When captives exploded in popularity as self-insurance vehicles in the mid-1980s, the motivation was often incubation from the hardening insurance markets and exploitation of attractive tax treatments using offshore domiciles. Nowadays, risk managers are becoming more ambitious in their use of captives, seeing them as powerful risk management tools which can help to lower total cost of risk in a sustainable and economic manner.

The drive to diversify

Solvency II, the EU risk-based capital rules for insurers, has driven EU domiciled captives to consider how much value is being driven from the capital deployed. North American captive owners are also exploring optimisation opportunities and examining how the incorporation of non-correlated risks into their captive programmes can positively impact overall capital requirements.

Capital relief is given for greater diversification, while mono-line vehicles – or those that write only a very few lines of business – must hold larger amounts of capital. Underwriting a more varied book of business therefore decreases overall volatility and enables more efficient use of capital.

Following on from Solvency II implementation and the associated heightened governance and reporting requirements, the Organisation for Economic Cooperation and Development’s recent review of Base Erosion and Profit Shifting (BEPS) has also driven worldwide captive owners to re-examine the rationale behind their captive. Further, the Panama Papers leak has forced companies across all sectors to think hard about the justification for their choice of captive domicile.

Strategic reasoning

Against this more challenging backdrop, we are more regularly being asked to carry out strategic reviews of captives. By asking a captive owner to imagine they were setting up a captive from scratch, we can work with them both to justify and defend the captive’s existence, but also to look more strategically and ambitiously about how the captive could be used to manage and transfer a whole suite of risks.

Despite current soft market conditions, access to reinsurance markets and preparing
for a hardening market continues to drive captive strategy. Our clients remind us that a captive strategy is a long-term play which should arch over the peaks and troughs of the insurance market cycle.

Aside from access to the traditional reinsurance market, we are seeing increased appetite for more innovative and sophisticated reinsurance products. For example, structured reinsurance deals can help our clients to manage risk volatility across multiple lines and over a multi-year period. Such a deal can prove to be a powerful tool in incorporating certain coverages that risks managers might find hard to access in the commercial insurance market. 

Incubating new risks

Many captive owners are going further still and are working with reinsurers to identify emerging and esoteric risks to incubate within the captive, until such a time that risk transfer becomes a more economically viable option. 

This approach gives reinsurers access to reliable loss data and a deeper understanding of the risk – which can then result in cost savings and more tailored coverage. Reinsurers can also help the risk manager with areas such as wordings, for example.

Lines of business such as cyber, trade credit, terrorism, non-damage business interruption, weather and reputational risk are increasingly being incubated in captives in this way and the growing trend is set to continue.