Finance with benefits
One of the most notable trends in the captive industry in recent years has been the increasing role of captives in employee benefit financing.
Corporations have been using captives to retain and manage non-life/property and casualty risks for decades, but until relatively recently, life/employee benefit risk has not been considered for captive inclusion to the same extent.
Although the idea of using a captive to fund benefits risks has been around for a number of years, the percentage of the total global captive population to adopt this approach remains relatively small, however, the numbers are very much on the rise. Given the current levels of interest in the topic, the expectation is that there will be spike in the numbers over the comings years.
This heightened level of interest is exemplified by the fact that the topic of ‘employee benefits and captives’ is now one of the leading agenda items of the numerous captive conferences on the annual circuit.
So why is employee benefits getting so much attention?
Quite simply, when implemented correctly, employee benefits in a captive can bring a range of significant advantages. Successful inclusion of employees in a traditional captive arrangement can result in very compelling cost savings but can also facilitate enhanced coverage and improved management of the risk.
By using a captive to fund insured benefits, companies can make significant savings on insurer profits and broking commissions. There is also the advantage of improved cash flow and the associated ability to collect investment returns. Financial efficiencies of moving from a decentralised structure to pooling are generally accepted to be in the region of 10 to 15 percent, but there are also incremental savings to be made from using a captive. Our work with clients suggests that the cumulative savings of using a pool and a captive, compared to buying locally, can reach 25 percent. Considering that for many organisations, employee benefits coverage costs are greater than property/casualty coverage costs, this percentage saving represents a significant prize. This also suggests that looking at employee benefits and property/casualty holistically could strengthen the business case for medium-sized companies to establish a captive for the first time.
These headline cost savings are obviously very attractive, and are resulting in many organisations commissioning employee benefits captive feasibility studies (we currently have an unprecedented level of enquires from clients). However, these premium and commission savings are not the only quantitative advantages that are available.
Diversification benefits available through the consolidation of life and non-life risks in a single captive portfolio can result in significant improvement on the captive’s return-on-equity measures. This is particularly true of captives domiciled in the EU, which are subject to tougher solvency and risk management rules under Solvency II, implemented in January 2016.
Solvency II is increasing compliance and governance costs for captives based in the EU, and companies have been looking at ways to reduce cost and get more from their captives. One way in which captives can increase premiums and broaden their risk profiles is to add employee benefits. Solvency II provides capital credit for non-correlated risks, giving captives diversification benefits when adding life risks to a property/casualty portfolio.
The advantages listed will likely appeal strongly to the risk manager and CFO of an organisation, but what about the HR director, who will generally be closest to the current employee benefits programme?
A common concern of HR professionals, who may not have had much prior exposure to captive insurance, revolves around the quality of benefits and the misconception that a group-owned insurance vehicle would not be able to offer the same quality of coverage as the current employee benefits insurance partners. However, using a captive can enhance coverage rather than dilute, and can give HR departments more control over employee benefits cover, as well as ensuring that cover is more consistent across various jurisdictions. The captive can be used to offer benefits cover that is not widely available in the local market, ensuring that employees across the group receive the same quality of coverage irrespective of which location they work in. Organisations can provide the benefits cover they want, not what insurers want to provide. Increased control of cover is particularly useful when looking to attract and retain talent. In an age when talent retention ranks high on the risk registers of organisations of all industry sectors, the flexibility that a captive approach can facilitate will likely be very appealing to HR stakeholders within the organisation.
In addition to the considerable advantages noted above, organisations that use captives to finance insured employee benefits risk can also achieve better management and transparency of data.
One of the more significant challenges associated with the centralisation of benefits is transparency. Information on employee benefits spend is generally difficult to access adequately, given its decentralised nature and the local authority over its purchase. As well as this, networks typically only provide data six months after the end of the underwriting year, making it difficult to achieve true visibility of the data. However, captives need to pay claims quarterly or monthly, so data from fronting insurers flows faster to support the cash-flow arrangement. Quarterly reporting means more transparency of financial performance and the ability to improve claims and cost management. This control of the data allows for improvement initiatives to be identified and also provides the central HR function with enhanced oversight of the benefits purchasing behaviour of subsidiaries.
For many organisations, these outlined advantages are compelling. So a legitimate question is: why are the numbers of employee benefits captives still relatively low?
Most insured employee benefits are relatively straightforward to include in a captive. The profile of employee benefits risks are usually high-frequency, low-severity risks that are relatively simple to forecast and therefore well suited to a captive approach.
However, this approach will not suit every organisation and there are significant challenges to successful implementation.
Firstly, companies require a critical mass of employees (usually at least 5,000) with a good geographical spread if they are to use a captive to fund benefits risk via a multinational pooling arrangement. Employee spread is important because companies will not want to add high accumulations of risks, such as concentrations of employees, in single high-risk locations, such as major cities or catastrophe-exposed zones. There are also important internal operational considerations, notably around the structure of HR and how it is connected to other parts of the business. In particular, there needs to be a degree of centralisation and cooperation between HR and the risk management function, which is not typical.
Effective communication and collaboration between the risk management and HR departments is an essential prerequisite for a successful employee benefits captive, and this can take some work to achieve in most cases.
Typically, risk management is a centralised function to drive non-life insurance programmes and HR is decentralised. So companies will likely need an additional layer to organise and centralise benefits, which will take time to establish. Moving to a captive-based approach could mean changes to carriers, and HR will want to know that insurers are able to deliver the required benefits locally.
The importance of engaging with HR and understanding its needs cannot be underestimated.
Another consideration for risk managers is the relative immaturity of the employee benefits captive concept and the ability of insurers to provide expertise, service and product.
Although the ability of insurers and networks to facilitate benefits funding by captives has improved, with a number of networks investing in developing employee benefits pooling systems that captives can access, still further improvements are required to bring the offering on par with non-life equivalents.
Another explanation as to why the numbers of employee benefits captives are relatively small is the lead time to transition from a decentralised approach to a centralised multinational pooling arrangement, which can take several years to correctly implement.
With many organisations already progressed on this journey, the numbers of employee benefits captives coming on stream over the next few years could effectively double the population of employee benefits captives, and as familiarity grows and the concept continues to mature, the uptake is likely to further accelerate.
So, in conclusion, although the concept has taken some time to gain traction and the uptake numbers are relatively small, the potential it represents, together with the momentum it is generating, will ensure that the financing of employee benefits through a captive will continue to trend strongly for some time to come.