Brown & Brown
Making the most of a captive
Doug Severs of Brown & Brown provides a snapshot of the current state of the captives market and some advice about their optimisation.
“Organisations should review their captive’s investment performance and investment policy at least annually.”
Doug Severs
Brown & Brown
Organisations seeking commercial insurance are experiencing higher premium rates and fewer coverage options. The impacts of the COVID-19 pandemic, Russia’s invasion of Ukraine, high inflation, supply chain interruption, and changing interest rates have been driving factors.
Increases in the frequency and severity of natural disasters such as Hurricane Ian have also had a substantial impact on the insurance industry. Commercial insurers are offering more restrictive coverage than before with exclusions for key perils such as wildfire or lost revenues due to viral outbreaks or pandemics.
During 2022, total captives worldwide increased from 6,074 (2021) to 6,191 (2022); and the positive trend of captive formations has continued in 2023. In short, the continued hard insurance market has led to organisations looking for ways to lower their total cost of risk (TCOR). As a result, we have seen greater utilisation of existing captives and a sustained interest in new captive formations. Whereas captives were traditionally used to fill mostly primary layers of coverage, we are seeing more captives being utilised across insurance towers to fill gaps in coverage, add capacity, and provide premium relief.
Higher premium rates for lines such as property and cyber are encouraging organisations to take on additional risk in their captives through higher programme deductibles and participation in excess layers. Captives with sufficient capital are diversifying their coverage by adding D&O and other executive liability lines. Of note is the 2022 Delaware legislative update (Senate Bill 203) making it viable for captives to write Side A D&O coverage under certain conditions; this is partially responsible for the uptick in captives writing such coverage.
Reinsurance rates remain impacted by the hard market which has prompted organisations to reevaluate their risk appetite, the limits they purchase, their pool of reinsurance partners and/or their sources of capital. To some extent, insurance-linked securities (ILS), traditionally used as cover for property catastrophe claims, are being viewed increasingly as a viable alternative source of capital. The continued expansion of risks covered by ILS beyond property catastrophe is likely to provide even more options to diversify reinsurance towers in the future.
As organisations rely further on their captives as a source of risk financing, it is essential that they optimise their captives through strategic plans focusing on key factors including risk retention strategy, investment strategy, collateral management, captive domicile selection, and corporate governance. Brown & Brown has been working with our clients, as well as captives managed by other managers, on “health check” engagements, the goal of which is to optimise and make recommendations on their existing captive programmes.
The following are some recommendations to consider for captive optimisation.
Risk retention strategy
Fundamental to a captive’s strategy is determining which risks to retain and which to transfer. The decision to transfer or retain certain risks centres around cost of capital in the commercial insurance market. If the cost of retaining a risk is less expensive than the cost of first-dollar coverage, then consideration should be given to placement in the captive. As a general rule, risks that could develop into long-tail events should be transferred, while risks involving frequency, along with some severity, are more suitable for retention.
Recommendation: Organisations should perform relevant financial modelling to support key decision points when it comes to deciding which risks to retain and at what levels. A TCOR analysis should be performed on a regular basis and will help identify optimum and appropriate levels of risk retention for each risk.
The TCOR should be carried out under various scenarios of risk retention and should contemplate relevant cost items including risk transfer premium, losses, collateral (if any), underwriting and operating expense.
It should be performed on a net present value basis in order to project TCOR in today’s dollars. The captive manager and actuary can assist with a TCOR analysis.
Investment strategy
Captives generate earnings primarily through underwriting and investing activities. The proper deployment of the captive’s premium dollars into investing activities is vital to ensuring the captive maintains sufficient reserves and cash flows and delivers an appropriate return on investment. The key objective for most captives is to ensure that preservation of capital is prioritised, cash is available to meet claims and other obligations as they come due, and appropriate returns are generated over time.
Due to volatility in operations, captives in their initial stages should emphasise liquidity, whereas mature captives should consider a more sophisticated and long-term approach that can generate higher returns and match cash flows with claim payout projections.
Recommendation: Organisations should review their captive’s investment performance and investment policy at least annually with their investment advisor to determine whether changes in the captive’s life cycle or financial market conditions warrant a change in investment strategy. To illustrate, it is well known that the rising interest rate environment that began in 2022 had a negative impact on captives holding material allocations in the fixed income sector. As a result many of the captives that sold fixed income investments in the past year experienced capital losses.
Looking forward, with further rate increases expected over the next 12 months, organisations should already be having discussions with their investment advisors on how they can take advantage of these higher interest rates and whether changes to investments allocations are needed.
Collateral management
Collateral is a material aspect of operations for many captives. It can be expensive and tie up assets at the parent or captive level for prolonged periods of time. While letters of credit (LoCs) are most common, other alternative forms of collateral such as collateral trusts, funds withheld, surety bonds, parental guarantees or back-to-back LoCs may be available under a lower cost structure and may offer greater flexibility.
Recommendation: Organisations should regularly evaluate the impact of collateral obligations on the parent and the captive, engage in collateral discussions with beneficiaries, and explore alternative forms of collateral if cost-savings and other benefits are achievable.
Captive domicile selection
A captive’s domicile plays a vital role in its operations. Over time, circumstances may arise that have a material effect on the captive or its parent. Examples include higher taxes and fees, changes in regulatory requirements, merger and acquisition activity at the parent or captive level and expected changes to the captive’s plan of operations.
Recommendation: Organisations should evaluate their captive’s domicile on an annual basis; the captive’s annual meeting is an ideal time for domicile updates, regulatory and otherwise.
Corporate governance
The captive’s board of directors is responsible for the strategic direction and oversight of the captive’s operations. The board should consist of qualified members with an appropriate blend of insurance and financial expertise. Captive boards typically comprise executives from the parent company and almost always there is a distinct difference between the operations of the parent and the captive.
Most parent companies are not in the business of insurance so it is important for the board to be properly educated on the fundamentals of captive insurance operations, including financial reporting and analysis, regulatory requirements and corporate governance. This is pivotal to their understanding of how their captive programmes are viewed and regulated in their domicile.
As their captives programmes develop further, certain organisations are considering the addition of an independent director to their board. A quality independent director, free of influence from the captive’s parent, serves as a disinterested voice and provides necessary risk management expertise. If they reside within the captive’s domicile, they can fill the role of resident director as required in most domiciles and provide guidance and updates on the local regulatory environment.
Recommendation: Organisations should consider routine training for their captive’s board members and addition of an independent director, if applicable. Training curriculum can be provided by the captive manager and may consist of operational and/or regulatory updates provided at board meetings or through a more formal curriculum if desired.
In conclusion, the continued expansion of captive programmes and captive formations through the remainder of 2023 is likely. This will highlight the true value proposition that captives offer to their parent organisations. Should you be interested in discussing a captive formation, an expansion of your existing captive programme, or other optimisation strategies for your captive, Brown & Brown would be happy to be of assistance
Doug Severs is a senior vice president at Brown & Brown’s Denver, Colorado office. He can be contacted at: douglas.severs@bbrown.com
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