Evolving European captives face up to hardening reinsurance market and transition risks

European captives rated by AM Best have been resilient to the effects of Covid-19 and have generally maintained stable ratings fundamentals, said the credit ratings agency. The onset of the hard commercial insurance market has driven an uptick in the use and importance of captives to help their owners navigate the insurance cycle and maintain access to insurance as capacity shrunk. But despite higher retentions generally, even captives with good claims records are likely to face further price increases for their reinsurance programmes in the 2023 renewals, predicts AM Best. The ratings agency also states in its latest report on the sector that a captive’s approach to ESG is often closely linked to that of its parent organisation and therefore management of transition risk could lead to further increased use of these important vehicles. AM Best notes that, since 2021, commercial insurance premium rate increases have started to moderate, as price adequacy improved and competition started to grow again among insurers. However, it adds that some lines are still seeing very strong rate increases with the cyber market still in a very hard stage of the cycle. “For the 2023 renewals, commercial insurers are expected to continue to seek price increases, on top of those achieved since 2018. Such price adjustments are partly aimed at ensuring that the inflationary environment is reflected in the price of cover and are expected to be accompanied in some instances by programme restructuring, including adjustments to deductibles,” states AM Best. The agency has observed an evolution in the use of captives that could represent a longer-term trend. “Several captives have increased retentions or limits on existing cover, as well as expanded into new lines of business as their parents have looked at increasing captive utilisation. There has also been a change in strategy among some parent companies that used their captives selectively and sparingly in the soft market. In the hardening market, captives have become central to the insurance buying process of some of those parents. In some cases, this has led to a reorganisation of departments in the parent company, to ensure the full integration of insurance and reinsurance purchasing decisions and captive management,” it says. “In this context, it is important for captives to ensure they can continue to support their parents’ risk management strategy, notably by maintaining relevant underwriting expertise and sufficient capital levels to cover any increase in underwriting or catastrophe risk associated with writing additional business,” adds AM Best. It says that while the hardening primary market provides opportunities for captives to demonstrate their value, it also presents challenges, not least through the rapidly hardening reinsurance space. “Many captives are highly dependent on reinsurance capacity to be able to offer the large limits required by their parent groups. The reinsurance market has trailed the commercial and specialty insurance markets in terms of price increases over recent years, but with significant catastrophe losses and inflation concerns affecting 2022, the market is now set to harden further,” states AM Best. “Captives, even those with good claims records, are therefore likely to face price increases for their reinsurance programmes in the 2023 renewals. Capacity, however, remains available. In a truly hard reinsurance market, such capacity may become much more limited. AM Best notes that most captives have longstanding and strong relationships with their reinsurance partners, which helps mitigate the risk of capacity withdrawal,” it adds. Europe’s top captive domiciles by number of licensed captives are Luxembourg, Guernsey and the Isle of Man. These three domiciles had a total of 483 licensed captives at year-end 2021, compared to 489 the year before, according to a recent survey by Commercial Risk’s sister title Business Insurance. AM Best notes, therefore, that the hard market has not yet resulted in an increase in licensed captive numbers in these domiciles. “The explanation is likely a combination of the time, effort and commitment it takes to set up new captives, which means that the formation of new captives might lag the onset of the hardening market,” it says. ESG-driven changes impacting a number of corporates will have a knock-on effect on captives. Since 2018, AM Best’s methodology has detailed how ESG factors can influence each of the building blocks considered in its credit rating analysis, namely balance sheet strength, operating performance, business profile and enterprise risk management. To a large extent, captives’ ESG considerations typically reflect the risk profile and the ESG strategy adopted by their parent company. These can vary widely from one industry to another. Transition risk – the financial exposure that could result from significant policy, legal, technology and market changes as the world transitions from a high- to low-carbon global economy – is another area captives may want to monitor closely, says AM Best. “Management of transition risk by a captive’s parent, notably in industries such as oil and gas, can impact their insurance needs. Against this background, captives are under more pressure to innovate and keep abreast of underwriting developments to cater for the changing needs of their parents’ evolving business models,” states the ratings agency. “Long-term management (or absence thereof) of transition risk by a corporate could also have consequences in terms of how easily they, together with their captive, could access the commercial (re)insurance market,” states AM Best. It notes that corporates with clear and credible plans to manage their transition risk should be in a position to maintain good access to the commercial (re)insurance markets. That access would enable their captives to continue to use fronters or reinsurers to manage the group’s overall retention. “Conversely, corporates lacking ambition when tackling an elevated transition risk exposure could find it increasingly difficult to maintain sufficient access to commercial (re)insurance capacity, as commercial insurers and reinsurers themselves adjust their underwriting capacity to some lines of business and industries to meet their own ESG targets,” warns AM Best. “Ultimately, this could lead such corporates to increasing their level of self-insurance, with the potential consequence of increased utilisation of their captives. With lower support from the commercial (re)insurance market, captives increasing their exposures would likely need stronger capitalisation and require more careful management,” it adds.

Evolving European captives face up to hardening reinsurance market and transition risks

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