Captives: The evolution of captives

Risk retention analysis

Ken MacDonald explains why captives have become so significant and how captive owners can maximise the value they derive from them through exploring risk incubators and using actuarial science.

A risk and insurance manager's job is a difficult one. It could be argued that the absence of bad things happening means they are performing at the peak of their profession - leading and influencing their companies to ever-higher levels of risk management performance. Likewise, it could be said that this is simply a matter of good fortune. As the saying goes: "Luck is the residue of design" - the true answer is likely a combination of both.

Captives are a key tool in a risk manager's armoury. The reasons for forming captives are generally well understood. Decades ago it was all about fiscal benefits and expanded market access. As these early benefits faded or became less relevant, captives continued to grow - not only in numbers but also in premium volume. But why?

The answer is control. The evolution and ever-increasing sophistication around consolidating and co-ordinating global coverage, drive for efficiencies and expansion of underwritten risk meant captives became an invaluable tool for risk managers in controlling their organisation's risk finance programme.

This has indirectly provided captive owners with an invaluable benefit - a more robust cost-of-risk metric to judge risk management performance. This contrasts with the formerly unsophisticated metric of premium cost. Captives helped move the discussion about insurable risk from being about cost to profit and loss. What is measured garners attention and there is little doubt that captives have positively contributed to heightening the profile of risk management in many organisations.

Risk retention analysisCreating more value
If we examine any category of insurable risk, it has two main characteristics; it is both fortuitous and quantifiable. Many risk categories that remain partially insurable or uninsured are fortuitous, but generally suffer from lack of data by which an underwriter could price the risk. We have seen several applications for which clients have used captives to 'incubate' risks in order to build data, knowledge and subsequently translate that into real market capacity. This incubation process can have the added benefit of helping the insured gain greater insight into the risk it is carrying.

Examples of this are particularly relevant for supply chain insurance. Brokers have historically looked at something like a stock risk as a marine transit exposure. But what happens when an event intervenes to interrupt the shipment or damage the goods - before title is assumed? A port blockage, credit default, political problems and even volcano eruptions are all scenarios one can envisage.

By understanding the specific risk issues affecting supply chains and tailoring programmes around addressing these key risks, real value can be created - for those reasons the captive has a significant role to play.

Whose capital?
Many captive owners gain significant value from examining their existing captive risk portfolio and capital structure and taking a more analytical approach to assess if they are retaining the appropriate level of risk.

In terms of assessing the level of risk retention, this requires an integrated review of risk tolerance, risk appetite, loss forecasts, risk transfer costs (premium) and cost of capital. Clients that have undertaken such a rigorous assessment not only gain a robust decision-making framework but also reduce their current cost of risk, sometimes significantly.

Analysis of the specific issues facing each client can allow us to understand the range and likelihood of loss and, from that point, design tailored loss-mitigation strategies. For instance, a client may have a particular exposure to a binary event - a scenario which gives rise to significant costs but with a low probability of occurrence. By modelling these events together with other possible sources of loss, we can understand the overall loss distribution.

Against these specific analyses of the client's business, an analysis of the options allows clients to establish an optimal solution - the option that minimises their retained losses but does not exceed their risk appetites. These can be plotted diagrammatically to highlight the best risk-reward. The graph below shows an example chart from work done for one client.

In this example, it is clear that its current risk transfer strategy is not optimal because it could either retain a lower expected risk cost for the same level of down-side risk, reduce its down-side risk for the same level of expected risk cost, or a combination of the two.

Of the six new options shown, the client is able to immediately disregard the two sub-optimal choices (shown in green), which leaves a clear choice from one of the four remaining optimal strategies depending upon its risk appetite.

By adopting such a framework for risk retention-risk transfer decisions, a company can easily examine other risk classes for potential captive application and quantify the expected financial benefits of this approach.

Control is always likely to be the key benefit of a captive, hence their global numbers continue growing. Yet as risk increases and its management continues growing in importance, captive owners must keep up. This can only be done by reviewing strategies and looking for alternative, value-maximising solutions.

Ken MacDonald is head of corporate risks at Miller Insurance Services.

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