The techniques employed by successful Captive insurers are growing in scope and sophistication and increasingly resemble those of conventional companies, says Karl Murphy of EMB
Predictions about business trends have an embarrassing habit of going wrong, but this one is made with confidence: the number of captive insurers owned by Asian companies will increase impressively over the next decade. Moreover, many more of them will be based in Asian domiciles, rather than traditional homes such as Bermuda.
The dramatic growth of many Asian economies, combined with the region’s developing insurance expertise and the continued long-term increase in the use of Captives globally mean that there is only one way to go, and that is upwards. Singapore, in particular, justifies its status as the continent’s leading Captive domicile, with its wealth of insurance experience, stable political and economic systems and low taxation.
The trend will not, however, provide a uniformly happy experience. Captives can be excellent mechanisms to transfer and manage risk, but there is a huge variation in professionalism and performance. Captives are as capable of giving their shareholders nasty shocks as any mainstream insurer, though failures tend to be hidden in the parent company’s balance sheets, well away from the glare of publicity.
Look closely at the annual report of any major domicile, and you will likely find that new Captive start-ups have been offset to a significant degree by operations that have closed down. Whilst some of these withdrawals will be successful operations now surplus to requirements, you can be sure that others have ended their lives in less happy circumstances. Running off a Captive is a time-consuming process and diverts attention from other risk management issues.
Successful Captives are usually those that behave like conventional insurers in the disciplines and expertise they employ, which means developing a technical approach towards pricing, reserving and overall strategy. Apart from the financial imperatives to do so, the regulators increasingly require Captives to demonstrate their financial soundness.
Be they regulators or shareholders, the common thread is a desire for control and predictability. This has many other advantages for the Captive manager. It assists faster acceptance of other insurance policies by group subsidiaries, group customers and joint venture partners. It makes buying reinsurance simpler and potentially cheaper. Ultimately it aids better use of capital, which is the whole object of the exercise.
Some companies do not have a clear idea of why they want a Captive, nor have they adequately compared the option with alternative strategies. So, at the risk of making a point that may be obvious to many risk managers, the effective use of Captives begins before they have been set up.
The first thing to investigate is whether a Captive is the best answer to your needs and, if it is, how much capital you will require. In approximately 25% of cases it turns out that there are better ways to achieve your objectives.
To answer this basic but vital question, the best tool is a detailed simulation model. By creating a financial model of the enterprise you can ask it to measure the consequences of any strategic decision that you might take. These models drive and quantify the variability of the balance sheet reserves, help with planning the upcoming year and are also extensively used for reinsurance buying and capital setting. Risk managers not brokers need to own these models using the various outputs to direct brokers down certain channels.
If built with care and diligence these models can integrate into a more holistic risk management strategy, linking up with the parent company’s balance sheet and providing a more macro view of risk appetite and uncovering the true scale of any downside risk.
Once up and running, the financial pressures on Captives are very similar to those of conventional companies. Anyone who treats a Captive as a shoe-string operation, trying to get away with low levels of technical rigour, is in danger of creating a monster. Any shortfall is unlikely to happen overnight; it will almost certainly be the result of under-pricing and under-reserving over a period of years.
The best way to prevent this from happening is to invest at the outset in systems to gather, retrieve and analyse data. This will make it possible to correct any misalignments before they become too serious and to test the assumptions upon which your reserving and pricing are based. At the early stages you may need to supplement your own claims records with publicly available market-wide data.
Once you have been through these processes, your Captive will have the sound basis it needs to provide your company with stability and effective risk management mechanisms. Ignore them at your peril!
This article appeared in Asia Insurance Review in May 2006
