Originally published in The Broker, Autumn 2009
The current tough economic conditions are causing risk managers and insurance buyers in all sectors to re-evaluate their costs and to examine alternatives. With the general expectations of a hardening market in the insurance sector beginning to be fulfilled, brokers throughout the UK are looking at the most cost effective ways that they can provide risk transfer solutions for their clients.
Most brokers will doubtless already be considering the level of self insurance that their clients currently retain. They will possibly be looking to increase that retention, particularly if the clients possess good loss histories, in order to minimise the effect that the hardening market will have upon their clients' premiums.
The obvious downside of increasing self retention is that no matter how good a client's loss history, they can never be 100% sure that they will not have losses which will impact upon that increased self retention. As a result there is a concern that clients might take a hit on their balance sheet, which in these times with credit both expensive and hard to come by, it is especially important to avoid. This risk has to be considered against the cost of transfer to the insurance market, which is no longer as effective as it once was, as the twin drivers of the market's need to increase premiums, and the clients' need to drive down costs collide. There may be benefits therefore of using a formally structured programme and an appropriate self retention vehicle.
Captive insurance company and protected cell ("PCC") structures, that have been successfully formed and domiciled in Guernsey for many years, have proven to be an ideal vehicle for those wishing to reduce insurance overheads and protect their balance sheets from unforeseen costs.
The captive concept allows clients to set up subsidiary insurance entities to which they pay premiums to take part of their self insured retention. It formalises the self retention structure and creates a fund to meet losses within the retention as they arise.
One of the major advantages of the captive or PCC structure is that it retains any underwriting profits for the captive owner. By combining an increased self retention with a formal captive participation, the client is able to benefit from the underwriting profit that would otherwise have been ceded to the traditional insurance market.
When risk is transferred to the insurance market, a typical insurer will be taking 25% of the premium to cover costs. Also, it is typical for insurers to rate premiums based on the experience of the market as a whole. Those clients are therefore being penalised twice, once in paying for the insurer's costs and again in paying to subsidise the poor loss experience of their peers. These cost inefficiencies can be partially eradicated if a captive structure is chosen. With a captive, clients can save money by paying rates based on their own experience and not passing these premiums on to the third party market.
Another benefit includes access to the reinsurance markets, which effectively enables the client to purchase from the wholesale rather than retail insurance market. As one might expect there can be significant cost savings to be made through accessing the wholesale market direct.
Those with captive structures may also benefit from increased investment income. The investment income arises because of the delay between paying a premium and receiving a claims payment. For liability covers this can be a period of many years, and with traditional insurance the investment income accruing to the premium funds during this time would go to for the benefit of the insurer during this time would be for the benefit of the insurer.
A final advantage of the captive structure is that it effectively enables clients to provide for reserves for events that they believe may happen based upon their loss history over a number of years. Clients can create an Incurred But Not Reported (IBNR) reserve – effectively clients build up rainy day funds beyond the level of known claims, to the level of claims that they expect will arise out of any one year. The captive is a tax efficient vehicle for this eventuality. With on balance sheet arrangements, funds set aside to meet such an eventuality are likely to be disallowed from a tax perspective.
The costs of setting up a captive have sometimes been seen as an obstacle for brokers, but the advent of the PCC structure has added a wider choice of captive options and reduced the entry costs. A typical stand alone captive might require the client to inject at least £100,000 share capital, with average minimum annual running costs of £40,000 a year. However, using the protected cell route in order to take advantage of the captive concept, clients can look at an entry cost as low as £10,000 to £20,000, depending on the level of reinsurance they buy. The other advantage is that the structure can be set up in only a few months.
Firmly established earlier in the year on the OECD 'white' list, Guernsey, with its robust yet pragmatic regulatory environment, is an ideal location. The jurisdiction has built a wealth of experience and expertise in the management and administration of captives, and was the first location to introduce the PCC.
Guernsey has grown to become the leading captive insurance domicile in Europe. Firms from Europe, USA, Middle East, Asia, South Africa, Australia and the Caribbean, as well as the UK have established captives in Guernsey showing its international reach.
It is more than ten years since Guernsey introduced the PCC legislation which offered small and medium sized enterprises an entry into a market which was previously the preserve of the multi nationals. However, there remain many firms that have not considered the captive concept option and with markets hardening and a sharper focus on clients' costs this is the time to re-assess the options.
About the author
Peter Child BA ACII is a Client Insurance Manager with Heritage Insurance Management Limited. Peter has 15 years' experience in the insurance industry having started his underwriting career with the trade credit and political risks insurer Euler Hermes. After seven years in the London Market he returned to Guernsey to work as a regulator with the Guernsey Financial Services Commission ("GFSC") where, as Assistant Director, he was responsible for all applications and approvals submitted to the Insurance Division.
Peter returned to the commercial sector in 2005 and joined Heritage in 2007. He speaks at various insurance conferences from time to time and is a committee member with the Guernsey Insurance Company Management Association (GICMA).
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.