Brown & Brown senior vice-president Doug Severs gives his take on the current state of the captive insurance market and recommends ways owners might look to make the most of their captive in this environment

Organisations seeking commercial insurance are experiencing higher premium rates and less coverage options.

The impacts of the Covid-19 pandemic, the Ukraine war, high inflation, supply-chain interruption, and changing interest rates have been driving factors.

Increases in the frequency and severity of natural disasters such as Hurricane Ian have also had a substantial impact on the insurance industry.

Commercial insurers are offering more restrictive coverage than before with exclusions for key perils such as wildfire or lost revenue due to viral outbreaks or pandemics.

During 2022, total captives worldwide increased from 6,074 (2021) to 6,191 (2022), and the positive trend of captive formations has continued in 2023. In short, the continued hard insurance market has organisations looking for ways to lower their total cost of risk (TCOR).

As a result, we have seen greater utilisation of existing captives and a sustained interest in new captive formations. Whereas captives were traditionally used to fill mostly primary layers of coverage, we are seeing more captives being used across insurance towers to fill gaps in coverage, add capacity and provide premium relief.

Higher premium rates for lines such as property and cyber are encouraging organisations to take on extra risk in their captives through higher programme deductibles and participation in excess layers.

Captives with sufficient capital are diversifying their coverage by adding directors’ and officers’ (D&O) and other executive liability lines.

Of note is the 2022 Delaware legislative update (Senate Bill 203) making it viable for captives to write Side A D&O coverage under certain conditions – this is partially responsible for the uptick in captives writing such coverage.

Reinsurance rates remain impacted by the hard market which has prompted organisations to re-evaluate their risk appetite, the limits they purchase, their pool of reinsurance partners and/or their sources of capital.

To some extent, insurance-linked securities (ILS), traditionally used as cover for property catastrophe claims, are being viewed increasingly as a viable alternative source of capital.

The continued expansion of risks covered by ILS beyond property catastrophe is likely to provide even more options to diversify reinsurance towers in the future.

As organisations rely further on their captives as a source of risk financing, it is imperative they optimise their captives through strategic plans focusing on key factors including risk retention strategy, investment strategy, collateral management, captive domicile selection, and corporate governance.

Brown & Brown has been working with our clients, as well as captives managed by other managers, on ‘health check’ engagements, the goal of which is to optimise and make recommendations on their existing captive programmes.

The following are some recommendations to consider for captive optimisation.

Risk retention strategy

Fundamental to a captive’s strategy is determining which risks to retain and which risks to transfer.

The decision to transfer or retain certain risks centres around cost of capital in the commercial insurance market.

If the cost of retaining a risk is less expensive than the cost of first-dollar coverage, then consideration should be given to placement in the captive.

As a general rule, risks that could develop into longtail events should be transferred while risks involving frequency, along with some severity, are more suitable for retention.

Recommendation: Companies should perform relevant financial modelling to support key decision points when it comes to deciding which risks to retain and at what levels. A total cost of risk analysis is a tool that should be performed on a regular basis and will help identify optimum and appropriate levels of risk retention for each risk. The TCOR should be carried out under various scenarios of risk retention and should contemplate relevant cost items including risk transfer premium, losses, collateral (if any), underwriting and operating expense. It should be performed on a net present value basis in order to project TCOR in today’s dollars. Both the captive manager and actuary can assist with a TCOR analysis.

Investment strategy

Captives generate earnings primarily through underwriting and investing activities.

The proper deployment of the captive’s premium dollars into investing activities is critical to ensuring the captive maintains sufficient reserves and cash flows, and delivers an appropriate return on investment.

The key objective for most captives is to ensure that preservation of capital is prioritised, cash is available to meet claims and other obligations as they come due, and appropriate returns are generated over time.

Due to volatility in operations, captives in their initial stages should emphasise liquidity, whereas mature captives should consider a more sophisticated and long-term approach that can generate higher returns and match cash flows with claim payout projections.

Recommendation: Companies should review their captive’s investment performance and investment policy at least annually with their investment advisor to determine whether changes in the captive’s life cycle or financial market conditions warrant a change in investment strategy. To illustrate, it is well-known that the rising interest rate environment that began in 2022 had a negative impact on captives holding material allocations in the fixed income sector. Regrettably, many of the captives that sold fixed income investments in the past year experienced capital losses. Looking forward, with further rate increases expected over the next 12 months, organisations should already be having discussions with their investment advisors on how they can take advantage of these higher interest rates and whether changes to investments allocations are needed.

Collateral management

Collateral is a material aspect of operations for many captives. It can be expensive and tie up assets at the parent or captive level for prolonged periods of time. While letters of credit (LOC) are most common, other alternative forms of collateral such as collateral trusts, funds withheld, surety bonds, parental guarantees or back to back LOCs may be available under a lower cost structure and may offer greater flexibility.

Recommendation: Companies should regularly evaluate the impact of collateral obligations on the parent and the captive, engage in collateral discussions with beneficiaries, and explore alternative forms of collateral if cost savings and other benefits are achievable.

Captive domicile selection

A captive’s domicile plays a vital role in its operations. Over time, circumstances may arise that have a material effect on the captive or its parent. Examples include higher taxes and fees, changes in regulatory requirements, M&A activity at the parent or captive level, and expected changes to the captive’s plan of operations.

Recommendation: Companies should evaluate their captive’s domicile on an annual basis; the captive’s annual meeting is an ideal time for domicile updates, both regulatory and otherwise.

Corporate governance

The captive’s board of directors (the board) is responsible for the strategic direction and oversight of the captive’s operations. The board should consist of qualified members with an appropriate blend of insurance and financial expertise.

Captive boards are typically composed of executives from the parent company and, almost always, there is a distinct difference between the operations of the parent and the captive.

Most parent companies are not in the business of insurance and so it is important the board be properly educated on the fundamentals of captive operations, including financial reporting and analysis, regulatory requirements and corporate governance.

This is pivotal to their understanding of how their captive programmes are viewed and regulated in their domicile.

As their captive programmes develop, certain organisations are considering the addition of an independent director to their board.

A quality independent director, free of influence from the captive’s parent, serves as an independent voice and provides necessary risk management expertise.

If they reside within the captive’s domicile, they can fill the role of resident director, as required in most domiciles, as well as provide guidance and updates on the local regulatory environment.

Recommendation: Companies should consider routine-training for their captive’s board members and addition of an independent director, if applicable. A training curriculum can be provided by the captive manager and may consist of operational and/or regulatory updates provided at board meetings or through a more formal curriculum, if desired.

In conclusion, the continued expansion of captive programmes and captive formations through the remainder of 2023 is likely. This will highlight the true value proposition that captives offer to their parent organisations.

Should you be interested in discussing a captive formation, an expansion of your existing captive programme, or other optimisation strategies for your captive, Brown & Brown would be happy to be of assistance.