management strategies currently utilised. The impact of the following risks should be considered and reviewed given recent market trends and uncertainty:

Inflation: Inflationary increases will impact insurance programmes through increased claim payments (especially property and casualty insurance portfolios), and/or increased operational expenses. Implementing pricing increases will help to reduce inflationary impacts on new policies, however captives should be paying particular attention to the inflationary assumptions being utilised in reserving as increased inflation may not be adequately accounted for in traditional reserving models.

Pricing and renewal analyses should also consider testing the impact of a continued high inflationary environment to assess programme sustainability in stress scenarios.

Furthermore, for any previously written policies for which pricing adjustments cannot be implemented, captives could expect to see higher claim costs than originally projected as a result of inflationary changes. The short-term profit expectations of these policies should be analysed in light of high inflation due to the likelihood of increased losses and expenses to allow management to plan appropriately.

Increased interest rates: As interest rates increase, fixed income assets will be devalued against market prices. Due to significant interest rate increases in 2022, captives that use conservative, fixed-income investment strategies may have experienced significant investment losses due to the reduction in market value of their holdings. These losses will erode the total capital base of the captive and may place a strain on future sustainability.

Given the uncertainty around interest rates and market returns in the near term, captives should review their investment strategies to ensure they are appropriate in light of added volatility and uncertainty in the market.

Many insurance products, particularly annuity and other investment-driven insurance programmes, may be negatively impacted by rising interest rates. For these programmes, increased policy lapses are common as interest rates increase and new policies provide cheaper options to insureds. These events can compound the risks noted above if policyholder payments are made and investments liquidated at the same time investment portfolios are devalued.

Hardened reinsurance markets: Over the past couple of years, there has been a noticeable and impactful hardening of the global reinsurance market resulting in significant reinsurance premium increases and reduced reinsurance capacity. These market conditions are generally not projected to soften in the short term as inflation, investment market conditions and significant catastrophic events continue to apply pressure to global reinsurers.

Therefore, captives that rely on external reinsurance markets/partners to manage their risk retention may see additional pressure in the short term as a result of rising reinsurance costs. This will put strain on captive operations and may require premium adjustments at policy renewal.

To combat this risk, captives should place additional focus on their reinsurance relationships, demonstrate differentiated risk characteristics and if possible, begin reinsurance renewal discussions earlier to allow for alternative risk management structures and strategies to be implemented if deemed necessary.

Alternatively, a hardening reinsurance market also provides captives an opportunity to take on additional risk as organisations look for alternative options to reduce overall insurance spend. Captives that have the risk appetite and resources available can expand their underwriting of new risks to drive growth and long-term sustainability for the captive.

Other strategic considerations

Aside from the key emerging risks discussed above, there are a variety of areas where organisations could benefit from strategically reviewing their existing captive structures to increase sustainability through agility and actively combating new emerging risks.

Data usage and automation: One of the benefits of implementing a captive is the added insight into an organisation’s risk profile provided by enhanced data availability as it relates to insured events. When utilised in a timely fashion and effectively, this data can enhance the strategic operations of the larger organisation by providing management with a better understanding of the underlying risks and root causes of loss within the organisation, which can lead to better decisions around risk management.

Implementing automation and strategically developed key performance indicators and data dashboards will ensure the timely and accurate reporting of financial results and allow management to more actively manage and mitigate future emerging risks. This allows for improved predictions of insured costs for planning purposes, and creates an opportunity to implement appropriate risk mitigation strategies to drive profitability for the organisation.

Other emerging risks: The risks inherent in any organisation will change as the organisation and industry evolves. Those risks which were originally agreed to be retained through a captive insurance structure may no longer align with the organisation’s risk appetite or long-term objectives.

For this reason it is important to regularly review the risks taken on by a captive, as well as the risks insured or retained by other areas of the organisation to ensure the effective utilisation of the captive structure to combat changing risk appetites and organisational needs.

Potential areas of focus in an effective captive risk review:

1. Emerging risks and underlying trends specific to the insured lines of business (eg, emergence of higher claims being rewarded in medical malpractice lawsuits, or increased awards in general liability lawsuits)
2. The potential impact climate-based changes will have on the organisation and insured lines of business. This review should be inclusive of the potential impact on longer-term investments in industries that could be downgraded due to environmental social and corporate governance (ESG) initiatives and regulatory changes
3. Data privacy and cyber risks in light of increased cyber attacks and the evolving privacy regulatory landscape
4. Regulatory and tax changes that could significantly change the benefit of the captive structure
5. Other insurance costs incurred by the larger organisation not currently insured through the captive. These insured programmes may benefit from the existing captive structure
6. Other uninsured risks that are retained by the organisation for which commercial insurance coverage doesn’t exist but may be insured through the captive

Conclusions

When a captive is being established, significant efforts are spent to develop the appropriate management structure, risk appetite, retained lines of business, insurance partners, etc. In many cases, these initial decisions are reviewed from a cursory basis and truly questioned only in instances where changing market conditions and external pressures put significant strain on the captive.

However, in order for an organisation to get the most out of its captive structure, these initial decisions should be regularly revisited and reviewed through a clear lens, not factoring in the already established decisions and ensuring that the structure remains ideal for current organisational needs.

At a minimum, recent market changes will require captives to closely review their capitalisation, risk acceptance, and pricing methodologies and be vigilant going forward to ensure their long-term financial stability due to increased financial pressures on the insurance industry.

More mature captives may be able to take advantage of the opportunities that come with hardened insurance and reinsurance markets as captives have a unique opportunity to utilise already developed structures to drive their growth by taking on additional insurance risks at increasingly higher prices.

From an organisational perspective, captive structures can be utilised to combat increased insurance costs for programmes that are well established, well understood and fall within the risk appetite of the captive. Further risk exposure for the captive could lead to increased cost savings for the organisation and increased risk diversification for the captive.

Ideally, captive management should regularly be reviewing the captive’s overall business operations to ensure that it remains appropriate and effective given changing organisational needs and market forces.

To drive this review, the following sample list of questions can regularly be asked by management to ensure the captive is effective in its role:

• How do recent global industry changes and emerging trends impact the captive’s sustainability?
• Do the current insured risks meet our organisational needs and are there new emerging risks inherent within the organisation that fall within the captive’s risk appetite and would benefit from being insured by the captive?
• Do the captive’s current insured risks remain within the risk appetite of the organisation?
• Does the captive structure continue to align with our cultural and organisational goals?
• Are we effectively utilising the data collected through the captive structure to inform organisational decisions?
• Do our third party relationships (insurance/reinsurance partners, captive or investment managers, etc) and agreements continue to support our business, or have organisational changes put us in position to optimise these relationships or internalise these roles?
• Does the chosen captive structure remain appropriate in light of regulatory changes?
• What opportunities exist for the captive to further support the organisation?
• What competitive advantage can be gained through the use of the captive to unlock value for the organisation?

The benefits that may be unlocked from the regular review and effectively utilising the captive structure should far exceed the cost of these reviews.