It used to be that captives were considered a risk financing solution used mostly by larger companies whose unique risks were difficult or impossible to fully cover by traditional insurance means. Fortune 500 companies and large commercial accounts were dominating the captive space. Yet, captive use has evolved, driven by the desire of companies to gain more control over their insurance placements and catalysed by the current hard market cycle.
Alonso Tello, VP captives and alternative risk transfer at AXA XL in Canada, explains how companies are using captives in new ways and how smaller organisations are now tapping into the captive market to manage some of their risks.
How can companies that have not traditionally had captives begin using them as part of their risk transfer strategy?
Alternative captive structures that fit the needs of a wider spectrum of organisations are gaining momentum. For a few decades, cell captives – whereby the owner of a core facility holds the regulatory capital, insurance licences, as well as managing the day-to-day operations, rents a cell to third-party organisations – have made it possible for small and mid-sized organisations to enter the market. So has the pooling of risks by insureds into a group captive – a single captive entity, in which they share both the risks and the profits from that captive.
Much has been written about the most common benefits captives offer, particularly in today’s insurance market cycle and with the current rate increases being applied across the industry. And there are some exciting alternative ways in which organisations are successfully using captives to enhance their risk management programme, attract more clientele, or even access other forms of risk transfer.
How can clients use captives to access insurance services for emerging risks?
A captive can give an organisation access to the services that often come with policies, without having to transfer all their risk to the traditional insurance market. For example, an organisation using a captive to retain its cyber risks could take advantage of the pre-breach and post-breach services that the fronting carrier may offer, even if it otherwise doesn’t wish to buy insurance capacity for cyber risks. The carrier would receive a fronting fee from the organisation, which would give that organisation full access to those services.
That gives organisations access to a host of services for which they otherwise may not have had the internal resources. Pre-breach services that help pinpoint vulnerabilities in a company’s IT systems, or that provide insight on best practices, can strengthen their cyber risk profile and mitigate potential losses. And following an event, the expertise required to properly notify and address the breach can be an invaluable service that the fronting carrier’s cyber proposition often includes.
How can risk professionals and their organisations use captives to incubate emerging or unique risks?
For some of the more unique coverage options, or for emerging risks that are difficult to place affordably in the traditional market, a captive can also enable a company to ‘incubate’ their risks and build up enough data over time to share with the market, provide greater comfort about the exposures for insurers, and hopefully improve pricing or open up capacity not otherwise available.
For example, a growing trend within construction has been the increased use of mass timber. This building material is not easy to obtain coverage for in the admitted market, even though its proponents advocate its safety, sustainability and cost-effectiveness versus other materials. Instead of potentially having to place the coverage for these operations separately, or retain them on the balance sheet, a company can use their captive to retain the risk for this exposure – as a sub-limit in the main programme, or standalone – and demonstrate its timber loss exposure over time, while maintaining the ability to build up loss reserves and protect the company balance sheet in the event of a loss.
Most fronting carriers would want to retain some of the risk in any structure that they underwrite, such as 5% or 10%, and the data that is gathered on these risks will allow them to understand the risk better. With a more detailed view of the organisation’s experiences in an exposure or coverage type, underwriters can assess the risk with more certainty and more accurately price those risks.
With a more accurate premium to reflect the risk assumed, the organisation may be better able to find more capacity in the market that fits its budget and complements the wider business operations.
Are you seeing companies use captives as a way to attract and retain clients? And how does this work?
While not new, cellphone damage coverage, flight cancellation insurance for travellers and other affinity insurance products are just a few examples of how some organisations are using captives to attract new customers and retain business. A cellphone provider that offers phone damage insurance with a purchase of a new phone can give buyers that additional incentive to purchase from that company and generate more premium for the captive. The same can be true for an airline wanting to give buyers an incentive to travel with them; with the aim of removing a potential buyer concern and therefore generate increased sales for the company.
Because the organisation, such as a cellphone provider, will most likely have large pools of loss data on the products they sell and repair, the loss frequency and severity are more predictable. The claim history can show trends and can be actuarially calculated with a greater degree of confidence. Rather than paying 100% of these premiums to a traditional insurer, a portion of those losses can be offset through a captive. Likewise, if the losses are lower than expected, the organisation can realise some profit on paid premiums ceded to the captive.
Such products are beginning to show up in the cryptocurrency market as well. Cryptocurrency storage companies are starting to offer breach coverage to their customers to remediate in the event of a security breach of the company’s platform. That gives customers an additional incentive to use their services, while also providing peace of mind. The first step is to identify a potential hurdle in the customer journey that can be addressed through insurance, and the next is to leverage the organisation’s captive to tailor coverage and potentially capture underwriting profit.
How is this greater use of captives for alternative risks helping clients’ overall risk management strategies?
Captives can give a company the chance to develop the capital they need for risk management initiatives. When loss history is better than predicted, those funds can remain in the captive and build equity over time. Those funds can then be directed toward preventative equipment, such as water-detection systems, telematics wearables, or technology that improves safety.
That can be a more impactful use of excess capital and can shift companies into a more strategic approach to managing their losses. Instead of adding more risk to the captive portfolio to use that capital, that capital can be used to improve risk profiles in a more tangible manner; especially when operating budgets continue to challenge everyone to do ‘more with less’.
Contributed by Alonso Tello, VP captives and alternative risk transfer at AXA XL in Canada