Governance and risk management in captives

Owning a captive insurance company is a common feature of a coherent risk financing strategy for corporates. Building the financial resources to meet the costs of operational loss events through an efficient structure is a sensible and well established approach that insurance risk managers often take. But having an insurance company within a group that may otherwise have no insurance sector management experience raises the question of how the parent will ensure excellence in governance and risk management in the captive.

In recent years a huge movement has been underway to create better resilience in insurers – largely driven by Solvency II in Europe and its equivalence elsewhere. Owners and directors have been required to adopt practices that ensure effective oversight of the company through detailed and thorough governance and effective risk and capital management.

The key consideration for insurance risk managers centres on assessing how your captive stacks up against the improved governance, risk management and solvency resilience that conventional insurers have built in recent years. The captive owner will look to the non-executive directors to oversee the operation of the company and demand an equivalent level of governance to match the contemporary practices in conventional insurers.

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Of course, firms that own captives rely heavily on their captive managers, whether a division of an insurance broker or an independent manager. Local non-executive directors in the captive’s domicile are appointed, usually with a background in insurance operations, insurance law or perhaps claims management. A governance framework of Board committees such as audit and compliance, risk management, investment and operations should be expected. All these features help to assure the owner that the risks being carried in the captive are well understood and mitigated.

The lighter regulatory touch that may be available has been cited as a key advantage of owning a captive insurance company in an “offshore” location. Some domiciles, such as Dublin and Malta are part of the EU and therefore subject to Solvency II. But the Solvency II regime is not just about working out a safe financial buffer for the risks the entity is carrying – there are material governance expectations that ensure that the firm is run effectively. The challenge to insurance risk managers is to assess the management of this subsidiary and ensure that it operates according to the best practices that ‘non-captive’ insurance companies adopt.

Take a parent company that is a substantial engineering conglomerate. Good governance dictates they will carry out an internal annual Board effectiveness assessment, with an external independent review say every two years. Naturally the assessment will look carefully at how the Board performs in regard to running its core engineering business and the personal contributions of each executive and non-executive director. So it should be with the captive insurance company where reviews of Board performance, independent of the captive manager and carried out by consultants with insurance company experience, will bring valued assurance to the parent that the company and its Board are performing well.

Solvency II has a role

Media coverage of the stringent capital requirements of Solvency II has given the regime some unfair negative connotations – suggesting perhaps much higher solvency margins are to be held that are unnecessary. Certainly, many captive owners will be bolstering their capital resources above minimum regulatory requirements but it is also hoped they will seek to adopt the advantages of a tight governance and operational framework that identifies and mitigates risks. If additional capital is not available, this may well raise the question of closing the captive.

Well run insurance firms set a clear risk strategy, with risk acceptance parameters detailed in a written risk appetite and tolerance statement. Where risks are to be fed through to the reinsurance market, a counterparty credit risk strategy should be set, covering financial limits per reinsurer, as well as minimum acceptable credit rating.

Solvency II has driven the demand from non-executive directors for comprehensive management information across all categories of risks, including strategic, insurance, financial, operation, regulatory and group.

The key risk information that the Board requires centres on underwriting exposure, and in particular aggregation or accumulation of losses from one event or series of events. Similar attention is given to liquidity measures, where lack of liquid funds may prejudice claims settlement ability. Captives can often give wider cover than that available in the conventional market and the question that non-executive directors should ask is how the potential losses can be modelled, given that there is unlikely to be historical data that includes the wider risks being carried going forward.

Solvency II requires careful and realistic stress testing. Often companies are reluctant to discuss extreme circumstances – dismissing them as implausible. Calculating the capital required to survive a 1 in 200 event, perhaps better described as generating a range of outcomes and looking at the cost of the 200th worst event, serves to highlight the boundaries to failure, or ruin, of the captive insurance company. Once the events exceed the operational and solvency capital, the uninsured losses will ultimately return to the parent.

Regular reporting of the risk profile, loss scenarios and solvency capital to the Board of the captive, and also the parent, is essential in maintaining awareness of the effectiveness of the governance and the risk exposures the parent is carrying. The non-executive directors have a key role in requiring appropriate reporting and ensuring Board debate on the risks that lead to effective decision making.