It is little wonder that many finance leaders often consider a captive to be economically negative from a consolidated group perspective, given its income (premium) is a related business unit expense.
It is little wonder that many finance leaders often consider a captive to be economically negative from a consolidated group perspective, given its income (premium) is a related business unit expense. However, I am not convinced that this is a true reflection of the positive benefits that a well-structured insurance purchase strategy linked to corporate objectives that optimises captive participation can provide.
It may benefit finance leaders to consider the widely cited statistic that the majority of corporates incur a total cost of risk (TCOR) of circa 1 percent of revenues (or 1 percent of the price of each product sold).
Therefore, considering a corporate with a bottom line margin of 15 percent of revenues, the 1 percent top-line impact translates to a circa 7 percent bottom-line impact. Earning volatility is something that I suspect many CEOs and CFOs seek to avoid—a well designed captive programme may aid understanding and controlling risk to reduce this volatility.
The argument often cited by risk and insurance managers is that a captive provides stability in commercial market premium and terms during times of market unrest.
This argument has perhaps changed of late, in part due to continued stable insurance market conditions following a number of recent world events.
The original drivers for establishing a captive are often overlooked where insurance typically ‘renews as expiring’, whereas the ultimate parents’ needs may have materially changed. Captive owners would benefit by regularly challenging the captive’s role to ensure that it remains fit for purpose and supports corporate strategies.
An optimised insurance programme often involves:
- Establishing corporate risks that are suitable for insurance protection;
- Analysing the financial tolerance of the corporate balance sheet and the board appetite towards risk retention;
- Understanding current insurance costs (both life and non-life) and adequacy of policy coverage;
- Designing a programme that links insurance purchase strategy to corporate strategy; and
- Performing own data statistical analysis and trending to market risk more effectively to underwriters.
When developing an insurance purchase strategy it is beneficial to map corporate risks (strategic, financial, hazard and operational) to available and purchased insurance covers. Understanding risks that pose a greater threat to a firm’s well-being aids discussions when planning insurance renewals with brokers and underwriters.
Undertaking this approach can often identify duplications of cover, inadequate limits and areas of a corporate balance sheet that may benefit from insurable risk transfer and/or captive participation.
In deciding the amount of risk to retain there are a number of methodologies to establish a firm’s financial tolerance and stress testing of analyst ratios. However, it is worth considering revenue and net earnings as the main items impacted—both directly influenced by risk management and financing efforts. Controlling and reducing associated costs has a direct positive impact on bottom-line results and operating margin ratios.
Understanding this impact is important when deciding how much risk to retain and how to fund.
Retention and captive strategies
Once a consolidated risk tolerance amount is established many captive owners may yield benefit to analyse and optimise the allocation between local business units and the captive.
This can often result in a reduction of frictional costs such as capital required in a captive and insurance premium-related taxes. In addition, in the event of a loss, it may be more efficient to absorb the loss against local country income versus the inability to utilise tax losses in zero-tax regime captive domiciles.
Retaining most of the risk in the captive naturally improves claims control and policy management, however, it is perhaps worth considering the cost/benefit in pursuing this strategy versus ‘balance sheet funding’. If loss of control is a concern many captive owners may consider adopting the same reporting principles as their captive in what many term as a ‘virtual captive’ arrangement.
It is therefore worth considering utilisation of a captive to act as a risk repository vehicle that supports and enhances corporate risk management efforts, linking insurance to corporate strategy rather than an insurance market of last resort, or indeed a vehicle that is available yet never considered in annual renewal cycles.
In summary, many captive owners may yield benefit in considering the following steps when developing insurance purchase and captive strategies:
- Design an insurance programme that is aligned and linked to corporate and risk management efforts, both life and non-life risks;
- Map corporate risks to insurance availability and regularly challenge why insurance is or is not purchased;
- Undertake regular risk tolerance and appetite reviews at both a consolidated and local level to establish the amount of risk comfortably retained and one that makes sense from a premium saving perspective;
- Optimise the retention allocation between local balance sheets and captive, being mindful of capital duplication and frictional costs such as insurance premium taxes and the like; and
- Explore a captive strategy that is part of centralised risk collation/warehousing efforts to improve data analytics and underwriter submissions, speeding up the annual insurance renewal process.
