Although captives are widely recognized as efficient vehicles to formally fund a wide variety of corporate risks, they must be managed with the same rigor that businesses apply across all their operations.
In the current extended soft commercial insurance market and low-interest-rate environment, captive utilization can be diminished by attractive pricing and conditions available in the traditional insurance market.
Today, as risk managers struggle to maintain the relevance of their captives, many see opportunities for expanded utilization by focusing more on non-traditional business and financial risks. Sometimes, this results in increased premium writings. In other cases, however, these efforts are offset by a reduction in traditional risks that have been removed from the captive’s portfolio and placed in the commercial insurance market.
In this dynamic environment, risk managers can take steps to improve their captive’s profitability, essentially by reducing operating costs. These include the following:
1. Reduce reserves and accelerate claim closures. Claims are the single biggest cost driver of a captive’s operating expenses. Even so, the typical claims adjuster has a heavy case load and may not be closing claims quickly enough. The result: reserves remain on the balance sheet too long, excessive collateral is required, retained earnings are tied up or additional paid in capital is required. In addition, the longer the claim remains open, the greater the potential for adverse development. An aggressive audit of open claims reserves above a defined threshold and open timeframe, by an independent, qualified firm that benchmarks the claims process on each case against industry best practices can have an immediate and material impact on the captive’s financials. Further, individually tailored predictive analytics and modeling can produce measurable claim cost reduction results.
2. Access the reinsurance markets directly. Often, one of the motivations for forming a captive is the ability to access the reinsurance markets directly. Yet, in many instances, captive managers and fronting carriers inject themselves into the process. Unfortunately, this can isolate the client from establishing relationships with the risk takers, particularly direct writers. If a captive needs facultative or treaty reinsurance, consider developing direct relationships with reinsurance underwriters, or choose an independent reinsurance broker to represent the captive’s interest. In this way, the captive’s costs will be more transparent and it may benefit from a stronger relationship with the ultimate risk takers.
3. Review opportunities to close, consolidate or re-domesticate. Of the more than 5,000 single- parent and group captives estimated to be in business today, it’s hard to tell how many are dormant or inactive. Of course, in numerous mergers and acquisitions the combined company emerges with an excess number of captives.
Although closing a captive can have financial advantages, doing so may be challenging. Stakeholders, including regulators, reinsurers and front companies, may not be motivated to move quickly. And financial tools, such as loss portfolio transfers and commutations that had upsides in higher interest rate environments, may actually have the opposite effects today.
Consolidating captives and transferring assets and liabilities may be viewed more favorably by regulators. However, the fronting carriers and excess reinsurers may be diligent about protecting their financial positions.
The re-domestication of captives from offshore to onshore domiciles, or from one onshore domicile to another, often is motivated by tax incentives or to satisfy U.S. Department of Labor requirements for using a captive for U.S. employee benefits.
These strategies require time and energy, which are generally in short supply. There is also some imbedded inertia as the current captive manager will be less than enthusiastic unless they have operations in the alternative domicile being considered, let alone profit center considerations.
4. Seek objective and independent viewpoints. Many risk managers utilize their incumbent retail insurance brokers for captive management and actuarial services, in addition to their ongoing corporate insurance transactional responsibilities. While there may appear to be some economies of scale, the lack of an objective and independent perspective may have costs as well. Whether you are exploring the feasibility of a captive or looking to expand a captive’s utilization, there is an inherent conflict of interest utilizing your broker—especially if options they’re evaluating may come at the expense of an existing insurance placement.
5. Strengthen governance. Many mature captives, particularly those with a history of underwriting third-party business, have challenges and complications similar to those of a large insurance company. Yet, large numbers of these captives lack an outside, independent director with insurance company operational experience. Today, that should be a red flag—especially in light of increasing litigation between captives and their reinsurers. Notably, in certain jurisdictions there’s evidence of plaintiffs successfully circumventing traditional arbitration clauses in reinsurance agreements and litigating coverage disputes in the civil courts.
In one such case a major corporation experienced $160 million of uncollectable reinsurance in a coverage dispute from a windstorm loss. The captive’s case first was dismissed in arbitration. Subsequently (in an unusual development), the captive’s parent initiated a civil action and the court also found in favor of the reinsurers. An outside, independent director with insurance company operational experience might help a captive avoid these types of circumstances.
Despite the prolonged soft commercial insurance market and investment returns depleted by low interest rates, many businesses and organizations continue to rely on captive insurers as a critical element of their overall risk management strategy. By taking steps to: increase claim closures; gain direct access to reinsurers; consolidate or re-domesticate captives as appropriate; seek objective and independent providers, and strengthen governance, you can improve your captive’s performance.
With an independent, knowledgeable effort, you’ll help maintain the value the captive brings your organization now and in the future.
John J. Kelly is founder and managing partner of Hanover Stone Partners LLC, a risk management services firm with expertise in a broad range of critical risk disciplines. He also leads Hanover Stone CaptiveGuard(SM), which provides governance, compliance, and strategic advisory services for captive insurers and their owners. Before founding Hanover Stone Partners in 2009, Kelly had more than 35 years of experience in the insurance brokerage industry, including senior leadership positions with Arthur J. Gallagher, Aon and Willis. Contact him at firstname.lastname@example.org, or 646-216-2181.