Barry Beard, Director of European Global Services & Complex Multinational, Chubb Europe
Hard market conditions across many lines of business have triggered a marked increase in interest around captive insurance over the past year. However, while captives can be a highly effective alternative to traditional insurance models they are not something which should be rushed into or taken lightly. So, when should you consider setting up a captive and what other alternatives are out there?
There is a view that captives are back in fashion but, personally speaking, I don’t think they ever went out of vogue. They have instead just become more relevant now, not least because of the opportunity they present as a risk management tool, particularly for multinationals.
Despite this, there remains a degree of scepticism about the concept of captives among those who don’t always understand their true potential. However, before we look at some of their capabilities, let us first define what a captive is for anyone who is unfamiliar: A captive is a licensed insurance or reinsurance company that is owned and controlled by a parent company or group. Its primary purpose is to insure the risks of its owner(s). In other words: it is a way to self-insure, to retain risks within an organisation. Some captives also write third party risk or the risks of their parent group’s customers.
There are several types of captives. Some are set up as a direct writing captive: these are owned by their ultimate parent but have an insurance licence and can issue insurance policies to its insureds. Such a captive is generally very sophisticated: it is basically an insurance company with a dedicated group of underwriters, actuaries and all other necessary expertise. It has to comply with the applicable rules, such as Solvency II within the European Union, and have all reporting requirements in place. Companies owning a direct writing captive will likely have been in the captive business for some time or have a very long-term outlook for their captive.
Many captives are set up as reinsurance only operations, whereby the requirement and solution for local insurance comes from the insurance market. In a process known as “fronting”, this means that licenced, admitted insurers like Chubb issue insurance policies on behalf of a captive insurer, wherever required and “front” some or all of that risk to the captive, which reinsures the risk. Such a captive can be set up in a number of different locations around the world such as Luxembourg, Ireland and Guernsey among the more traditional territories. But the possibilities for domiciling a captive elsewhere are also increasing. France for example, has been looking at legislation for captives, and there are some captives already in Germany and in Sweden. This demonstrates that regulators are recognising that captives can be an effective mechanism to self-insure risks.
Benefits of a captive
The increased interest in captives is partly driven by the hard market conditions in certain lines of business. A captive can lower a company’s insurance costs and also reduce the amount of money exiting the parent group on a net basis. But providing protection against certain emerging risks can also be an important factor. Captives can be highly relevant for companies that are buying insurance for certain risks for the first time, such as environmental impairment liability, cyber or cover for Strikes, Riots and Civil Commotion (SRCC). An increased budget may be required to pay for this additional insurance and the captive can soften the net cost to the parent. These risks can also be easily assumed into an existing captive with meaningful reserves to accommodate potential claims.
A captive helps risk managers exert greater control over their risk and risk financing, particularly for a multinational company. It allows them to:
In addition, there can be a diversification benefit if more lines are put into the captive, including more predictable risks. This may allow the captive to run a sustainable profit in the long term. This highlights the need for a proper strategy when considering a captive.
Caution and consideration
Although a captive can be an effective risk retention solution for some companies, they are not a silver bullet and they do have down sides. Having a captive brings the additional overheads and risks associated with running a distinct insurance company. Without careful underwriting some risks could result in substantial losses and financial difficulties, maybe years after the risk was first written.
Yet, as more companies look to set up a captive it does seem that some of them are moving at a pace they might ultimately regret. There are some jurisdictions where you can create a reinsurance captive in a very short space of time – potentially as quickly as a month. This is not something we would recommend. Most companies we speak to want to take their time - planning more than a year in advance. This careful approach enables them to flush out any potential issues and set up the captive in such a way that they can really reap the benefits. Another option is to start small, testing it with one line of business for example. This way you can gather evidence and determine whether or not it is a suitable solution for your organisation. If so, you can add other risks over time.
It is important at the beginning to consider the end. A captive should have an exit strategy because exposure takes time to run-off and closing a captive and avoiding longer term costs has to be considered carefully. To shut down a captive, all exposures need to be run-off fully to the satisfaction of local regulators. An alternative is for the original fronting insurer to accept a commutation of any remaining risks, but this can be a further negotiation and extra cost.
Captives are not the only option
Of course, while captives appear to be increasing in popularity, they are not suitable for everyone. There are other options that have a lower threshold.
One option is to increase deductibles, sometimes also called Self Insured Retention depending on local terminology. This may be acceptable in one jurisdiction but not in another one: a smaller subsidiary may be unable to take a higher retention in that specific claim or territory. That is why captives are such a useful tool for multinational programmes: you can still have lower-level deductibles at a local level, but the captive takes a buffer. It does a so-called ‘deductible infill’, taking the risk from a local deductible up to a group retention level. The organisation can operate with the same deductibles as before, but with a centralised group retention and appetite from ceding the risk into the captive.
However, not all companies want to own a captive. I spoke to a risk manager recently who expressed it quite clearly: “It's not my core business to be an insurance company”. At Chubb, we like to develop long-term and sustainable relationships with our clients. We have in-depth conversations with them, asking many questions so we can really understand the intricacies of their business and improve our decision-making process in such a way that everyone will benefit. We also discuss risk retention with our clients: what options are they considering and why? What are their needs? We found that for some the step from not buying insurance or increasing deductibles to setting up their own captive is too big.
To help bridge this gap for some of our clients we have developed a compliant solution that allows companies to centralise risk on a multinational programme without having to set up a captive: Chubb Deductible Recovery. It's currently available in some regions and can be relevant in certain situations, for particular lines of business and clients that fit the profile. It allows a multinational company to still have the lower level deductibles on local policies, but take a larger retention across all risks on the central level.
Some clients have used this solution for two years now. It is set up individually, line by line, and it has allowed them to dip their toe into the water. This has given them the insight they need to decide if they can take a larger share of multinational risk centrally. If so, it makes sense for them to set up a captive, bringing in different lines of business once it is established.
Captives are a great risk management tool but they are also a long-term play that requires careful consideration. There is no one-size-fits-all solution when it comes to risk retention. Determining the right solution for a client’s situation always starts with in-depth analysis and conversations around their business and risks.
If you are considering establishing a captive or think that Chubb Deductible Recovery might be a potential solution for your needs, then contact me at email@example.com for more information.
Barry Beard is Director of European Global Services & Complex Multinational, Chubb Europe