Businesses stay true to captives despite soft market conditions

Captive owners still see value in putting property and casualty risks through their captives rather than directly purchasing cover in the commercial insurance market, according to a report from AM Best. In a review of the captives it rates, it found that despite soft open market conditions European parents are continuing to deploy their captive vehicles and in some cases are also increasing the size of their captive programmes. The main reason for parents' undiminished appetite for self insurance is the ability to access reinsurance markets directly at a time when capacity in that market is cheap. "However, it also shows that captives are not considered simple risk financing tools to be utilised when capacity is unavailable or prohibitively priced in the commercial insurance market, but are considered altogether more strategic risk management tools," the report said.hideThe European captives rated by AM Best are generally well-integrated in their parent's overall risk management framework and are valued for the benefit they bring to the group's risk management, independently of any savings on insurance buying, the rating agency said. "Typically, groups make use of their captive to centralise claims and loss information, allowing for more effective internal reporting and communication of such information within the group. The parent is then able to use this information to support its risk mitigation and loss prevention actions,” it explained. In addition, by making use of a captive to optimise its insurance buying, for instance by retaining more at a group level than individual business units or subsidiaries would otherwise be able to do gives access to international reinsurance markets, making businesses less reliant on local insurers. For captives that do make use of reinsurance, the competitive market has allowed them to increase reinsurance cessions at cheaper rates and to lock in favourable terms through multi-year programmes. There's also evidence that captive parents use reinsurance relationships to gain access to sophisticated risk management, catastrophe modelling and other technical capabilities that are important to them, said AM Best. European captives rated by Best have achieved very strong profitability over the last five years and typically have expense ratios significantly below commercial insurers, which supports their strong profitability. The low interest rate environment, combined with volatile equity markets, has limited the returns captives can achieve through their investments. But European captives are generally less troubled by the reduction in investment income than their commercial insurance counterparts, AM Best said. While some commercial insurers have started to invest in riskier assets in an effort to boost returns, it is not a tactic that captive insurers have employed. Most aim to match their assets and liabilities with portfolios that comprise cash, highly-rated fixed income securities and for some, a small proportion of equities. Amongst the European captives it rates, AM Best sees examples of captives with very low investment returns because investments are held either as loan-backs to the parent with very strong liquidity features and therefore very low returns, or invested externally in a very conservative and liquid portfolio. Despite the enduring appeal of captives, however, there are challenges ahead for the industry, the report said. These include the Organisation of Economic Cooperation and Development (OECD)'s action plan on base erosion and profit shifting (BEPS) aimed at tackling tax arbitrage, the need for contingency plans for captives hit by Brexit and an increasing regulatory burden, both in and outside the European Union (EU). Early signs suggest that Solvency II has not been a major disruption for European captives, however. Preparing for the new capital adequacy and risk-reporting rules, which came into force on January 1 2016, has been high on the agenda for EU-domiciled captives for several years. In Best's view, the captive community has reacted positively to the challenges posed by the new regime. Konstantin Langowski, financial analyst and co-author of the report, said: "Captives that are used simply as a risk financing tool will come under even more scrutiny by taxation authorities in the future. However, in Best's opinion, the great majority of captives that currently hold a Best rating are being used as a platform from which the parent company's enterprise risk management programme is implemented. Nevertheless, questions relating to the commercial purpose, pricing and substance of captives will have to be appropriately addressed in the changing tax landscape."

Businesses stay true to captives despite soft market conditions

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