As the reinsurance market hardens dramatically, Philip Stamp and Paul Bawcutt foresee a new wave of captive utilisation.

Even before 11 September it had become clear that market conditions in the insurance world were deteriorating. Most market observers were already predicting higher rates and more restrictive conditions. With captive insurance companies already established as a feature of many companies' risk management programmes, recent developments indicate that this relatively static market is now ripe for change – all the more so in the wake of 11 September and other major losses such as this year's industrial explosion in Toulouse. Many industry players are dusting off old captive feasibility studies and reviewing existing strategies to investigate whether a captive could help them manage the cost of risk more effectively over the next twelve months and beyond.

In this article we will focus on three main areas that affect current thinking on captives. What are the external influences shaping the captive sector – and how can we assess their impact; what challenges will captives face in this new environment; and how can captive strategies help today's major corporations to control the cost of risk?

Rise of the captives?
Theory suggests that captives will very much come into their own in these difficult times. But for this to come about in practice, captive owners would have needed to adopt a more aggressive approach before this year, to put themselves in a stronger financial position. We have argued for many years that captives' retention strategies have been too cautious. If captives had taken on more risk, built up their funds and retained more premiums in the soft market, this would have reduced the amount they will now need to spend on reinsurance protection.

Looking at some of the changes in the market – and specifically those that will impact on captives – there are probably half a dozen major issues to be considered. The first issue facing captives relates to today's more restrictive fronting conditions. We have already seen one German insurer withdrawing fronting arrangements from three major corporations. Fronting companies are asking for higher fronting fees, and – because of the increasing concerns about re/insurer security – fronting companies now seek more onerous terms both from captives and their owners. This will be in the form of letters of credit or financial guarantees, or, in some cases, parental guarantees from the parent company. We have to stress that we consider parental guarantees to be extremely negative for captives and represent a course of action which we do not recommend. There may even be situations in which fronting arrangements are no longer available. In this environment, smart captives will profit where they have already established locations that allow them to write directly into other countries. Examples of this approach include Dublin-based captives writing into the EU, the Lloyd's captive with its ability to write into 60 countries, and US captives located in Vermont and Hawaii.

Significant increases
On the debit side, there will clearly be very significant increases in insurance costs and much higher retentions imposed on captives and their owners. For some industry sectors, retentions are already being increased from levels of $500,000 to $50m. In reality, these financial retentions are often well within the financial capabilities of the owners. Previously the soft market has allowed organisations to take advantage of an insurance market willing to charge low prices, and has not required insureds to take on too much risk. This is now changing.

We will now see reductions in capacity and much lower policy limits. This means that buyers will need to be much more precise about the cover they need. The days of being able to buy full value insurance are over. It will be critical to calculate losses from the worst-case scenario as insurance will only be available up to a fixed loss limit. There will also be less cover available. It is becoming clear following recent announcements from Munich Re and Swiss Re that terrorism cover is likely to be excluded on a global basis. There are also likely to be restrictions on reinstatements of cover and other onerous conditions could leave large gaps in many major corporations' insurance programmes.

Captives that have substantial and free capital reserves will be able to take on more risk and reduce external costs. Those that have not will need to decide whether to put more capital into the captive or whether they simply retain more risk at the parent or operating company levels. One of the issues relating to the use of captives, as against self-insuring, is the level of premium taxes. Although a captive offers an efficient funding mechanism, if premium taxes are high it may be more economically efficient to retain the risk internally rather than pay a premium to a captive that attracts premium taxes, which – depending on where in the world the captive is located – can range from 0% to 100% in places such as certain Australian states. Where a captive seems problematic, the ‘virtual' captive may be a good alternative. We are seeing a significant amount of interest in this approach, in which a fund is kept on balance sheet but managed as a separate company.

However, we may now find that we are moving back to a situation where a captive will be valuable because of its ability to access the reinsurance market. With significant new capacity being developed in Bermuda, a captive can provide a good way of accessing these new markets.

These comments apply particularly to the property insurance sector – the sector that is facing the greatest challenges currently. We would also anticipate that the liability sector will be significantly affected. Again, there will be restrictions in cover and premium increases, though probably not of the magnitude experienced in the property marketplace. However, captives have always played an important role in the liability area. This is because with liability insurance there is usually a long delay in the payment of claims, and, consequently, the investment income developed on the premiums is substantially greater than with property insurance. If the captive is able to claw back investment income from the insurers this usually produces a very beneficial result.

We are in a new environment for captives. The re/insurance market is problematic, hence we will face a number of key challenges:

  • higher primary premiums and related taxes;

  • higher reinsurance prices, particularly for catastrophe exposures;

  • less credit for levels of self-insurance;

  • lower policy limits;

  • less cover; and

  • most importantly, less choice.

    Insurers are likely to take a more negative attitude toward captives. In soft markets they tend to support captives, if sometimes grudgingly, but in hard markets they see an opportunity to be rid of unwelcome competition. This could manifest itself in a lack of co-operation and, in extreme cases, a refusal to front for major corporations. In responding to these problems captives will need to be financially stronger, to take more risk, to revisit their location strategies and to consider seriously the option of going down the direct underwriting route.

    Captive owners themselves are now actively reviewing the potential for developing new capacity. In the hard casualty markets of the mid-1980s, this led to the formation of a number of casualty group captives and similar vehicles in locations such as Bermuda and the Caymans – and, ironically, in the creation of ACE and XL – originally set up by major non-insurance corporations to deal with a large gap in capacity. The irony lies in the fact that, as ACE and XL grew, their original corporate buyers withdrew as shareholders so that the insurers created specifically by buyers to solve a problem are now the organisations creating difficulties for insureds in the new market conditions. Perhaps the next time new capacity is developed by insureds they will think more carefully before opting for a short-term financial benefit.

    Developing capacity
    Within Aon, we are in touch with our captive owners to review what opportunities exist for developing new capacity. The response so far has been positive, and it seems likely that new capacity will be developed using a captive-owner facility based in the Cayman Islands. We would also expect others to develop solutions through broking, risk management associations or other initiatives. It is difficult to develop property capacity vehicles without a substantial financial commitment. However, when one considers that major corporations may be faced with retentions of maybe $50m, contributing say $5m, $10m or even $20m as an investment to create new capacity would seem a sensible option. At the lower levels of risk retention, we also expect to see the revival of risk exchanges where captives swap retentions between one another to introduce a degree of risk spread and to develop initial capacity.

    The revival of captives as a mechanism that responds to the new market conditions will attract the attention of major corporations around the world, with senior management showing increasing interest as costs mount. This may well be an opportunity – though perhaps a short-lived one – for risk managers to sit down with top management and put across the risk management case for captives as a means of minimising the cost of risk.

    More aggressive retention strategies will become a reality over the next twelve months. Higher retentions will undoubtedly be necessary to contain cost increases. A captive is ideal for this purpose, particularly where multinational risks are involved or where substantial capacity is limited to the reinsurance market. Committed captive owners and those who advise them are now on the cusp of a new and significant era.

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