Towards a virtual model

The global insurance market continues to harden. Economies have slowed down, the COVID-19 pandemic is wreaking havoc, and there is a level of political uncertainty present in many parts of the world. A combination of those three has inevitably led us to a market with less capacity and higher premiums.

Amid these difficult conditions, we are faced with seeking out new ways to diversify our risk financing options. Risk managers are exploring index-based coverage, fronting options or captive insurance. Most large (Fortune 100) companies have had captives for years. They have the size and the structure to self-finance the risk and to navigate a rather complicated regulatory, legal and financial process. However, not every organisation is prepared to take that on.

If setting up a captive sounds good to you in theory, the following criteria could help you determine if you are, in fact, ready:

• Is your expected loss lower than the premium set by your insurer implies?
• Do you feel that in the current market the capacity is limited, and the premiums are too high?
• Are you looking to purchase reinsurance or access the wholesale risk transfer market?

If you answered “yes” to any of those questions, perhaps it’s time to talk captive insurance. If you’re also concerned about the cost and the complexity of setting up a captive, a virtual captive solution might be a better alternative.

Simply put, a virtual captive is a multi-year insurance agreement between you—a customer—and a licensed insurer that provides an efficient captive approach for risk financing. It streamlines the setup by using the insurer’s existing risk management infrastructure, and allows you to self-finance the risk, yet keeps it on Swiss Re Corporate Solutions’ balance sheet.

No set-up expenses

A traditional captive can be costly. A virtual captive keeps the mechanics of a traditional captive with one major difference: the insurer handles the setting up and administration of the supporting balance sheet—virtually taking it off yours.

No management cost

Insurance companies are set up to manage risk transfer products and services and can easily take on the complexity of the administrative process, including navigating any regulatory requirements. This means you can tap into a broad range of services as part of your virtual captive agreement, for a lot less than setting up a similar in-house infrastructure from scratch.

Performs as a captive

A virtual captive covers the same risks as a traditional captive, but instead of having a legal entity on your balance sheet, it is structured as a multi-year insurance agreement between you and the insurer.

The premium for the duration of the agreement is based on the expected losses—the risk that you agree to finance—as well as the cost of administration and using our balance sheet.

In the event of a no, or low, loss scenario, you would receive a low claims bonus at the end of the agreement period. Likewise, if the losses exceed a predefined threshold, you may have additional premiums due. This payment structure is similar to the dividend payment of a captive to its parent, and the call for additional capital depending on the underwriting result of the captive.

Let’s say you’re a steel producer and a key supplier for the automotive industry, among others. Your property insurer calculated an expected loss that seems too high, resulting in a premium increase that you would rather not pay.

Instead, you are willing to self-insure the layer between your current deductible and $5 million. After considering a simple retention on your balance sheet, a protected cell company and a full captive, you opt for a virtual captive structure.

Your own actuarial analysis estimates an expected loss of $1.5 million per year. You also assess your maximum self-financing risk appetite for a three-year virtual captive agreement and arrive at $1.75 million per year, plus $3 million additional premium, in case the losses exceed the premiums paid (for a maximum of $8.25 million self-financing risk appetite.)

Your licensed insurance partner—Swiss Re Corporate Solutions—proposes a three-year virtual captive programme with:

• An annual premium of $1.75 million
• A maximum coverage of $5 million per case minus deductible per event
• A maximum coverage of $7.5 million per year
• A maximum coverage of $15 million for the three-year period

In the event that your losses are lower than the amount of premium paid or are absent entirely, you receive a low claims bonus. In this example—74.2 percent times net premium, minus losses, plus additional premium—that would be approximately $3.9 million.

At the same time, if your losses exceed the premium amounts—eg, a loss of $15 million over the three-year period that would exhaust your maximum coverage—you would be required to pay an additional premium ($3 million in this case.)

In either scenario, you benefit from a captive approach to risk financing, gain access to wholesale reinsurance markets, and avoid the associated costs of implementing a captive.

Not quite. Although the risk is to a large part self-financed (the same as with a traditional captive), the insurer’s risk appetite and the volatility of certain markets still play a role. However, a virtual captive is more flexible than most traditional insurance programmes.

Most importantly, if you are looking for a hard market solution that is simpler to set up, simpler to exit, and comes with more easily navigable regulatory and reporting requirements than its traditional counterpart, a virtual captive is worth exploring.