You wrote last year that the risk community is increasingly focused on emerging risks, as penetration of the captive concept increases. Are you now seeing these trends feed on one another?
We are seeing all different types of emerging risks being placed in captives today including product warranties, healthcare provider risk, employee benefits, cyber, excess workers’ compensation, wage and hour, and marine risks. Many of these emerging risks are not correlated with the standard captive risks of workers’ compensation, general liability and auto liability, so captive owners are interested in how these risks interact with one another and the diversification effect.
The diversification effect is similar to what you can achieve in an investment portfolio when you take non-correlated assets and pool them together to achieve diversification and greater stability. In a captive, the diversification effect of non-correlated risks leads to a reduction in required captive capitalisation and annual funding. Understanding the interaction of captive risks including these emerging risks and measuring the diversification effect is one of the most important breakthroughs that I have experienced in my 36-year captive consulting career.
Does it then follow from this that captives have to ‘optimise’? If so, how and why?
What I find from talking with captive owners is that their captives were optimal when they were set up, but have operated for years without refinement. So decisions on deductibles, retentions, reinsurance attachment points were optimal at inception but not revisited and refined for changes at the captive owner, insurance market conditions, and so on.
It is imperative that captives be monitored and refined continuously to keep the captive operating on an optimal basis. From a practical standpoint, this should be done at least annually.
Furthermore, the captive optimisation should be done on a holistic basis and not by coverage line, which was the typical method for captive optimisation 10 years ago.
Optimising towers of risk and then summing up annual funding and capitalisation requirements by tower fails to recognise the interaction of risk and diversification effect. Fortunately, at Willis Towers Watson we have developed a new software called Igloo to better understand the interaction of risk on an aggregated basis, and which allows for captive optimisation on a continuous basis.
What is the ‘diversification effect’ of putting non-correlated risks in captives? What are the advantages of this effect?
One of the findings of studying the diversification effect from non-correlated risks is that many captives are over-capitalised. We have found that captive owners are generally satisfied with the savings generated by their captives annually and they assume their captives are operating fine, but in the back of their minds they wonder about capital adequacy.
Many captives accumulate capital and surplus over the years and we find when studying diversification effect that there is what we call ‘surplus surplus’.
That ‘surplus surplus’ can be redeployed in covering other emerging risks within a captive or increasing captive retentions. Still, other captive owners choose to lower premiums on a forward-going basis because of this over-capitalisation.
As the emerging risks typically are not as correlated, captive owners have a diversification opportunity for the first time to measure.
Is the diversification effect almost like a balancing act?
It’s a balancing act, as you can now model and measure the diversification effect with the software that’s available. So you can play various ‘what-if’ scenarios.
A captive owner and its team of risk management, treasury and financial personnel can sit around the table with the software and add and subtract coverages, change deductible levels for the corporation, change captive retained limits and study alternate reinsurance attachment points all done in real time, facilitating better captive decision making.
What can now be done in a single day, previously took many weeks utilising the spread sheet tools from 10 years ago.
What about disadvantages? With diversification comes cost—how can optimisation of the captive help in this regard?
Of course, there’s a cost of utilising software. The software can either be run by your actuary or the captive owner can purchase the software and run it themselves. The software can range in cost from $100,000 to $200,000.
But, once you have paid that front-end software cost you can run the software regularly with minimal additional cost.
Once you have all the data inputted, doing the ‘what if’ scenarios will help companies with their captive decision-making process. In addition, it keeps your captive on the cutting edge, which should be the number one goal for all captive owners.
In the article you wrote last year, you predicted what’s ahead. Looking to 2018, what change do you expect to see?
We’ve had a couple of manufacturing companies and restaurant chains talk to us about putting commodity risk in their captives and still other companies are exploring putting business risks into their captives.
Next year should also be a big one for companies putting their employee benefit risks in captives. There has been considerable interest in medical stop-loss, group life and long-term disability.
There has also been increasing interest in post-retirement medical. Outside the US, an increasing number of employers are studying the feasibility of putting their pension risks in captives.
As I look into my crystal ball, I see 2018 as the most active year for forming captives and placing emerging risks in captives in years.
Even in today’s soft insurance market, companies continue to look for more ways to take advantage of their captive tools. So, I think you’ll see the upcoming year as one of tremendous captive growth and opportunity.