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By Matt Latham, Head of Global Programs and Captives at AXA XL

Trends in the wider insurance market have always had an impact on the captive market. Indeed, many captives trace their origins back to times when insurance capacity for certain lines became more scarce or more costly.

For example, in the mid-1980s, a group of large companies set up captives to manage the U.S. liability crisis. This gave birth to XL – one of our predecessor companies – and ACE.  Both are now, of course, part of global insurance companies.

Recent years have seen large catastrophe losses, which have had an effect on the insurance, reinsurance and retrocessional markets. Two years ago, Hurricanes Harvey, Irma and Maria ripped across parts of the U.S. and Caribbean causing tragic loss of life, widespread destruction and large insured losses.

Last year, windstorms in the US, Japan and Europe, wildfires, freezing conditions, flooding and drought contributed to another heavy loss burden for the insurance industry as a whole.

This has led to insurers reducing capacity in certain lines of business and seeking increases to premiums or changes to terms and conditions. When you add in other factors such as a persistent low interest rate environment, it seems likely that this trend will continue for a while. 

When market conditions change, having a captive in the risk management armoury can prove extremely useful. Through opting to retain more risk in a vehicle such as a captive, buyers can purchase coverage from insurance markets at a higher attachment point where rates may be less pressured.

One of the great benefits of underwriting through a captive is that you have greater control of the premium that you will charge. And that price is influenced purely by the losses sustained by the company rather than by the losses and other macro impacts in the wider market.

This means that the captive can somewhat insulate a company from the price fluctuations of the insurance market. The more risk you take, the more control you have over your insurance premium.

Take the theoretical example of a company that buys €100 million of property and business interruption limits. It uses a captive to take the first €500,000 of any loss and the traditional market for the rest. The captive has a premium of €1 million and the rest of the market currently charges €4 million.

Given current market conditions and a lack of appetite for the industry that the client is in (there have been significant property losses in their sector), the insurance market wishes to increase its price to €6 million. In order to mitigate this, and with confidence in its risk management processes, the captive agrees to increase its retention to €2.5 million. The premium it requires for this is €2 million. As a result of the increased retention, the insurance market is willing to offer terms above €2.5 million for a premium of €3.5 million instead of the €6 million originally called for.

As a result, the total premium is now €5.5 million instead of the potential €7 million. The captive has taken on more risk, so we should not just look at the premium but – assuming normal loss patterns – it has helped to mitigate price increases that were not attributable to its own loss experience. This type of discussion enables all parties to understand the optimised risk financing model for the client. It also creates a relationship where everyone’s interests are aligned. 

New terms, new risks

One area where we are seeing an increased interest in using captives is for cyber risk.

As underwriters have become more inclined to make clear exclusions in their policies to avoid so-called “silent” cyber exposures, many insurance buyers have begun looking at writing more of their cyber coverage in their captives to fill those potential gaps.

And as the terms and conditions that risk managers are being offered for other lines of business may be tightening, we can expect to see companies seeking to write more coverage in their captives. 

New formations

A risk manager who is thinking of setting up a new captive typically needs to present a business case to their company board. Some risk managers that have explored this in the past may not have had enough motivation to convince their board of this strategy. Increased rates or restricted cover can give this argument real weight.

Demonstrable cost savings – showing how the captive can optimise risk financing costs – can give a risk manager the leverage they need to persuade their board.
While a change in traditional insurance market dynamics might be the impetus for a company choosing to set up a captive, once the captive is up and running, risk managers and their boards often begin to feel a certain degree of comfort with retaining more risk. This can often lead them to explore underwriting different lines of business within the captive and, therefore, the captive becomes an integral part of an enterprise risk management approach and a key tool in the overall risk management philosophy of the company.

Captives are now firmly on the radar of newer companies and companies that have not previously self-insured. In recent months, we have been having discussions with numerous companies, of different types, about setting up a captive.

It may seem counterintuitive, but enlightened insurance underwriters are very supportive of their clients setting up captives. When a company takes a larger retention or sets up a captive, that may mean less premium available for insurers, but as the attachment point increases and the focus on risk management activities is enhanced that should make the premium that insurers take on more profitable.

All of this requires constructive and ongoing dialogue between the client, their advisors and the insurer. Insurers don’t want to walk away from difficult markets. We want to help our clients to develop a sustainable risk financing strategy that will see them through the peaks and troughs of the insurance cycle.

 
This article was originally published in Captive International.