Captive sector flourishing as market challenges remain

It is no surprise that a hard market has seen an increase in captive formations. Lorraine Stack, managing director, Marsh Captive Solutions, International, says the historic growth seen since 2020 is definitely continuing in 2022, noting that Marsh formed more than 200 new captives globally in the last two years and the formation activity is not slowing down.

But what is more surprising, she says, is that historically, in challenging market cycles new formation activity tended to happen in a handful of domiciles, “but this is the first time we have seen formations in every domicile, even in some of our more mature locations”.

The hard market may be moderating but Stack says many buyers are approaching their fourth renewal with the bar set considerably higher, at a time when expenses are coming under increasing pressure. And she points to coverage restrictions being introduced by insurers in some areas such as cyber.

And with issues such as the conflict in Ukraine, rising inflation, natural catastrophes and weather related events adding complexity and uncertainty to the landscape, she sees more and more companies looking for alternative risk financing mechanisms to lessen their reliance on the commercial insurance market.

She also explains that Marsh has seen a shift in the landscape during the last two years, as enquiries are coming from companies of all sizes and not just those with large premium spend that would have been more traditional players in the captive space.

“Over 70% of our new formations globally in 2021 were captives writing less than $5m in premium. This signals a trend of increased sophistication around the approach to risk financing among smaller companies, along with an increased awareness and understanding of the captive concept… The level of new enquiries coming to our consulting teams around the world is still high, indicating that formation activity will continue even as pricing moderates,” she says.

It is not just captive formations but greater utilisation of existing captives being seen in the market. As Derek Bridgeman, managing director within the SRS European Management Group, explains: “Those with existing captives are keen to understand how the captive structure could be used to further support the group’s overall insurance placement, while those without captives wish to evaluate and understand the potential financial and strategic benefits which could be derived from a captive vehicle.”

Marine Charbonnier, global programmes and captives regional director, Europe, AXA XL, says the insurer has seen an increase in cessions to captives these last few years. “Clients are exploring new ways to transfer and manage their evolving and emerging risks using their captives, and we anticipate the growth the captive market is experiencing will continue in the second half of 2022 and through 2023,” she says.

The truth is, through 2020/2021, brokers and risk managers often faced a situation whereby there was no economically acceptable market solution available, says Bridgeman, adding that the speed of the market change and the scale of the hardening caught many risk managers short with no alternative options.

“The captive, therefore, provided an alternative that enabled the group to mitigate the effects of the hard market. In many cases, the captive was used to manage the volatility effect on premiums and deductible levels. The response of captives to the significant challenges encountered through the hard market has resulted in validation and internal buy-in as to the value a captive can provide,” he says.

According to Bridgeman, a captive represents a longer-term risk financing strategy and one that delivers stability in costs and a buffer against market cycles. “Even as the hard market abates, rates remain high, supporting captive formation, and the desire to protect against market cycles is front of mind. It will be a while until risk managers feel confident in the ability of the insurance market alone to provide stable risk financing solutions,” he says. “The expectation is that, as long as challenging terms exist within the commercial markets, corporates will continue to explore ways in which they can reduce their dependence on these markets.”

New uses or traditional focus?
With the growth in captives and the greater use of existing captives, clearly many captives are focused on traditional property and casualty (P&C) lines where the hard market has most impact. But there are also signs of expansion of the use of captives into new areas and new risks, and greater innovation in the sector.

Francoise Carli, Zakubo Consulting, notes that the hardening market “has been a fantastic booster for growth and innovation in captives”, adding: “Most large corporate see their insurance prices increase drastically, independently of their risk profile or claims background. Therefore, increasing the share of the risk taken is a natural process if insureds can afford it, especially if risks are properly managed.”

She sees two main areas that could be more visible or attractive in the coming months. The first is cyber risk, where prices and capacities are becoming unrealistic but the risks are still there and are increasingly being scrutinised by boards and top executives. “This trend will give room to a lot of innovation for all digital solutions to be covered, including perhaps their impact on business interruption,” she says.

The other major change to be expected is the growing influence of the multiple indexes and rankings that all large corporates are trying to match, such as the Dow Jones Sustainability Index, or FTSE4Good Index, according to Carli.

