Captives: Eye to the future

Study shows captives continue to grow regardless of market conditions

By Michael J. Moody, MBA, ARM

At this point in time, captive insurance companies have become a staple in the alternative risk financing landscape. No longer just a tool for Fortune 500 companies, captives have now become a favorite of midmarket accounts as well. The number of risk retention groups (RRG) and group captives continues to grow annually. Additionally, rent-a-captives and cell captives have both seen increased interest recently. At this time, most industry observers believe the future for captives is good. And a recent Marsh Global Benchmarking report titled “Next Generation Captives: Optimizing Opportunities,” indicates that interest in captives remains despite softening within the property and casualty insurance market.

Valuable insight

The Marsh study indicates that there are an estimated 2,750 captives, worldwide, that are owned “by publicly identifiable parent companies,” which account for the majority of single-parent captives. Of that number, Marsh surveyed 900 owners or about 33% of the group. The breakdown by region found that 32% of the 900 are located in the Americas, 32% in the EU countries, and 33% in Asia Pacific countries. While determining the property and casualty insurance premiums paid to captives is difficult, Marsh estimates that it is in the $50 billion to $60 billion range. Further, Marsh indicates that this figure represents an estimated 20% of corporate spending on such insurance.

One of the key findings of the study confirms the fact that captives, via global formations, have experienced a steady pattern of growth going back at least 30 years. And as it points out, this “has remained constant irrespective of market conditions.” The primary reason for the sustained growth is reflective of the new and varied uses corporations are finding for their captives.

When viewed regionally, there are several key items of interest. These are noted as follows:

• Captives owned by U.S. firms have been and continue to be the most significant contributors to the overall growth in captives.

• Some countries, such as France and Japan, have seen growth more closely tied to market cycles rather than sustained growth.

• About 75% of all captives originate from six countries, with the United States accounting for an estimated 57% of the total.

Interest in captives comes from every major industry segment. Based on the survey results, financial institutions had the highest participation, accounting for over one-fifth of the global total. The survey noted that much of the interest by financial institutions was directed at usage for customer-related coverages, such as personal insurance, and financial products like mortgage-related coverages. Additionally, health care, manufacturing and retail/consumer products accounted for on another 30% of the total.

Other industry segments represented included construction, transportation, technology and energy, all of which accounted for about 6% each of the total. The survey indicated that the significant distribution among so many industry segments was a testament to the flexibility of captives in meeting their owners’ needs.

The study also notes that captive usage in developing counties such as Russia, India and China lags behind the more developed counties. It suggests several reasons for this lag. The study indicates that these countries typically have a highly competitive, indigenous insurance market which frequently results in risk being transferred to insurers at rates lower than expected claims costs. Additionally, they note that these countries typically have a restrictive regulatory environment that may limit or preclude the use of captives. Finally, they point out that there is also an absence of losses actually occurring, such as general liability losses, due in large part to a less litigious operating environment.

Finding value

One of the major objectives of this initial benchmarking survey was to determine the overall “value” that corporations are obtaining from their captives. An often-noted advantage from captive utilization is the ability to access the reinsurance markets. So it is interesting to note that despite the advantages of direct access to reinsurance markets, on a worldwide basis, only about 40% of the captives go directly to reinsurance market via their captive. This holds true for both the Americas and EU regions but is much higher in the Asia-Pacific region. In the Asia-Pacific region, the survey notes, these captives typically are greater purchasers of reinsurance and are currently in the 70% range.

Another highly touted benefit of captives is a reduced expense factor. In fact, lower operational expenses are one of the hallmarks of captive operations. The survey confirmed this aspect, noting that highly predictable risk layers of coverage within the insurance industry typically carry an expense loading in the range of 25% of the premium. The analysis reflected that more than 65% of the captives surveyed operate with expense ratios of 5% or lower, thus noting a significant savings for corporations that use their captives for funding predictable loss layers.

The survey confirmed that it is difficult for most captives to “prove their value.” One approach that the survey investigated was a return on capital employed (ROCE) method. It notes that while captives have become an accepted tool within the risk management community, many questions still remain with regard to the value of the captive. As a result, many wonder if it is the most appropriate vehicle to finance an organization’s risk.

Overall, about 22% of the group surveyed showed less than 0% return on ROCE while over 85% were averaging between 10% and 30% returns. The survey found that about 17% of the group was averaging between 30% and 100% return, while about 4% of the group exceeded 100% return. Of course, the survey points out that the results can be improved easily by either increasing the premiums sent to the captive or reducing the captive’s capital. However, Marsh believes that the ROCE comparison can provide a good benchmark to follow over time.

Summary

The survey notes that the captive industry is now entering its third generation. The first generation can be traced back more than 100 years. Many of the early industry insurance companies were examples of these captives. The second generation, which started in the 1960s, occurred when corporations began to embed their captives as an integral aspect of their corporate risk-financing strategies. The third-generation captives are identified as “optimized,” since they are pursuing a clear strategy, but they are adjusting the strategy to best use capital and take full advantage of current insurance market conditions.

Other important findings that the survey highlighted are:

• Captives are significantly better capitalized than would be required for the current amount of risk retained. As a result, many captive owners are in a perfect position to assume additional risk when the market turns.

• The majority of captives continue to cover their owner’s predictable level of losses. However, over 20% of the policies written by captives currently have a per-occurrence limit of $50 million or more. This trend illustrates that captive owners are moving out of their “comfort zones” and optimizing the use of the captive to maximize their captive’s value.

Bottom line, the Marsh benchmarking study confirms that the role of captives continues to evolve. And despite challenges from changes in regulatory, accounting, tax and insurance market conditions, captives have found ways to remain relevant. The survey cautions, however, that captive owners must remain informed to ensure that the captives remain optimal risk-financing vehicles. The report notes that expanding the scope of coverage provided by the captive is critical and states that “leaving a captive to write only the business it has historically written probably means the maximum benefit is not being gained.”

The Marsh study has proved an excellent tool to begin a serious benchmarking effort. Many single-parent captives can use the information in the Marsh study to determine how well they compare to other captives worldwide. Additionally, much of the data is provided by region and industry segment. This information should help captives design proactive strategies that maximize their usage while assuring their continued use in the overall business plans of their owners.

For example, it’s clear that captives can provide a pivotal role in risk-financing; and as corporations begin to move towards an enterprise approach to their risk management programs, captives can prove to be a valuable resource by providing a focal point for an ERM program. *