Captive formation

You get out what you put in

Much has been said about the hardening market incentivising a growing number of captive formations. As the cost of insurance increases, and as the availability of some lines of coverage declines, the case for setting up a captive insurance company grows increasingly compelling.

While it is entirely rational for companies to be thinking along these lines, however, the hardening market is not, as a single factor in isolation, a good reason to set up a captive, says Guenter Droese, representative advisor at the European Captive Insurance and Reinsurance Owners Association (ECIROA).

Droese is, of course, a strong advocate of captive insurance companies. Captives are, he stresses, powerful risk management tools that many European companies should be thinking about. He is adamant, however, that companies should not see captives as a panacea. Behind every effective captive there is a team of people who have done a considerable amount of hard work to facilitate the benefits that a captive delivers.

“Data that is gathered by the captive can be analysed and acted upon to reduce claims and improve working practices.”
Guenter Droese, ECIROA

This hard work amounts to more than a token feasibility study to assess whether the economics make sense. Droese argues companies considering a captive should be conducting comprehensive, root-and-branch reviews of their risk management procedures.

“The hard market may make more companies look at captives because they don’t want to pay more premiums but this is a short-term view,” he explains.

Markets are cyclical, the price of insurance rises and falls. If the level of commitment is limited to reducing the next insurance bill, the case for the captive is likely to evaporate relatively quickly. There is little point in going to the trouble of setting up a captive if it is likely to be abandoned as soon as the cost of commercial coverage comes back down again.

More than that, though, thinking about a captive in those terms is to miss the bigger point. “In many cases businesses consider captives primarily to save premium but the impact on the P&L is actually not that big,” Droese says.

“If a company does not have good risk management in place, if it has a bad loss ratio, there is no point in creating a captive—it may crash quickly. You need to look at your risk management processes first.”

Droese admits that the amount of work involved in setting up a captive can be intimidating. “Setting up a captive requires a lot of work,” he says. “That is a big reason why we don’t get more of them, even among businesses that would benefit from having one. You need to conduct a thorough risk assessment of the business.

“If you do not have a clear idea of the frequency and severity of claims the business faces, how do you hope to improve it?”

Protecting the balance sheet

Droese notes that even when clients say they have done a risk assessment, too often it turns out they have not done it thoroughly, and the assessment has not been target-driven.

Getting a company into the necessary mindset to take on this challenge is itself a significant undertaking. Captives remain a niche product that few people properly understand, and convincing the necessary people that the effort will pay off can be its own struggle.

“When corporate insurance or risk managers don’t have direct access to senior management it becomes very difficult to make the case for a captive,” says Droese.

“They need to persuade one or more people at levels between them and the C-suite of the benefits, and that is a hard thing to do. If the risk manager has direct access to the C-suite it becomes easy.

“Once you have convinced the senior management level they will usually give you the freedom to act.”

A well-managed captive that has the ear and the trust of the parent’s senior management and where the risk management processes are robust can deliver benefits that will quickly endear it to even the most sceptical executives. Data that is gathered by the captive can be analysed and acted upon to reduce claims and improve working practices, ensuring it comes to be seen as indispensable.

“Captives can insure risks that cannot be insured in the commercial market” Droese notes. “And they can set a higher attachment point for excess layers, making it easier for the insurance underwriters to provide additional capacity at a reasonable price.”

The benefits are not only measures in terms of costs, he adds. “In a hard market the price of insurance rises and capacity falls but policy wordings are also a huge issue that much less attention is paid to.”

As many companies found out in 2020 when their business interruption policies failed to pay out when they were forced to close their doors due to COVID-19, having a more inclusive insurance policy can be extremely valuable.

“If a company has strong risk management and is above a certain size, I would always recommend creating a captive because it sets aside resources that will protect the P&L and the balance sheet,” Droese concludes.

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