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In a hard market with tough rates and even tougher coverage restrictions, companies are turning to captives. Are they right for you?

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Caveat emptor. Although recent market trends are motivating many clients to consider alternative options for their insurable risks, it takes much more resolve to form a captive and stay with it for the long term.

The appeal is easy to see. While Canadian insurers had a positive start to 2021, as reported in the Q1 MSA Report1, several headwinds still exist for insurers and policyholders in the Canadian casualty market. Even clients with strong risk management and great historical loss experience are feeling the pressure during renewals – and it’s not just about pricing either.

As the market continues to be fraught with rising prices and decreasing coverage and capacity, captives begin to look more appealing to customers. Yet the appeal may be short-lived, especially for those organizations that do not fully understand how a captive operates, and what the potential drawbacks to owning a captive are.

Understanding the Captive Option
A captive is typically a wholly owned and controlled entity put in place to insure/reinsure the risks of its parent company or subsidiaries. The company sets up the captive, funds it with its own finances, and hopefully benefits from an improved total cost of risk over time.

That takes commitment and capital. A form of self-insurance, a captive helps set aside money for future claims within a specified and pre-agreed portion of an insurance placement. That means any claim that comes in, even at the outset of the captive’s operation, is partially or fully self-funded, depending on the structure selected.

Case in point: A risk management team for a client is contemplating setting-up their own captive, for the primary $10 million of their liability program. An important question to consider: What happens if you have a $10 million claim on Day Two of the captive?

While the client’s historical experience might be very good, accounting for the possibility of a large loss in the captive’s business plan helps manage key stakeholder expectations in the event of a worst-case scenario. If the worst-case scenario does become a reality early on, the organization will be prepared, and be better able to ‘stomach’ the claim, focusing instead on the captive’s long-term benefits to the business. Captives, are, after all, in the business of insurance. And insurance, by design, is meant to protect companies against the unexpected. Therefore, any company considering a captive should clearly define their tolerance for risk and set their retentions accordingly.

In a challenging rate environment, with double digit increases still a reality for most product lines throughout 2021, and with certain exposures becoming harder to underwrite than others – sexual abuse, for example – the insurance industry saw an uptick in the number of captive formations as well as increased use of captives. Marsh, the largest captive manager globally, saw over 100 new captives forming across the world in 2020, and is reporting “significant increase in premiums written” by the over 1,500 existing captives in their global portfolio.

The trends in the primary and excess casualty markets are also influencing the interest in captives. Frequency and severity of losses in both primary and excess casualty markets are stemming from nuclear verdicts, aggressive litigation, large settlements, social inflation, the impact of millennials in the jury pool, and the impact from the involvement of third-party litigation financing.

Also, for any organization with exposures in the United States, underwriters are increasingly factoring loss cost and adverse litigation trends into their terms. And awards are far exceeding historical precedent. In 2019, juries levied an $8 billion USD verdict against Johnson & Johnson for their Risperdal drug, $2 billion against Bayer for its Round Up herbicide, and $11 billion against PG&E related to wildfires. The nuclear verdicts continue to climb – in August 2021, a Florida jury delivered a $1 billion verdict against a trucking company in an accident that killed one person and injured 13 others.

Some organizations will use captives because they stand behind their risk management efforts and seek to make their risks more appealing to underwriters, while helping to keep rates in check by retaining a larger portion of potential claims.

Such nuclear verdicts and ongoing increases in the severity of claim outcomes have underwriters re-examining what they will underwrite, the geographic location, and in some cases, the statute of limitations. Particularly for sexual abuse claims, most provinces have no statute of limitations on such claims. Therefore, the potential for latent long-tail claims could impact the ability to retain meaningful traditional insurance coverage for that risk. In that case, a captive could be a good vehicle for setting aside funds to cover such exposures.

As more and more insurance carriers pull back on providing certain primary coverages, and with capacity being deployed with increasing scrutiny in the market, the captive route becomes a more viable option to address these business risks over time. Yet captives provide other strategic benefits, as well. Some organizations will use captives because they stand behind their risk management efforts and seek to make their risks more appealing to underwriters, while helping to keep rates in check by retaining a larger portion of potential claims.

Where Captives Fit
Forming a captive is not for everyone. As mentioned previously, those entities who can retain more risk and have the available capital to do so are often best suited to captive use. For organizations that are highly leveraged, the challenge would be to weigh the affordability of self-insuring losses against their business model and sources of capital.

Also, a captive must make financial sense when compared to the traditional insurance market. For the captive to be better than the traditional Canadian insurance and reinsurance market, the traditional market would be presenting significantly high premium rates, more restrictive coverage terms, or possibly refusing to cover certain types of loss.

In fact, certain loss exposures in Canada are continuing to attract double-digit rate increases. The reason, in part, is that insurance carriers are continuing to seek rate, to keep up with the continuous increase in loss costs, further amplified by the inability to make investment returns in a low interest rate environment. That rationalization is creating the overall tightening of underwriting, which is causing many organizations to look for new ways to obtain coverage at a more affordable rate.

The captives that work well are ones that have a heavy risk management presence; that are run by organizations that want more control over the claims process and are very heavily involved in that process and want greater influence at the negotiating table.

The Successful Captive
For a captive to succeed, an organization needs to understand the basics: what a captive does, how it should be run, and what their role and responsibilities are in the retaining of that portion of their loss exposures. They also need the framework in place to support the success of the captive. Losses do not go away. Risk management helps, but sometimes the type of risks an organization faces makes it difficult to obtain coverage at a lower price point.

The best approach is to be prepared for what might happen. Review how much loss the organization can take on, what the worst-case scenario would be, and what would happen if a large claim hit early in the life of the captive.

 

Resources

1   MSA Research (June 2021). MSA Quarterly Outlook Report - Q1-2021


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