This current market is a great opportunity for captives to demonstrate their lasting value to their parents and to the global insurance industry as a whole. The global insurance and reinsurance markets are suffering from the impact of COVID-19 claims, which are likely to cost the market circa USD100bn in insured losses. At the same time, it is also being negatively impacted by the fall in equities and interest rates plus the economic downturn which will result in businesses reducing their insurance purchases as a result of client insolvency, reduced inventory values, reduced turnover and so on.
Some market commentators are suggesting that the total insurance and economic loss to the global insurance and reinsurance market will be circa USD203bn. In this environment, it is not surprising that markets are recalibrating their risk tolerance appetite and their pricing outlook. Captives and their parents should see this as an opportunity to do the same.
The headwinds in the market were already clear last year. In a
survey conducted by Principal Re in June 2019, 90% of the
respondents (underwriters, brokers and risk managers) concluded
that rates would increase for businesses that had enjoyed a
loss-free record and 60% expected to see deductibles increase or
come under severe pressure. Today, these headwinds have become a
reality as we see the pressures brought on by the "Four
Horsemen of the Hardening Market" looming large across all
businesses, all geographies, and all classes of insurance.
The pressure is being felt in terms of:
- reducing capacity
- increased premiums
- increased corporate retentions
- restricted wordings
Protection for traditionally insurable risks
- mitigate market-imposed rate increases through higher per loss deductibles
- fill the gaps in capacity shortages that may have arisen from an uneconomically available capacity, or simply insufficient capacity at any price
- reinstate coverage breadth that has been removed as a result of market dynamics
- increase the captive's profit potential by including new covers for non-traditionally insurable risks
- purchase a portfolio aggregate stop-loss programme to bring overall pricing stability and loss quantum certainty, including cover for non-traditionally insurable risk exposures where possible so that the captive becomes a true risk partner with, and a profit centre to, its parent.
Case Study using a captive to tackle the key challenges brought
by the "Four Horsemen of the Hardening Market"
- 35% premium increase for 2020 renewal
- 20% increased self-insured retention
- Market could not provide 100% capacity
A deal was then structured whereby they could use their captive to push back against this (over)reaction from the market.
The first step was to consider their overall risk appetite quantum as this had undoubtedly changed over the years since their retention level was last analysed. It was concluded that Company XYZ could retain significantly more risk and at a better cost of capital than being offered by the renewal market. Having agreed to the revised retention level with the parent, it was calculated how best to use this increased retention capability in the most efficient way:
- The market requirement for an increased primary retention. Rather than settling at the 20% increase required by the market, Company XYZ chose to increase their retention by 20% and in addition write 100% of the primary $2,000,000 layer, thereby putting them in a position to negotiate a reduction to the 35% overall premium increase and to take the primary layer premium into the captive in full.
- The balance of the parent's increased retention pot was used to plug capacity shortfalls in the first excess layer of the programme to ensure it was 100% placed.
- The captive also ensured that the cover it provided to its parent contained a Difference In Conditions provision allowing the captive to maintain the breadth of cover for its parent from which it previously benefited.
So far, so good. However, the increased retentions, whilst affordable, would put a strain on the captive's balance sheet were there to be a deterioration of the expected loss record in the first year of account.
The second and final step was to ensure that were an annus horribilis to occur in the early years of the new cell captive's existence, a bespoke captive reinsurance structure would provide sufficient protection on an aggregate stop-loss basis.
This programme effectively caps the increased captive retention as the stop-loss cover attaches once the aggregate losses paid by the captive in any of its layers of participation exceeds a predetermined prescribed amount. This approach covers the captive from both a deterioration in frequency and severity.
The captive's annual aggregate exposure in the above schematic is unaggregated, which the parent considered a step too far, so it wanted to explore the possibility of buying this down via the aggregate stop-loss market. The captive aggregate stop-loss reinsurance programme was structured to provide capacity on a "second loss" basis whereby the captive would retain a net annual aggregate after which the stop-loss programme would provide an additional buffer As the probability of there being further losses in these layers was estimated at close to zero, the captive's parent then took the decision that further losses would be realised in their own balance sheet.
The premium retained in-house in the captive programme reflects and rewards the company's true loss experience and risk management performance.
Protection for uninsurable risks
There are a number of more creative and strategic uses for which a captive can be employed that will heighten its overall financial benefit to a business by monetising those day-to-day risks that are inherent in an organisation but for which the traditional insurance markets are unable to provide sufficient, or even any, cover.
Most captive owners will have a well-established Enterprise Risk Management (ERM) process which is an integral part of managing their business. This provides a guide to systematically identify, assess, treat, monitor and review risks with the aim of improving the captive's ability to reduce the likelihood and/or impact of identified risks that may affect the achievement of business objectives.
One approach to risk mitigation is to design reinsurance solutions for these under/un-insured exposures thereby generating a new revenue stream to the captive. Some of the examples we have developed include contingent business interruption, loss of use / loss of attraction particularly in non-damage scenario, commodity / trading risk and reputational risk.
Labuan - an ideal base for captive growth
Businesses in Asia looking to take advantage of the strategic growth opportunities that captives provide can look no further than Labuan International Business and Financial Centre, a comprehensive midshore jurisdiction that has actively facilitated captive formations since 1998.
Labuan IBFC is one of the fastest-growing captive centres in Asia with 52 captives and 72.8% of the total premiums originating from international markets. With 7 new approvals H1 2020 alone, Labuan IBFC has approved more than USD267.9 million worth of premiums.
Labuan IBFC offers facilities to set up a range of captives - from pure and rental-based captives to protected cell companies, which offer a cost-effective self-insurance option to small and medium enterprises who find traditional captives out of reach.
The future for captives
2020 will prove yet again, and perhaps more convincingly than in any previous market crisis, that using a captive creatively will bring stability and certainty to corporate insureds in a hard market. Four Horsemen beware!
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.
