The number of captive insurers is rising, and Raj Ahuja says these firms are also now growing in scope and sophistication.
Insurance cycles may come and go but it seems the captive market is only heading in one direction. The number of captive insurers rose by around 400% in the decade to 2002 and has continued to increase. Though the rate may fluctuate as prices harden or soften, the trend is always pointing upwards.
But this superficially uniform picture is deceptive. Leaving aside the fact that captives come in many different types and sizes, their financial performance varies dramatically.
They are as capable of giving their shareholders nasty shocks as any mainstream insurer, though captive failures tend to be hidden in the parent company’s balance sheets, well away from the glare of publicity.
Just as conventional insurers have been developing a more technical approach towards pricing, reserving and overall strategy, many captive managers and owners have seen the need to invest in support they might previously have regarded as unnecessary.
Apart from the financial imperatives, the authorities increasingly require captives to demonstrate their financial soundness. Dublin, for example, has for several years required them to have actuarial sign-off.
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.
Many captives have always been exceptionally sound and sophisticated operations, BP’s Jupiter being the best known. Others continue to be shoestring operations. In the middle are the majority of captives, which are not necessarily very large yet aspire to high levels of professionalism.
The effective use of captives as a risk management tool begins before they have been set up. Some companies do not have a clear idea of why they want a captive, nor have they adequately compared the option with alternative strategies.
Guernsey is Europe’s largest domicile for captives, and a particularly well-run centre that attracts a large proportion of blue-chip companies. Its continued growth has come despite some 30 surrenders in the first five months of the year.
While some of these withdrawals will be successful operations now surplus to requirements, you can be sure 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.
So 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 need. In around 25% of cases it turns out there are better ways to achieve your objectives.
In my experience there is no substitute for a comprehensive and detailed stochastic simulation model. These models drive and quantify the variability of the balance-sheet reserves, are vital for 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 be made to 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 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. Any shortfall is unlikely to happen overnight; it will almost certainly be the result of underpricing and under-reserving over a period of years.
By contrast, investment in systems to gather, retrieve and analyse data will make it possible to correct any misalignments before they become too serious. In the early stages you may need to supplement your claims data from publicly available sources. It is also important to test the assumptions on which your reserving is based.
CASE STUDIES
A captive in Guernsey underwrites extended warranty business on behalf of its parent, an electrical goods distributor. An actuary has been called in because, although the earned loss ratio shows the captive to be profitable, the finance director is worried the trend is increasing.
First, the actuary splits the policies into appropriate levels for duration and type of product. There are significant differences in the experience for brown and white goods, and longer duration policies will remain on the books for a longer period.
Warranty business can take five or more years before the policies are fully exposed. In the meantime quite a lot of additional business may be written at poor rates. Finally, if the premium earnings pattern is wrong, and claims emerge at a different rate, there is further potential for misleading results.
In this case study five-year white goods business has been written for several years. During the actuarial investigation, it was discovered that the earnings pattern used is inappropriate, and experience later in the term of the policy will be worse than assumed.
Unless premium rates are increased, or cuts in commission implemented, the captive is unlikely to be profitable. In addition, an additional unexpired risk reserve may be required to cover losses on the unearned premium reserve. As a byproduct of the analysis, it was found that claims inflation was running far higher than general inflation levels in the economy; subsequently claims controls were tightened up considerably.
A UK retail operation writes its EL and PL cover through its captive in Dublin. The company keeps £20,000 ($37,000) of each claim, with any additional amounts passing through to the captive. About 100 claims are expected to hit the captive each year. In the past the captive has taken advantage of favourable reinsurance rates, purchasing a comprehensive programme in the form of an excess-of-loss policy with a deductible of £100,000. When it came to renewing the policy, reinsurance rates had increased significantly and the captive considered alternative reinsurance strategies.
Option 1 is to keep the same £100,000 retention. Option 2 is to increase the retention to £250,000 and option 3 is to significantly increase the retention to £1m. The cost would be £3.1m for option 1, £2m for option 2 and £0.6m for option 3. The actuary fitted a statistical distribution to the past claims experience to assess the various reinsurance options while also using market benchmarks. This gives a range of possible net losses to the captive.
Option 3 gave the lowest expected reinsurance premium plus net losses of £7.59m. But in this case there is a reasonable probability (over 5%) that the total net claims plus reinsurance premium would exceed £10m, which represents the assets of the captive. In other words the captive would have to ask for further monies from its parent one year in every 20.
Option 1 gave the highest expected reinsurance premium plus net losses of £7.78. The probability of total costs exceeding £10m is minimal, at one in every 1,000 years.
Option 2 seems to give the best balance between retaining risk within the captive and having a low probability of having to receive additional funding from its parent. The probability of net claims plus reinsurance premium of exceeding £10m is 0.5% (one in every 200 years). The expected cost to the captive is £7.73m. The management team was able to make an informed decision based on a through review of data, analytics and variability.
This article appeared in Insurance Day in September 2005
