Contrary to popular wisdom which suggests that the importance of the captive declines in a softening market, David Stafford believes that they can still thrive
The issue of the growth of captives in a soft market as opposed to a hard market is one that is often mulled over. The general view is that in a soft market captive growth stagnates as risk managers migrate back to the standard risk transfer market in search of lower pricing.
It is probably true that when the market hardens, particularly when it hardens overnight as was the case post 9/11, the demand for captives keeps captive managers working well into the night on feasibility studies and business strategies, some of which have been growing dust for years and are taken off the shelf in a panic reaction.
But is it the case that in a soft market the opposite happens and the well dries up in relation to interest in captive formations? Most captive managers believe this is not the case and that whilst the level of enquiries and interest does fall off, the enquiries that do come through are generally of a better quality, well thought out and approach the captive concept with sound reasoning.
So what drives the growth of captives in a soft market? The notion that the well dries up pre-supposes that the only or fundamental reason for forming a captive is pricing or insurance cost. This is clearly not the case. The pre-dominant reason behind the formation of a captive should be the achievement of sound insurance objectives which generate greater benefits to the corporation than if insurance were purchased in the traditional insurance market. Therefore, although cost will clearly be an issue, it also comes down to the other perceived benefits of a captive such as control, provision of optimum coverage, access to reinsurance markets, a tool for improved loss control, flexibility, investment income and - most importantly - stability when the market turns hard again, as it undoubtedly will.
So what areas of growth or uses of the captive are particularly focusing the minds of the owners of captives in this soft market? Well many of them are variations on the themes outlined above such as:
- Stabilising and minimising total cost of risk finance;
- Becoming a focal point for risk identification and control;
- Creating capacity for uninsurable risks;
- Obtaining cost-effective transfer of risk; and
- Integrating with strategies of the parent company.
The last one in particular is a hotspot for captive owners, in particular:
- New products for uninsured risks;
- Joint ventures - new geographical territories;
- Mergers and acquisitions;
- Profit generating mechanisms; and
- Employee benefits.
However the overriding issue is that groups with mature captives in a soft market will find uses for their insurance vehicle. Increasingly captives are being used as profit centres with profit generating mechanisms - such as customer and employee insurances - being written through the captive.
In a soft market this can generate real income for the group whilst also being an effective deployment of corporate capital invested in the captive.
David Stafford is European regional director at AIG Global Risk Management.
A recent report conducted by AM Best concluded that trends in premium volume, loss reserves and admitted assets revealed that the captive sector had stabilised as it absorbed the benefits of the recent hard market while coping with legacy issues still affecting some within the industry.
Over the five years through 2004, the captive market witnessed a 56% rise in net premiums written, but only a 3.6% increase in the past year, according to the study. Loss reserves and admitted assets grew by 39.6% and 28.7%, respectively, over the past five years. The industry maintained the pattern in 2004 with growth rates of 6.0% and 5.9%, respectively, a fact which the rating agency concluded might be a sign of more business remaining in the commercial market or more relaxed pricing by the captives even while loss reserves are growing.
However, despite aggregate growth in surplus keeping pace in the past year with an 8.3% increase, the five-year cumulative growth was a mere 0.7%, which raised concerns. As a result, while the underwriting risk covered by captives has grown, it has come at the cost of increasing leverage over the five-year period. AM Best however added that one possible argument could be that owners are using their captives more efficiently and that they are still operated in a more conservative manner than the insurance market in general.