Designing Captives for Latin America

Risk management in large organisations has evolved considerably but the implementation of new approaches varies by region. Outside Latin America, captives are more readily accepted as a way of managing corporate risk but there has been increased activity within that region, and it is no secret that captive solutions have gained momentum. There are now more than 100 captive insurance and reinsurance companies in Latin America, and while interest is increasing substantially, awareness still lags behind.

The number of new captives in any region is influenced by economic growth. Regional economies are showing signs of strengthening, thanks to the increasingly positive global sentiment and stabilising domestic environments. There are some critical factors for success when setting up or developing captives to improve risk management.

Creating a new captive
The starting point for creating a new captive should always be a detailed feasibility study. It sounds obvious but it is surprising how far some organisations progress with a new programme, only to find that they have not completed the required analysis. A feasibility study will reveal information vital for maximising the benefit to an organisation and answering essential questions. For example, a study can be used to determine the optimal programme structure, risk retention, preferred domicile, services providers and detailed planning for the setup and licensing of a (re)insurance captive.

Captive Health Checks
Owners of a captive should have a clear understanding of what to expect when their capital is used to establish a captive reinsurance company. For captives in all regions, including Latin America, the right retention is one of the key factors in maximising profitability. If the captive sets its retention at an optimal level, it has the right balance between:

  • Opportunity costs – the capital needed to be set aside for years with a worse-than-average claims experience.
  • Risk transfer costs – the premium the captive owner will pay for external insurance.

In order to determine an optimised retention, the risks borne by the captive should be analysed, with two possible approaches available:

  • Fully customised risk insights – the individual customer’s specific risk is analysed via tailor-made assessments.
  • Semi-customised risk insights – the risks are analysed on a broader scale. For example, an industry segment is reviewed to determine whether there are common risk patterns.

At Zurich, we call this a ‘Captive Health Check’. We recommend that captive owners not only do such health checks before starting, but also when the captives are up and running. The underlying risk of a captive might change over time and so does an optimised retention.

The two alternative approaches
A captive health check via ‘fully customised risk insights’ means that customer-specific data (such as detailed information about the individual claims) is analysed via actuarial methods. The purpose is to project the past loss experience into future underwriting years. This extensive process involves close communication between the captive owner and the actuary performing the analysis, and depends on providing sufficient and detailed data. This tailor-made analysis is also referred to as quantitative risk analysis (QRA).

A captive health check delivered via ‘semi-customised risk insights’ means data from a group of captives sharing common risk factors (for example: industry, geographic locations) is analysed and results are produced from aggregated data. The resulting information will not be as granular as a QRA, but can give captive owners a starting point. This is often the case when insufficient data is available, or a potential captive owner wants an initial idea of captive retention without a full QRA.

At Zurich, we have analysed various industries based on our portfolio. While clear risk patterns emerged for the retail sector, other industries do not reveal such consistent patterns. This demonstrates the importance of close communication between the fronting company and the captive owner. Tailor-made analysis has a greater chance of obtaining an optimised retention level.

While we see an opportunity for Latin American retailers to start a captive with retention levels based on benchmark data, we recommend that for greater confidence they analyse their individual risk profile via a QRA.

Arbitrage and further developments in captive capability
Once an optimised risk retention level has been determined, captive owners can use the vehicle to execute arbitrage strategies, which are particularly relevant in the current market environment. According to Paul Wöhrmann, head of captive services at Zurich Insurance, three types of arbitrage have been observed to date:

  • Pricing arbitrage: A-rated insurance companies with large networks, for example, have expense ratios of a certain size. As reinsurance carriers are not required to finance a large network, they may have a different pricing approach from insurance carriers. Reinsurance carriers can therefore provide price offers for high excess layers that could provide financial benefits.
  • Capacity arbitrage: This was recently experienced in the banking industry, where organisations require large fronting limits with tailored wordings. The respective fronting insurers in the primary layer can have limited underwriting appetite. However, the insurance industry does have an underwriting appetite, more or less, for the excess layers. Comprehensive reinsurance panels behind a reinsurance captive could protect the gross captive exposure above a certain threshold. This generally requires a substantial captive risk retention and attention to counterparty credit risk matters.
  • Coverage arbitrage: A captive customer may want an insurance company to issue a tailor-made programme that meets their requirements or expectations, but exceeds the coverage the insurance company would provide. These policies could get proportionally reinsured up to 100%. Subsequently, the captive might have to accept wording exclusions to get reinsurers interested in such risks. For example, if insufficient data is available for specific risks, Monte Carlo simulations cannot currently be properly performed. In essence, the wording of the tailor-made insurance coverage would be much broader than that of the retrocession level behind the captive, with the captive covering any deviations.

Captives are often the first route into the global reinsurance markets in general and these approaches would certainly apply for Latin American captive owners.

Good reasons to look at captives
There are many good reasons to explore the risk management benefits that captives can bring. If this is something you are considering, a feasibility study will be a logical starting point and provide vital information from which you can make well-informed decisions. At Zurich, we can share our experience and provide more information on how to assess the benefits that a captive could provide to your organisation

Contributed by Adriana Scherzinger, head of captive services Latin America, Zurich Insurance Company, captive professional chosen as Captive Review’s Ones to Watch in 2018; and Christoph Betz, fully qualified actuary SAA, working as pricing specialist for Captive Services, Zurich Insurance Company. He was shortlisted for the “Rising Star Award” at the European & UK Captive Awards 2017, presented by Captive Review.