“All these rankings contribute to a better understanding of the values of the mother company, and captives can play a role in supporting the risk analysis and the mitigation processes. This will strengthen the insurers and financial markets’ trust in the company, and will push captive owners to improve their prevention schemes and to develop their risk anticipation processes. There is no doubt that this will help in creating new coverages,” she says.

AXA XL’s Charbonnier says the majority of captives are focusing on traditional P&C lines, but she is also seeing clients place new and emerging risks into their captives, such as environmental impairment liability, employee benefits, or for some, niche risks specific to their group’s activity.

“Historically, captives have been used by clients to underwrite high-frequency, low-severity risks, but in recent months many have been using their captives to underwrite less traditional lines of coverage such as cyber. We have also seen increased interest from those more sophisticated captive clients for parametric solutions,” she says.

Marsh’s Stack says that given market conditions, captives are absorbing higher retentions in traditional lines such as P&C. But she says Marsh is also seeing more captives participate in less-traditional coverages such as D&O, cyber, crime, and excess liability – often where the captive will absorb higher retentions but also where the captive will cover exclusions in commercial insurance policies.

As an example, she explains that D&O was not historically a common coverage written by captives. Just over 50 of the more than 1,500 captives managed by Marsh are writing the coverage, but she notes that D&O premium has increased 50% in the last year to more than $75m, showing that many captive owners are using their captives to fund increased retentions. And she points to a continuing rise in affinity business, where companies are entering the insurance business via a captive to offer competitive insurance to their customers and influence total product cost.

ESG and captives
In the last year or two, there seems to have been a lot of talk about ESG and captives, and undoubtedly there is a role to play for captives to play here. “Captives have an intrinsic role to play across all aspects of ESG, in fact the opportunities are endless for this transformative financing mechanism,” says Stack.

For example, she says that within a transitioning energy context, captives can fund coverage gaps, enhancing resilience to environmental risks. And captives are also highly likely to be used to provide customised coverage for exclusions and perils that commercial insurers will struggle with, given the pressures of carbon-neutral underwriting commitments, she explains, adding that captives may also be used to provide third-party coverage for sustainable activities related to parent industries.

“From a social perspective, we expect to see an increase in employee benefit captive utilisation for companies keen to enhance D&I positive benefits across their organisation. We also expect to see captive investment strategies being used to support sustainability and socially responsible activities in line with parent ESG frameworks,” says Stack.

Charbonnier says AXA XL has an increasing number of clients that have been including ESG information in their risk presentation, which she says is a welcomed trend for insurers. “When ESG is embedded in a company’s operations, there seems to be a strong [positive] correlation to their loss ratio. And captives are well positioned to contribute to identifying a company’s ESG challenges and helping them address these,” she adds.

SRS’s Bridgeman says there are a number of opportunities for captives to play a role in ESG, not just in support of environmental initiatives but across the whole ESG framework, such as enabling green industries to thrive by providing guidance on insurance structures and provision of insurance facilities to industries looking to transition to greener products, as well as the provision of innovative insurance products to address the volatility in achieving ESG goals.

He adds: “Ultimately, captives drive corporate behaviour, reducing risk through awareness and reward. Captives also facilitate the centralisation of data and governance, which allow corporates to ensure that they are engaging and supporting specific, measurable, achievable objectives for their corporate goals.”

Zakubo’s Carli says captives are efficient tools to understand, measure and mitigate new risks that traditional insurers do not want to bear. “Through their enterprise risk management, most large captive owners have found ways to measure the impact of certain risks, and can design products with no or little risk transfer to the market, to support some of their critical risks. This has been the case for years in environmental risks, with remediation financing for example,” she says.

“This could and should be extended to all kinds of climate risks, to pandemic issues, to scarcity issues relative to water or energy. If captives cannot be involved in risk bearing at the beginning – due to the lack of existing data – they can be very active in risk monitoring and ESG strategy implementation of actions until they can cover them, and their impact on other aspects of the business. This is another positive chance for captives to contribute to their mother companies’ global strategies,” says Carli.