We are living in a VUCA period. The elements of a VUCA Business Environment, according to the Centre for Executive Education, are Volatility, Uncertainty, Complexity, and Ambiguity. VUCA is an acronym that arose in the 1990s from the US Army War College strategic leadership training to describe a more volatile, uncertain, complex, and ambiguous, multilateral world that emerged from the end of the Cold War. The relevance of VUCA for risk managers is that climate change and pandemics are challenging to predict in terms of frequency, severity, aggregation, and timing of impacts arising from these specific perils or threats. The more uncertain and volatile our environment becomes, the greater the need for alternative risk management tools.
So, what do climate change, pandemics, and supply chain disruption have in common? Business interruption! Managing risks to business operations associated with climate change, pandemic, and supply chain are becoming more complex, and, therefore, we have less clarity, or more ambiguity, about what is the appropriate investment balance between loss prevention, mitigation, and risk financing. We may be able to identify the inherent risks associated with our business environment, but it is far more challenging to assess the residual risk. There is much debate about the difficulty of modelling the likelihood of and impact from pandemics and natural catastrophes. What we do know is that these events will substantially disrupt our business operations and supply chains. Moreover, there is also a growing interrelationship among the various risks associated with these events. For example, a health care crisis quickly becomes an economic crisis resulting in increased hazard and operational risk to our personnel, IT systems, data privacy, premises, business operations, suppliers, customers, boards, and earnings before interest, taxes, depreciation and amortisation (EBITDA).
Having said all of this, can an organisation fund first-party physical and nonphysical damage business interruption losses in a captive insurance company? This coverage must also include contingent business interruption coverage because it is an integral part of this exposure. The first question is, how can we estimate funding and at what limit of coverage? If commercial insurance is unable to insure pandemic triggered business interruption, how can a captive insurance company? Self-insurance is intended for high-frequency, low-severity risk, not for highly volatile and unpredictable threats. Despite all this noise, the clear signal is that a captive can be used to fund and manage this risk proactively, not retroactively to bail out the parent. No one, however, is suggesting that any organisation attempt to transfer the entirety of this threat to a captive. Again, the modelling is not perfect, but as we learn more, it will improve. It is essential to move forward cautiously and start small but start.
A captive insurance company is a strategic risk management tool. The captive, therefore, can be a conduit for loss prevention, loss mitigation, and business resilience investment. A captive should not be used to accumulate idle capital from its retained earnings. A captive, however, can use its retained earnings or excess capital to provide some funding for loss prevention initiatives by offering risk management grants to its member insured(s). This begs the question; can the captive also fund a portion of the member insured(s) investment in their suppliers’ contractually required risk management initiatives? This type of grant should be viable if appropriately structured. Nonetheless, this grant process must be adequately governed and regulated with input from the captive manager, external auditor, actuary, tax attorney, board, and domicile insurance regulator.
Moreover, a skilled, diverse, and active captive board can communicate to the captive’s parent(s) the need for a more reliable connection between the member insureds’ risk owners involved in managing business continuity. This improved risk communication will facilitate a more robust business continuity planning process. But how can a captive board facilitate this improved risk communication? The right place to start is to include business continuity and business disruption threats on the captive board’s strategic meeting agenda. The captive directors need to discuss the relevant business continuity issues from an enterprise risk management (ERM) perspective to develop a strategic plan that will support its member insured(s) specific needs. These issues may include:
How does the member insured(s) manage their organisation’s most critical operational functions?
What is the depth and breadth of the member insured(s) supply chain risk management programme?
What is the current state of the member insured(s) crisis and business continuity management, emergency response, disaster recovery, and business continuity planning?
What are the best estimates of the likelihood and impact of a disruptive event that will impact operations? Are these forecasts based upon a risk identification and assessment of the entire organisation that then specifically examines the threats identified to the member insured(s) mission-critical functions?
Does the member insured(s) understand the minimum amount of time that the organisation can be down before it suffers critical and permanent losses?
Does the member insured(s) understand whether it can operate essential functions while it recovers?
Will its investment in loss prevention and mitigation protect the member insured(s) against preventable losses?
How can the captive contribute to this initiative?
This list is not industry-specific or all-inclusive. The discussion, however, will enable the captive to determine if and how it can provide the type of coverage which enables its parent to seek a more effective balance between risk control and risk financing. The roadmap to risk financing in a captive has three curves in it.
