Captive alternatives gain traction

Insurance markets worldwide are showing rate increases, reduced capacity, and tighter underwriter scrutiny in response to the COVID-19 pandemic, social inflation, above-average catastrophe losses and downward pressure on investment returns.

There are now more captive insurance companies than traditional insurers globally, estimated at more than 7,000 captives domiciled in more than 70 jurisdictions. The US is the world’s leading market for captive insurance, used by up to 70 percent of Fortune 500 companies. Globally, 46 percent of companies are likely to explore a new captive, according to a recent survey by Aon.

Captive insurance use is also expanding from traditional large global corporations to mid-sized companies. As risk managers continue to explore captive insurance to self-insure their company’s risks, they quickly realise that not every organisation is equipped to handle a full captive. At least, not right away.

For those considering risk retention, new business models for captives are readily available. Structures such as protected cell companies and virtual captives enable smaller corporates to access the benefits of captive insurance without needing to set up the infrastructure themselves.

The best solution for each organisation falls in a different place on the risk retention spectrum (Figure 1), considering risk appetite, capital position, exposure, and other factors. One of the key advantages of retaining risk is that the programme can be customised to the insured’s circumstances and risk appetite to a greater degree than a traditional risk transfer programme.

At the same time, a structured solution such as a virtual captive, offers turn-key implementation that alleviates the headache of regulatory set-up and navigation.

Figure 1: The risk retention spectrum

Let’s take a closer look at a few practical options for customers to manage risk retention strategies, while improving the efficiency of their insurance programmes, and managing responsibly the downside risks of increased retentions.

If you have the appetite for increased risk retention but want to cap the downside risk potentially caused by several losses, aggregate stop loss cover provides insurance protection where the aggregate losses in the risk retention layer exceed a predefined threshold.

Covers can operate directly or behind a captive and on a single year or a multi-year basis, the latter giving the insured long-term stability around how much risk they are taking within the retention layer.

Some key considerations for the aggregate stop loss tool are the insured’s risk appetite, the insured’s situation, the exposure that we might expect, and the insured’s capital position. Aggregate stop loss, if offered direct to the insured, doesn’t solve the requirement, if any, to evidence cover at a lower level. To achieve this, the insured may need to use one of the other tools.

If you’re looking to increase retention and considering a captive, but don’t want to set it up from scratch, a virtual captive offers a turn-key alternative. It is effectively an insurance policy, typically multi-year, with mechanisms built in that replicate those of a captive. It utilises the insurer’s balance sheet and administration infrastructure, to get the same benefits that they would get out of a captive, but via a (structured) insurance policy.

A few different attributes are on offer, for example a multi-year term and a premium funding component to help fund (expected) losses. There is also an experience return (low claims bonus) at the end of the term, to replicate a dividend back to the parent in case of an underwriting profit in the captive. In turn, there may be experience surcharges which kick-in if actual loses exceed certain thresholds, much like a capital injection into a captive.

“If your organisation is looking to reduce its dependency on the insurance market, now is the time.”

Typically, an aggregate stop loss component is already built in, to transfer risk beyond the corporate’s risk retention appetite—similar to a captive buying a stop loss where the captive’s risk-bearing capital reaches its limits.

Several potential motivations are available for a virtual captive:

• The insured may like the captive mechanism but doesn’t want to go down the full-blown captive route.
• At the end of the policy period, if the insured decides not to continue with the arrangement, there are no winding-down issues, as there can be with winding down a captive.
• Through the virtual captive route, the insured can (hopefully) build up some capital. At the end of the three-year term, they have an underwriting profit and they get a low claims bonus, which they could use to partially capitalise a full-blown captive.
• By using the aggregate stop loss component within the virtual captive, the insured can limit their downside risk, where the losses significantly exceed their retention appetite and projections.