Originally published in Worldwide Risk Solutions, April 2012
Fiona Le Poidevin, Deputy Chief Executive of Guernsey Finance, explores how captive insurance offers a new revenue stream for brokers.
Some say that insurance brokers are a breed apart. While this may be the case to some extent, I am sure that they, like the rest of us, are eager to tap into any possible additional flows of income. Those that are, will be very interested to learn more about a potential new revenue stream for their business offered by captive insurance.
The captive concept
A captive is an insurance company which is usually formed for a specific purpose, primarily self-insurance. It is called a 'captive' because, in its purest form, it is set up by its owners only to insure the risks of its parent and/or fellow subsidiaries.
These can be established as either direct-writing captives, who then use a third party reinsurer, or as reinsurance captives, where a fronting company (conventional insurer) acts as an intermediary. In either case, the major distinction from using the conventional insurance market is that both the premium and risk are captured within the structure, allowing captive owners to benefit from any resulting underwriting profits.
Captives can be established through conventional limited companies, Protected Cell Companies (PCCs) or Incorporated Cell Companies (ICCs). The cell company concept was pioneered in Guernsey when, in 1997, it introduced the PCC.
A PCC is a company made up of a core and individual cells. Each cell is distinct and therefore the assets and liabilities of each are ring-fenced. This legal segregation ensures that no claim against one cell will be covered by the funds from another.
The ICC, like the PCC, has cells but in this case the cells are separately incorporated and distinct legal entities. This offers flexibility in terms of an individual cell being able to migrate away from the main structure, to convert to a stand-alone company and also potentially to amalgamate or merge with other incorporated entities.
Cell companies offer the advantage of one parent being able to write different lines of business into individual cells. They also provide the possibility of third parties being able to own a captive and allocate individual cells to different clients.
This latter point means that captives are no longer the preserve of large international organisations. The ability to take a cell of an existing structure rather than establish an entirely new, conventional limited company has distinct benefits such as flexibility and cost efficiency which, for small to medium sized businesses in particular, makes captive insurance more viable.
As far as brokers are concerned, these developments mean that their clients, typically small to medium sized enterprises, can begin to think about utilising a captive program to insure at least some of their risks. If they do embark on a captive programme then there are two potential routes.
One option is to offer clients the ability to tap into captive insurance through the use of a 'pure captive' which sits as part of the client's group structure and complements other coverage through the conventional insurance market. This could either be via a wholly owned subsidiary or a cell of a PCC or ICC. There are significant upsides to the 'pure captive' approach but there also needs to be an awareness of the downsides as per the below.
Advantages for the client
- Owned directly by the client as a mechanism to manage self
- Potential for underwriting profit
- No fronting insurer required – first party
- Over time premium can be geared to actual loss experience
- Positive cash flow and investment income on premiums and
- Possible greater control over claims
- Influence over policy terms and types of risks covered
- Potential leverage with the external insurance market at
- Assists the client by providing a focal point for risk
Disadvantages for the client
- Initial capital requirements
- Exposure to possible losses
The key thing to remember is that the broker still has a part to play. The client is unlikely to put all its risks into the captive and so the broker will need to work through the insurance programme with the client to determine which business sits within the captive and which risks will still need to be insured on the traditional markets. The broker may also be involved in policy production, pricing of risks, general administrative tasks and reinsurance at the back end, from the captive back out to the external market. By identifying the need for a captive insurance programme, the broker will have provided a comprehensive service to the client which can only enhance and improve the client relationship.
Third party captives
A second option is for brokers to establish their own (reinsurance) captive. Client risks are covered through conventional insurers and then at least some proportion of these are reinsured though the broker (reinsurance) captive, with the risks of different clients written into separate, individual cells. Third party captives offer some of the following advantages for brokers:
- Tailored service for clients creates more value from existing
- Earns additional revenue
- Enhances control
- Ability to identify good quality business – low
- Hedge against a hardening market
- Pricing and cover flexibility
- Access to reinsurance markets
Perhaps the most startling advantage for a broker is the potential flow of extra income. Compared to seeking coverage solely through the conventional insurance market, use of a broker (reinsurance) captive not only retains the premium within the structure but also generates an underwriting profit which only has to be shared with the client.
Our advice is that brokers should not be scared of what this means for their business but actually, by embracing the captive concept, they too can benefit. Certainly, doing nothing is not an option because it is likely that clients will hear about the advantages of captive insurance from another source. The client may then go direct to an existing captive insurance provider or even decide to establish their own structure.
So what should brokers do now? The first thing is for them to understand and build their awareness of captive insurance and the second is to think about how they can offer captive insurance to their clients, considering both pure captives and third party captives. They should then start to educate their clients about the benefits of captives.
Traditionally, captive insurance vehicles were established in 'offshore' domiciles, such as Guernsey, principally for tax reasons. Today, experience and expertise, flexible structures and proportionate regulation are just as, if not more, important and these are areas where Guernsey excels.
The insurance industry in Guernsey has its origins dating back to the 18th century and the Island's first captive insurance company was incorporated in 1922. Since then, Guernsey's insurance market has grown to the extent that research from both Business Insurance and Captive Review recognises the Island as the largest captive domicile in Europe and number four globally.
Guernsey plays host to subsidiaries of global names such as Aon, JLT, Marsh and Willis, as well as independent, boutique operators such as Heritage Insurance Management and Alternative Risk Management (ARM), providing an holistic environment for insurance solutions.
The strength of Guernsey's captive insurance sector is reflected by the fact that approximately 40% of the leading 100 companies on the London Stock Exchange with captives have them domiciled on the Island. However, firms from across Europe, the USA, South Africa, Australia, Asia, the Middle East and the Caribbean have established captives in the Island.
As mentioned earlier, Guernsey pioneered the PCC and it has since also introduced the ICC. This experience means that Guernsey has built a range of financial services professionals with the highest level of expertise in utilising the structure. In addition, the Island has, through legislative advancements, developed a regulatory infrastructure that enables them to be particularly widely employed.
Indeed, regulation is an important factor in choosing a captive domicile and as such, Solvency II is a key issue. There is significant uncertainty around Europe and beyond regarding both the timing of introduction and also the implications in practice of Solvency II. However, in Guernsey, we have opted for certainty. The Island is not part of the EU so we are not required to adopt its Directives and currently the Island doesn't have any plans to seek equivalence under Solvency II.
Guernsey will continue to meet the standards of the International Association of Insurance Supervisors (IAIS) – the IMF has commended the Island for having high levels of compliance with the 28 insurance core principles of the IAIS – but its proportionality principles mean that we are able to provide a more attractive environment for captive owners and other niche insurers.
The right conclusion
What we are saying to brokers is that captive insurance is a viable option for their clients, including SMEs. Brokers should take the initiative to become more informed, pass this on to their clients and then start looking at how and in what form captive insurance could become part of their risk management programme. This will be the best way to retain clients and of course, it may also generate a new revenue stream for brokers.
For more information about Guernsey's finance industry please visit www.guernseyfinance.com.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.