Captive formations

Preparing for a surge

Challenging economic conditions and the rising cost of insurance is set to trigger a surge of captive formations in Europe, according to AM Best.

A November 2020 AM Best Market Segment report titled “Europe’s Captive Segment Poised for Growth Amid Hardening Insurance Conditions”, notes that Guernsey, Luxembourg and the Isle of Man all recorded a reduction in their number of registered captives during 2019. In each jurisdiction—Europe’s three largest domiciles for captive insurance companies—the number of licences surrendered exceeded the number issued, AM Best notes.

This trend is set to reverse in 2020 and 2021, AM Best predicted, as hard market conditions make captives more attractive as a risk retention tool.

Since the beginning of 2020, commercial re/insurers have commonly reported double-digit percentage increases in rates, and a tightening of terms and conditions, AM Best notes, with casualty lines particularly affected.

“Amid tougher renewal discussions, AM Best has observed an uptick in the use of existing captives, as owners seek optimal risk transfer solutions,” the rating agency says. “A number of captives have increased retentions or limits on existing cover, while in some instances they have expanded into new lines of business as their parents have looked at increasing captive utilisation.”

AM Best argues that the performance of captives in Europe throughout the COVID-19 pandemic corroborated its view that the European captives it rates have strong capital buffers that provide resilience against severe market shocks.

AM Best-rated European captives have not reported significant underwriting losses related to the COVID-19 pandemic, it says. While some have reported lower premiums as a result of the pandemic, this has typically been accompanied by a reduction in claims activity, it adds.

Meanwhile, AM Best notes, an increasing number of captives owners have integrated environmental, social, and corporate governance (ESG) factors in their operations, which has had an indirect effect on captives.

“Cyber risk and environmental liability are just some of the new areas of coverage for captives.” AM Best

A customised approach

European captives are exempt from EU Directive 2014/95/EU, which sets out the disclosure requirements of non-financial and diversity information for large companies. Despite this, an increasing number are considering incorporating ESG factors into their operations, AM Best says.

In practice a captive’s ESG approach tends to be closely aligned with that of its parent, AM Best notes, with initiatives governing things such as corporate governance and investments at the group level filtering down to the captive.

Many captives hold “a large part of their investments in inter-company loans, with the underlying assets invested by their parents,” the rating agency says.

“A change in a captive parent’s operations, notably in an effort to manage transition risk in industries such as oil and gas, can have a knock-on effect on its insurance needs,” AM Best says. “Ultimately, this would require a captive to adapt accordingly.”

Conversely, new opportunities may arise for captives that could push some in the opposite direction, away from more ESG areas. As commercial re/insurers integrate their own ESG factors into their strategy, capacity shortages could arise in some lines of business or sectors, creating business opportunities for captives in so-called “toxic” industries, AM Best notes.

“Captives make use of their privileged access to data and proximity to risks to develop customised products.”

AM Best advises captives to assess ESG exposures as part of their risk management activities to better understand the potential impact on their business.

“A failure to do so can present significant risks, be they financial or reputational. Cyber risk and environmental liability are just some of the new areas of coverage for captives, and as such will require a fresh consideration of ESG factors for operators,” it adds.

AM Best argues well-structured innovation allows companies to develop sustainable competitive advantages and better respond to external challenges such as low investment yields, stagnant growth, and deteriorating expense ratios. This is the thinking behind the development of AM Best’s innovation scoring system, allowing investors to better appraise how open companies are to embracing innovation and harvesting those benefits.

Captives are themselves the result of innovation, AM Best notes. “They were created to provide insurance solutions not readily available in the open market, to develop flexible risk coverage and to improve the risk management and loss prevention capabilities of their parent groups,” the rating agency explains.

“The success of this innovation is demonstrated by the endurance of the model and by the continuing importance of captives to their parents. Captives make use of their privileged access to data and proximity to risks to develop customised products that cover the changing needs of their parents.”

Captives are harnessing digitisation to make it easier and more cost-effective to write third-party business which, AM Best notes, strengthens their relationships with key partners and secures diversification advantages for the captive.

“Big data and actuarial developments are also supporting captives with the underwriting of new products, whether for the benefit of their parents or third parties,” AM Best adds.

Share this page

Image Credit: / Sutadimages