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enterprise risk management CAPTIVE REQUIRED? Captives make it easier to include all risks in an enterprise-wide program By Michael J. Moody, MBA, ARM
The utilization of captive insurance companies has increased worldwide for the past 30 years. And at this point, there appears to be little let up in sight. The recent hard market in the U.S. has stimulated additional interest in captive insurance companies. For many corporations, the captive alternative is providing a valid risk-financing vehicle for their current property and casualty risks. Many of the offshore domiciles and all of the onshore domiciles continue to report a backlog in captive approvals even after a record setting 2004. But it is not just the new captive formations that are noteworthy; existing captives are also being pressed into increased usage, with resulting increases in premium volume. Obviously, captive insurance companies have found a permanent place in financing property and casualty risks. But what about the new world of enterprise risk management (ERM)? Do captives have a place in the expanded, holistic approach that is reflective of ERM? Background Much has been made over the past couple of years of the new concept know as enterprise risk management. At long last, organizations are realizing that risk and uncertainty can create opportunity. This recent revelation has resulted in a significant expansion of the whole concept of ERM. No longer can organizations afford to let risk operate in individual silos that address only a portion of the total risk management landscape. ERM is requiring a holistic view of an organization, so that it can effectively manage uncertainty and respond appropriately to risks, as well as exploit opportunities as they arise. The Committee of Sponsoring Organizations of the Treadway Commission (COSO) published an integrated framework for ERM implementation. For the most part the framework was written to provide a systematic approach to assist organizations in identifying events, and measure, prioritize and respond to the various risk challenges an organization may face. The COSO framework outlines eight key components that make up ERM. These include: • Internal Environment—sets the basis for how risk is viewed and addressed by an entity • Objective Setting—assures that a process is in place for setting objectives • Event Identification—reviews internal and external events to distinguish between risk and opportunity • Risk Assessment—risks are analyzed to determine how they should be managed • Risk Response—develops a set of responses that align with the entity’s risk tolerances and risk appetite • Control Activities—policies and procedures to help ensure risk responses are effectively carried out • Information and Communication—relevant information is captured and communicated to appropriate parties • Monitoring—ERM program is monitored and modified as needed These components, when taken in total, should serve as the main elements of any ERM program. Captive realities Organizations today are not waiting to fully implement an ERM program to expand the strategic role of their captives. In fact, many captive owners have viewed the expansion of risk as a necessary element to a successful captive operation. One area in particular that is helping captives spread their risks and possibly gain a more favorable tax deduction for the property and casualty premium is funding a portion of the employee benefits through the captive. Over the past couple of years, a handful of companies have sought and received the Department of Labor’s (DoL) approval to use their captives to fund employee benefits, especially group life and long-term disability benefits. Now that the template for successful approval by the DoL has been established, growth in this area is expected to increase significantly over the next few years. Many risk management experts believe that most captive owners will ultimately choose to fund some portion of their employee benefits through their captives, thus increasing the strategic value of the captive. Other non-traditional property and casualty risks can easily find a home in a corporation’s captive as well. During the soft insurance market of the 1990s some traditional insurers began to offer what became known as “integrated risk programs.” For the most part, these integrated programs typically were multi-year, multi-line insurance products that included coverage for non-traditional P&C risks such as foreign exchange risks, commodity risks, etc. But, the hard market that started several years ago has driven most of these products into extinction. However, potential reinsurance products that utilize a similar integrated approach are becoming available in today’s softening insurance market, and a captive provides a corporation direct access to the reinsurance market, so these new products could become part of the captive’s offerings. Further support for the broader view of the uses for captives can be found in traditional portfolio theory, which has its roots in the investment world. The theory states that the aggregate variances of multiple risks is lower than the sum of the individual risk variances, assuming that the individual risks are not perfectly correlated. The theory can best be viewed as allowing firms to take advantage of the natural hedging that exists in most organizations’ risk portfolios. It would appear that this hedging could best take place in the confines of a captive insurance company. Conclusion For the past 30-plus years, corporations have been able to increase the flexibility of their risk financing programs through the use of captive insurance companies. Today’s more holistic view of risk management can also benefit from the strategic use of captive insurance companies. Properly structured captives can serve as the focal point of an organization’s enterprise risk management program. Many of the eight interrelated ERM components as presented in the COSO Framework can be effectively administered through a captive. It can function as the centerpiece of such a program, taking maximum advantage of natural hedging for a wide array of risks faced by an organization. And with potential reinsurance products that incorporate risks beyond traditional property and casualty exposures, corporations can use their captives for additional protection. It would appear that, while a captive may not be a prerequisite for an effective ERM program, it could provide a great platform from which to build a strategic ERM program. * The author |
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