Compliance issues that arise from insurance regulation, contracts, loan/bond covenants, and other legal demands that require commercial insurance. The member insured can partner with a commercial insurance company to address compliance issues, which may be in the form of a large deductible, fronting programme, or by providing supplemental or difference in conditions cover to fill gaps in a commercial insurance programme.
Capacity refers to the access to global reinsurance and financial markets, which is a significant captive advantage. Finding the required capital to support funding for loss costs can be elusive. The captive is not unique because it can use its retained earnings over time to increase its ability to underwrite higher amounts of risk. What makes the captive notable, however, is that it is also able to negotiate for additional underwriting capacity directly from the reinsurance and insurance-linked securities markets. In the event the captive accumulates too much capacity, i.e., overcapitalised, it can issue dividends, or provide loan backs, with regulatory approval, to support the parent’s cash needs.
Control defines the captive owner’s desire to design a risk financing programme that meets its specific needs. For example, its willingness to control the cost of risk, claims management, underwriting, coverage terms, loss prevention engineering data, global risk management strategy, and access to reinsurance capacity. This control enables the captive owner to structure its risk financing programme to meet its specific needs. The captive’s business interruption insurance policy, for example, can be drafted to cover the member insured(s) particular threats or perils and then negotiate directly with underwriters for reinsurance coverage. The reinsurance market is difficult at that moment, but those organisations that have a robust risk management story to tell, and have exceptional environmental, social, and governance (ESG) ratings will be in a stronger position to access reinsurance capacity. In other words, these characteristics should get a reinsurance underwriter’s attention. Moreover, the captive regulators will focus on the strength of the captive’s solvency and liquidity ratios within the context of its risk profile, policy wording, funding, and the parent’s financial strength when reviewing the captive’s business plan amendment to add business interruption insurance coverage. The captive regulator’s approval should add credibility to the reinsurance underwriting process providing more control, not less, to the captive owner.
Funding business interruption risk in a captive is not a panacea. The member insured(s) have programme structure decisions to make:
What is the goal of the business interruption programme? What is the appropriate balance between investment in loss prevention, mitigation, and risk financing to provide financial relief from any negative impact on EBITDA and working capital?
What is the coverage trigger? Nonphysical and physical damage events?
Is this “all-risk” coverage? How is civil authority defined?
Does coverage include contingent business interruption?
Who will draft the statement of coverage? How are key coverage terms defined, such as the policy limit, business income, period of restoration, extra expense, and business income from dependent properties? What exclusions are needed? This list is just a sample of the coverage issues that the member insured(s) must discuss. Business interruption coverage expertise is required to develop the appropriate coverage statement.
What is the deductible or waiting period before coverage incepts?
Who will manage the claims? Business interruption losses are complicated and require skilled claims adjusters and experienced forensic accounting consulting.
How is this coverage coordinated with other exposures such as cyber and terrorism?
Is there a need for a parametric insurance programme or catastrophe bond to supplement this captive-based programme by addressing a specific threat not well covered by the reinsurance market, such as a viral cause of the business interruption, for example?
There may be tax implications from insuring broad-based business income coverage in a captive if some risk covered is considered business risk as opposed to insurance risk. Always talk with your tax lawyer.
One can argue that we had 100 years to prepare for this current COVID-19 100-year event. What did we learn, if anything, from the 1918 Flu Pandemic?
We can forecast almost anything. But it is a fool’s errand to think that any organisation can predict and fund for a COVID 19 business disruption event in a single policy year. The captive cannot underwrite more risk than it has the capacity to support. But the captive can add value to the management of volatile and uncertain risk in a way that is most beneficial to its member insured(s).
And the captive can build increase its capacity to do so overtime, if managed properly. A captive is not a panacea. It is a strategic risk management tool that can be used to support its parent’s business continuity planning and management programmes resulting in a more resilient organisation.
Insurance regulators and reinsurance underwriters will be assessing these programme proposals carefully.
The more clarity the captive business plan amendment brings to the compliance, capacity, and control questions, however, the more likely vital stakeholders will understand and approve the plan.
Once implemented, the captive’s business interruption insurance programme becomes an essential tool in the member insured(s) VUCA management toolbox.
