It is widely reported that the insurance market is still softening. Even with the Caribbean storm losses of 2005 the market overall has remained competitive, and many organisations are witnessing the benefits of this competitiveness with stable or decreasing renewal rates.
During every soft market cycle the viability of the use of captive insurers is questioned. Many people wonder, 'Why would anyone bother using a captive when insurance is so easily available?'
While it has also been recently reported that captive growth is slowing, interest in the establishment of new captives has not completely stopped. Nor are we experiencing a reduction in the number of captives worldwide.
As can be seen from Figure 2, the captive environment experienced a boom after 2001, partially in response to hard market conditions and risk managers looking for alternative means of financing their risks during this time. Most observers agree that market conditions began to soften again in late 2003. Since then, the rate of captive formation has slowed, but it has certainly not ceased, let alone gone into reverse.
So why is it that during a hard market cycle we see a sharp increase in the number of captives established, but continued growth and no actual decrease in captive numbers when the market softens?
In principle, there is no reason why captives should be at a disadvantage in a soft market. Insurance pricing is a function of:
Expected losses + reinsurance pricing + insurer profit + expense ratio - investment income.
So even if the market is soft, and investment returns in a captive may be relatively low, a captive should be able to maintain competitiveness, provided it has a low expense ratio and profit expectation (many captives in fact do not operate to generate profits in themselves).
Additionally, given the increasing worldwide focus on corporate governance, organisations are continually required to demonstrate that they have identified and are managing their risks appropriately. This increased focus on risk management has also led to an increased focus on the importance of appropriate risk financing strategies. This is evidenced by Figure 3.
As a result of this, organisations are becoming far more sophisticated in their approach to insurance purchasing. Risk and insurance managers are increasingly taking a more long-term approach to risk financing and are looking to become less dependent on the ever-volatile insurance market.
As part of this long term view many organisations now put more emphasis on cost of risk, as opposed to purely considering insurance premium spend. Understanding the cost of risk enables organisations to determine their optimum risk financing programme, and make decisions about how much risk to retain and how much to transfer.
Furthermore, to achieve the most cost effective risk financing programme generally means retaining significant amounts of risk. The general principle should be to keep as much claims cost out of the insurance market as possible, while keeping the volatility inherent in retaining risk at a manageable level. Therefore, risk managers often make their insurance buying decisions once the cost of risk under various programme structures and claims scenarios has been analysed to determine appropriate retention levels.
Using this approach, organisations can continually assess their cost of risk and use their captives to take advantage of the changing market cycles by increasing captive retentions during the hard market, and retaining less risk when the market is soft. While this approach provides a reduction in the impact of market volatility, it does not avoid the issue completely.
Although a captive is not the only method of retaining this risk, another reason for the increasing use of captives, as compared to less formal arrangements, is that a captive is a truly transparent vehicle for retaining risk and ensuring compliance with regulatory, tax and accounting standards.
None of these factors is directly related to insurance market conditions, and they apply throughout the market cycle. It is, however, true that during soft market conditions it is harder to make a business case for risk retention in a captive, as opposed to risk transfer to the insurance market, based purely on financial criteria. Put simply, often the market does not give worthwhile credit for risk retention.
In almost half of the captive feasibility studies undertaken by our firm in the UK during 2005, our review concluded that there was no business case to justify establishing a captive in the short term. However, this means that more than half of these studies did recommend establishment of a captive, and the vast majority of those have now proceeded to implementation. An examination of these cases reveals a range of themes, some of which are outlined below.
Access to reinsurance markets
This is one of the reasons most often cited for considering a captive. Despite this, it has historically been rare for the captive's parent to achieve real advantages in this area. However, more recently a number of organisations have found that they have actually been able to gain tangible benefits from approaching the market with a reinsurance programme, as opposed to a directly purchased one.
Market perception
Some market sectors are insulated from the current generally competitive conditions, perhaps because of the perceived threat of claims - or even actual claims activity - or because the market is unable or unwilling to adequately assess the risks. Organisations can find that there is either no, or no viable, insurance cover for risks which are central to their operations. Examples of these include product liability and professional indemnity risks for particular industries. These organisations, particularly the ones with confidence in their own risk management, are increasingly considering captives as the most appropriate vehicle to finance such risks.
Rewarding good risk management practice
As mentioned previously, most organisations are taking a more professional approach to risk management in order to comply with corporate governance and achieve best practice. When risk management improvements are successfully implemented it should follow that the frequency of losses will reduce. However, insurers generally do not give immediate premium credit for organisations simply undertaking risk management initiatives and only respond a number of years later when improvements in the claims history are apparent. If this improved risk is retained within a captive then the organisation should experience immediate benefits as it will experience a reduction in claims payments, ultimately improving the captive's profitability.
Aligning losses with management responsibility
Depending on an organisation's culture, it may be desirable to have each of its operating businesses self contained from a risk financing perspective. One recent example that our firm worked with involved the formation of an additional captive. The parent organisation was willing to incur the costs of the extra captive subsidiary in order to allow it to align responsibility for claims within its - substantial - retentions more closely with the results of the operating businesses from which the claims arose.
Customer insurance schemes
The ability to sell high-volume insurance policies to purchasers of consumer goods on a cost-effective basis has been a feature of the UK retail market for several years. This area has generated strong interest among captive owners and has remained unaffected by general insurance market conditions.
Previously uninsured risks
A number of organisations have been considering insurance solutions for risks which have previously been uninsured. The specific reasons are different in each case, but most could be categorised as arising from a desire to comply with current standards of governance. A common theme has been the desire to minimise premium spend in the external market.
If there is a theme here, it is flexibility: the ability of the captive insurer to respond to the needs of its owner. Like its owners, every captive is unique. This remains true in a soft market as much as in a hard one. The conventional market may be pricing mainstream property and liability risks less expensively at present, but this does not mean that it is assessing every corporation's risk profile accurately, or responding fully to every need. As the captive insurance industry has matured, there is clear evidence of its willingness and ability to do just that.
Additionally, and this is harder to quantify, there are lingering after-effects from the hard market of 2001 and 2002. Even though current market conditions are generally benign, the risk and insurance managers that have worked with our firm over the past three years can clearly recall the difficulties that they faced at that time. They remain reluctant to fully entrust their fate to the market next time around. This indicates a long-term shift in insurance buyers' willingness to consider the need to have their own alternative available.
- Alastair Paterson and Scott Gemmell are consultants with Marsh, E-mail: captive.enquiries@marsh.com
