An Introduction to Captives

Sophisticated organisations are continuously To be (or not to be) a captive owner looking to develop successful risk financing A long term view strategies, and many utilise a captive to Every organisation has its own specific approach accomplish this goal. In this article, Adrian to assuming risk, but often those companies that Sykes explains captives, their benefits, the want to maintain a large degree of control with typical profile of their owners and more. regard to their group risk and spend seek to form a captive. The most successful captives A captive: what exactly is it? are those where the parent views the captive as Whilst numerous definitions of a “captive a long term strategy. This has been borne out by insurance company” abound, essentially it is an those companies who have operated captives for ‘in-house’ insurance or company, a number of years, as typical in the energy sector. formed primarily to insure its owner and affiliated Adrian Sykes companies. It is a risk management and financing Size of the group’s insurance premiums vehicle that offers an alternative to conventional When deciding whether to form a captive, is a global fronting insurance as it enables the parent/affiliates to companies need to consider whether the group’s underwriter at AIG’s essentially ’self-insure’ or ‘retain the risk’ through insurance premiums are sufficiently large to justify Global Risk Solutions its captive. The captive provides the owner or the investments that needs to be made in terms of in the EMEA region. its affiliates with insurance coverage for risks the: Adrian joined AIG in that the owner wishes to retain, and the insured • time and resources required to establish and 2006 in , entities pay premium to the captive. Any profits operate the captive, and made by a captive are retained within the parent before transferring to • capital investment in the captive needed to company’s group rather than being ‘lost’ to the AIG’s London office comply with the regulations of the jurisdiction insurance market. three years ago. Prior in which the captive is domiciled. Typically, a captive has none or very few to AIG, Adrian worked If these investments don’t seem prudent in view employees requiring some or all of the usual of the premium levels, a Protected Cell Company in the insurance broking ’insurance company’ functions to be outsourced (PCC) or similar rent-a-captive type structure may sector for 18 years. to third parties. The majority of them do not have a provide clients with a simpler, more cost effective rating issued by a credit rating agency. It is possible alternative for retaining risk. These structures for an organisation’s captive insurance company to enable clients to enjoy many of the benefits of a write non-parent exposures (third party risks), but captive but without the same level of investment. this is dependent upon the jurisdiction and its rules for captives. Claims history Captives have been in existence for over half a Remember, a captive is a means for the century. Today, there are over 6,000 captives organisation to retain risk rather than transferring about operating in 59 territories worldwide and the risk to the commercial insurance market. Since writing premium income of over US$70bn per the commercial insurance market pricing reflects annum. the industry’s loss trends and the organisation’s claims history, companies may benefit by Why retain risk in a captive? retaining risk in a captive when they have a: A company may chose to retain risk in a captive • claims history that is better than its industry (or for a variety of reasons including: is improving), or • It may be more cost efficient than transferring • risk management processes that improve the the risk to the commercial insurance market. organisation’s overall risk profile. • Over time, it may provide greater certainty of Conversely, we have seen examples of where a insurance spend by insulating the company poor loss history has resulted in either a captive against the market cycle of insurance being formed by the parent or an existing captive premiums, so as to ‘smooth’ the peaks and assuming an additional deductible layer at the troughs. level above the local deductible. The rationale • The traditional insurance market may not for this is to enable the overall program to remain provide any available solutions to the in force in compliance with either compulsory company due to: insurance requirements or the requirements of –lack of cover for a difficult to insure risk regulators, clients or other counterparties, or so as not to increase the local operating deductibles. –restricted capacity as regards coverage, limits, This is an example of where a captive shares the or policy terms. risk with an incumbent market carrier in order to • As a licensed insurer, a captive has the ability ‘smooth’ the deductibles across a program. to directly access the reinsurance market, with all the attendant benefits that go with it. 1 An Introduction to Captives

So, a captive might work. What’s next? Services basis. In addition, non-compulsory coverage in other Once a company has decided a captive might be right for territories where non-admitted insurance is permitted may also it, a feasibility review would be the next step. Typically, the be written by the captive. parent engages an outside consultant to conduct a feasibility A parent with risks outside of the scope of the captive’s licence review. Generally (though not exclusively) the consultant is an may seek an insurance carrier to front those exposures in order insurance broker or insurance company with experience in to obtain locally admitted insurance policies and benefit from captives. The objective of the feasibility review is to determine the carrier’s own multinational licences and network. In order the potential value of a captive to its owners and, ultimately, to for the arrangement to operate as efficiently as possible, it is evaluate whether the captive is a viable strategy for a particular important that any fronting carrier considered has a global organisation to pursue. network presence to match the “footprint” of the insured. The The review will focus on the financial aspects of a captive captive will then assume the exposures (either in part or in full) formation, but will also look at areas such as choice of from the fronting insurer via a contract of reinsurance between domicile, lines of business, insurance or reinsurance (or both), the parties. limits to be written, and whether a fronting carrier is needed The captive is up and running for a number of years. in order to provide front end policies in territories where Now what? local insurance is required, for example to meet compulsory insurance requirements or because the territory falls outside the For a mature captive, it makes sense to periodically assess captive’s licence. the functionality and financial effectiveness of the existing programme, as well as to consider additional lines of coverage Which risks to insure? for the captive. This review should evaluate the captive’s: In principle, virtually any risk can be covered through a captive • performance in meeting the objectives of its original business structure. At entry level, one or all of commercial property, plan casualty and marine are most common. For more mature • actual vs. planned experience in terms of writings, captives or where the principal exposures of the parent may be premiums, losses, etc. more financial in nature (for instance, banks) coverages such as Crime and Professional Indemnity may be written. • operation including data flows and internal controls Under the provisions of Solvency II in Europe, which impacts • service providers’ role and performance captives as well as the commercial insurance market, there is • opportunities for writing new risks; and an incentive to a captive owner to diversify their portfolio of • capital position and any additional capitalisation needed exposures. For example, by insuring Trade Credit insurance if it is to expand. in the captive, in addition to say Property and Casualty, this creates an additional risk diversification which may support Is the captive way the only way? the captive’s capital requirements, particularly in a Solvency No. A captive vehicle is just one of the risk financing options II environment because the additional line is not correlated open to a company. Other options for retaining risk include to the other business. This may have the impact of reducing choosing to be uninsured, increasing deductibles and structured proportionately the amount of capital that the captive needs to solutions. hold in order to maintain the minimum solvency levels. What’s the role of a fronting carrier? For more information, please contact Generally, there will be a limited number of jurisdictions in Adrian Sykes at 44.207.651.6120 or which the captive can write risks on a direct basis. For example, [email protected] or visit an EU domiciled insurance captive can write coverages across the EU and EEA by a single policy issued on a Freedom of www.aig.com/globalrisksolutions.

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