Captives: Setting and Selling the Strategy
For many companies, allocating capital into a captive can be a less costly way to finance certain risks compared to buying insurance from commercial markets and paying deductibles / retentions.
Captives can also save money and create value in other ways:
Captives can increase parent company revenues by capturing a share of the underwriting profits and investment income that would otherwise go to the insurance company.
Retaining a greater proportion of the risks creates an incentive to improve performance with appropriate risk management controls. In fact, many risk managers report that after forming a captive,managing risk becomes a much greater priority.
Captives can be used to cover emerging risks as well as unique risks that commercial insurers don’t cover, or the cost is prohibitive. For example, captives can be used to cover cyber risks or non-property damage business interruption losses.
Captives can insulate parent companies from swings in the insurance cycle. When prices increase in a hard market, for instance, a parent company can shift risks into the captive, and vice-versa.
Given these and other benefits, why don’t more companies form captives? And among those that do have captives, why are they often underutilized?
We believe there are two fundamental – and related – reasons for this.
Firstly, captives are frequently regarded merely as a tactical option for financing certain risks. And secondly, organizational barriers regularly have to be overcome to form a captive and then manage it effectively.
Both factors stem, at least in part, from the legal and regulatory provisions that apply to captives. These have always been demanding, and Solvency II has added even more complexity. Many risk managers have had limited exposure to these technical issues, and CFOs and Treasurers typically have even less experience. That can create two challenges for risk managers: developing a captive strategy that delivers value to the parent organization, and getting buy-in from internal stakeholders.
Impartial input can help
We believe many risk managers can profit by working with a neutral expert to structure a captive that finances the parent company’s risk with greater consistency, certainty and capital efficiency. They can also help sell the strategy internally by demystifying the technical issues.
Companies have been using captives for close to 30 years now, and there are many experienced professionals – in independent consultancies, accounting and law firms, as well as at brokers and insurers – that can help risk managers set and sell a sound and workable captive strategy. Impartiality is the key.
It could be argued that insurers may not be completely impartial as they could be disinclined to see a risk taken out of the market and put inside a captive. In our experience, however, most major insurers take a balanced view. They recognize that while the risk transfer element of the relationship can diminish when the client forms a captive, the insurer can continue to have a productive and profitable relationship with the client by supporting the captive with, for example, captive fronting, claims management and structured reinsurance.
Such impartial expert input can also be useful in generating more value from an existing captive. We’ve seen many instances in which the captive is only covering a few risks and is not capital efficient. When a captive is underutilized, the parent company is potentially creating an environment in which its total cost of risk could increase as a result of greater volatility in the captive.
In these situations, impartial experts can help identify different options for reducing volatility by broadening and diversifying the risks written through the captive, and for optimizing its capitalization in line with the parent company’s financial condition and strategic objectives.
A well-capitalized and diversified captive can also change how a risk manager is perceived internally, and escalate his/her importance within the organization.
With a captive, a risk manager can help the company’s business units mitigate operational risks that traditional insurance markets aren’t able to cover. That not only makes the business more resilient, it can also heighten a risk manager’s visibility and relevance. And these discussions about how to best confront different emerging and unique risks can create a context for closer collaboration with operating units in developing more robust programs for minimizing traditional and non-traditional risks.
Also, when a captive is a core element of a company’s risk management program, the risk manager necessarily develops a deeper appreciation for the company’s financial situation, and the CFO, in turn, has a greater understanding of the company’s overall risk landscape. That tends to lead to more nuanced discussions, and collective decisions, on how to best balance the company’s risk tolerance and financial capabilities. And when that occurs, the risk manager is in a position to demonstrate the value of the role in helping the company achieve its strategic objectives.