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Weathering insurance market storms with captives

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Weathering insurance market storms with captives

Executive Director, Sherman Taylor explores how captives were used in the past to supplement traditional insurance in hard markets, and how this very important risk management tool can be confidently used by risk managers to navigate the challenges of today’s insurance market. *

* Article first published in Captive Review's Cayman Islands report Janurary 2021

The traditional (re)insurance market is continuing to harden and is facing significant headwinds over the next 2-4 underwriting years. The coronavirus pandemic is a rare event that has introduced additional uncertainty into a market that was already under stress from successive years of major catastrophe loss events around the world. The impact of the hard market is already being felt by organisations when renewing their insurance programmes; significant rate increases and difficulty in obtaining required coverage due to diminished capacity of traditional (re)insurers are some of the challenges.

Expanded role of pure captives 

For this article, we will focus the use of pure captives as a means to address the current difficulties in the market. Pure captives almost exclusively undertake related business, and the classification has different names depending on the jurisdiction; for instance, in the Cayman Islands market, they are known ‘Class B insurers’, whereas, in the Bermuda market, they are known as ‘Class 1 insurers’. Pure captives are generally more suited to high frequency, low severity risks; they are typically used as an adjunct to an organisation’s insurance programme and not as a complete replacement. Captives traditionally cover risk such as general liability, auto and some workers compensation, however, discussion within the industry points to a future expanded role for captives that may see new and non-traditional types of risks being covered. 

(Re) evaluating the captive solution 

The current circumstances in the insurance market have resulted in a shift in some of the fundaments related to captives. There are three general groups who may benefit from this shift: 

  • Existing captive owners, who should take a closer look at their captive’s current insurance programme with a view to identifying new opportunities and re-imagining the underwriting strategy.  
  • Risk managers who may have previously conducted feasibility studies for a new captive formation and determined that it was not the right solution at the time. They may find it worthwhile to revisit the original underlying assumptions to make sure that they still hold in these very different market conditions.  
  • Risk managers evaluating a captive formation for the first time as they try to adapt their organisation’s overall insurance program in the prevailing environment.   

Captive formations in a hard market cycle 

An uptick in enquiries and discussions about new captive formations is already noticeable in the major captive jurisdictions including Cayman Islands and Bermuda, and this can be directly linked to what is happening in the wider insurance market. 

Following some very costly catastrophe losses in the past few years, many insurance carriers have adjusted their book by either exiting certain lines altogether, excluding cover for certain geographical areas, reducing limits offered, increasing rates, or some combination of these measures.  

The year 2020 has seen a continuation of the trend where large insurers are dealing with expensive loss events like the California wildfires. Not surprisingly, the quarterly combined ratio data publicly available for many large insurance carriers indicate continuing profitability concerns. In addition, uncertainty of the ultimate impact of coronavirus has already resulted in increased stress on the balance sheets of traditional carriers. The insurance industry received more bad news recently when businesses in the UK discovered that their coronavirus business interruption insurance claims will likely be eventually paid by their insurers. This was following a High Court judgment in a test case brought by the Financial Conduct Authority earlier this year. Historically, there is a distinct correlation between prevailing market conditions and the number of captive formations. In soft markets, such as in the late 1990s, when rates were low and there was excess capacity, new captive formations were rare. However, the current market conditions are reminiscent of the mid-80s' hard market which saw a flood of new captives.  

Hard market cycle may endure for medium to long term  

The present challenges in the insurance market do not appear to be short term. It is generally expected that for the foreseeable future, the industry will continue to experience significant year-on-year rate increases, reductions in overall capacity and a lack of appetite for certain types of cover. Current trends towards excluding certain geographical areas from cover based on poor loss experiences can be expected to continue as insurers try to limit their exposure. The industry’s experience with pandemic claims will likely to lead to a tightening of exclusion language in insurance policies which will protect the balance sheets of insurers from events like pandemics, but will create coverage gaps for the insured. 

A captive solution is not a quick fix, and the medium to longer term nature of the current problem means that there is adequate time to develop an appropriate captive solution to address it. While there is no restriction on the type of related business that can be written by a captive, careful planning and analysis is necessary to make sure that a captive functions economically, minimises losses, and retains sufficient profitable business to eventually become a profit centre for the captive owner.   

While control over insurance costs is a main attraction for captive owners, another equally attractive benefit is the ability to access the reinsurance market through a captive. Such access could provide flexibility when structuring an insurance program, allowing the organisation to strike the right balance between risk retention and profit. Flexibility is important in a hard insurance market as it allows risk managers to optimise coverage solutions with less limitations.   

New and emerging insurance risks 

The hardening of the traditional (re)insurance markets is coming at a time when some newer, previously uninsured risks are coming into focus. For example, the digitalisation of the business world is inevitably leading to heightened enterprise-wide cyber risks; yet, the insurance solutions that exist for these types of risks remains very limited. Technological advancements in the automobile industry such as the advent of autonomous driving vehicles is another example of a developing coverage gap in the insurance market. One of the challenges of covering newer risks such as cyber is the availability of reliable loss experience data to base pricing on. Here, captives can play a role in the way such risks are covered, at the same time helping to develop the type of actuarial data needed to better inform coverage in the future.  

Conclusion  

The current market conditions and the coronavirus pandemic together highlight the need for risk financing plans to be flexible and forward looking enough for organisations to cope with unexpected shocks. The challenge for organisations today is to find ways of inexpensively filling any void in coverage that could arise by such events. Captives are already a key risk financing technique for many organisations, and we may be witnessing a further evolution that will make them a fixed part of the delivery channel for commercial insurance.   

Our team provide a full suite of administration and fiduciary services to the ILS and captive market from our Bermuda, Cayman and BVI offices, ensuring that all structures remain compliant with applicable regulations in each jurisdiction. If you would like to discuss how we could support your captive needs, please get in touch via my profile below or learn more here.

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