Captive Review talks to market experts about the current hardening reinsurance market and how captives can approach buying decisions at upcoming renewals.

To many captives, reinsurance buying is a vital part of how they construct their risk coverage programmes.

Larger captives especially, as well as those with greater years of legacy exposures and a greater breadth of exposures in general, will use the reinsurance market in a similar way to traditional insurers, often utilising excess of loss and catastrophe reinsurance to cover losses in excess of its stated retention.

And so, just as commercial insurers feel the effects of reinsurance capacity constraints, shrinking coverage and hardening rates, captives will also take a hit.

Earlier in the year, Guy Carpenter was already calculating a 15% rate online for US property catastrophe between January 2022 and July 2022 (not taking into account the impact of Hurricane Ian) which has not occurred since 2006, raising expectations of a true hardening of the market at 1.1.

But across the board, Peter Child, CEO of SRS Europe and managing director of SRS Guernsey, thinks that almost all classes will be affected at 1.1 renewals and into 2023, with professional indemnity, cyber and directors’ and officers’ among other lines seeing the biggest rate rises.

“There’s talk that the increases need to be in double digits, and there appears to be sufficient desire across the reinsurance market to drive these kind of increases,” Child warns of upcoming renewals. “Partly this is due to losses driven by climate change, the conflict in Ukraine and inflationary pressures on claims reserves. Also, the inflationary environment provides for more investment opportunities for investors outside of insurance.”

Captive approach

Reinsurance buyers generally now have a number of factors to consider when deciding how much reinsurance to buy, but there are some differences with how captives approach the matter.

Most commercial insurers will use treaty reinsurance in order to help manage their risk, but as Owen Williams, global programme and captives regional director, UK, at AXA XL explains, very few captives have enough critical mass and diversity among exposures to purchase true treaty type reinsurance.

Instead, the vast majority buy reinsurance in the facultative market, hence the difference in how they go about this.

“While treaty reinsurance is very much about reinsuring a portfolio of risk and having discussions around how an insurer manages its approach to underwriting, the facultative placement is much more about the specifics of the individual risk you’re ceding, for example the business’ approach to risk management or specific locations,” Williams explains.

When AXA XL is considering writing reinsurance of captives, he says they look at the captive to ensure it has appropriate claims handling capability, just as they would any other cedant.

The key driver of appetite is always the risk itself, not the entity its being ceded from. But what he is seeing more of from captive reinsurance buyers is an increasing appetite to look at parametric reinsurance triggers.

“For AXA specifically, we see this in the climate and weather space, given our specialist knowledge and focus in this area,” Williams adds. “But there’s no reason that captives couldn’t consider parametric triggers for other types of risk.”

Captive options

Seeking out innovative solutions is nothing new to captive owners, and many have long looked at mitigating their exposures by purchasing reinsurance on a multi-line or multiyear basis.

Even this strategy is coming under pressure for captives, though, according to Dan Teclaw, an associate director at AM Best.

“Some companies that used to have multi-year deals have shortened them due to expense and lack of availability, as reinsurers have reduced their commitment to these arrangements,” Teclaw says.

Captives have not typically been buyers of non-traditional forms of reinsurance like cat bonds, industry loss warranties or sidecars, and neither do they tend to use collateralised reinsurance.

Nevertheless, when looking at how much reinsurance to buy this year, Teclaw says there are still a wide array of options open to captives.

“Captives do internal analyses to determine how much they are willing to pay for what they think their loss experience is relative to the price, and either decide to accept it, possibly buy to a lower return period (for example, 1 in 200 vs 1 in 250 or 1 in 500), increase retentions, or participate in different layers of their property cat tower,” Teclaw says.

Based on how the current reinsurance market is looking, he thinks the most viable option for most captives is either increased participation or buying to a lower return period.

However, the right option will depend entirely on the captive in question, the lines they are writing, what their internal analysis reveals, as well as the level of exposure a captive is prepared to take on.

And this is far from being a straightforward process. Teclaw says that modelling uncertainty is still an issue in untested lines like cyber, and the impact of inflation has also somewhat clouded decisions around reinsurance purchasing.

“For captives, inflation and the cost of reinsurance can impact their risk/reinsurance purchase decisions as they try to balance both of these headwinds while staying within their stated risk appetites,” he says. “How captives deal with global inflation is yet to be determined, but finding solutions to this recent phenomenon is truly crucial.”

Advantages

Still, the opportunity to take control of your own risk programmes and access reinsurance markets is a major attraction to setting up a captive.

Even if reinsurance is proving more expensive to buy, it can be more advantageous than continuing in the traditional insurance market where rates are also hardening.

The ability of a captive to fill gaps in coverage and smooth over costs provides much needed flexibility when considering reinsurance buying, according to Alex Gedge, senior captive consultant at Hylant, especially for a parent that requires certain coverages to operate.

“You’re not beholden to the market in the same way because you have this great tool there that can respond accordingly, and you have the option of whether you want to go to market or not,” Gedge says. “It can be a part of the conversation to show the reinsurer you take the risk seriously, and say ‘if you bleed, we bleed with you’ because we are also taking a stake in the risk.”

In addition, she adds that captives are in a position where they can show to reinsurers all the risk management processes put in place, and often years’ worth of data showing how well the captive performs.

“It ends up being a nice partnership a captive can form with the market, which is a really good way to build strong long-term reinsurance relationships,” Gedge says.

So, despite the difficult market, there is still good reason for many captive owners to be positive when approaching reinsurance buying this year.

AM Best’s August captives report found that for the 140 US captives it rates, captive owners and members saved $10.1 billion that would have gone to the traditional market absent of captives’ existence, which Teclaw says continues to justify the use of captives in hard market conditions.

“Captives consider their risk appetite and tolerance for risks that they may be interested in retaining based on their unique knowledge of their own risks and loss experience, relative to the market, justifying keeping those ‘savings’ in house,” he adds. “Dynamic hard-market conditions continue to warrant captives’ activities and abilities to manage this to better loss experience than the industry lines.”