Marco Giacomelli, head of IGP employee benefits network, gives an overview of current trends and possible future scenarios in one of the most dynamic segments of the captive’s world.
Today there are approximately 6,000 captives established in over 60 domiciles worldwide and writing reinsured risks for a total premium in excess of $70 billion each year, according to AM Best’s Business Insurance Survey March 2022.
Of these, about 30% are established in the traditional domiciles of Bermuda, Cayman Islands and Vermont, with some European jurisdictions gaining popularity, especially among captives that aim to write biometric risks as primary insurers on a cross-border basis.
It is estimated that today there are over 200 captives, or 5% of total, writing employee benefits risks, either under a single country, multi-local or globally coordinated approach.
It is speculated that this number might actually be underestimated, especially if we consider that while it is relatively straightforward to account for the number of employee benefits programmes reinsured via single-parent owned captives, this assessment becomes more difficult when considering other captive structures such as segregated/protected capital cells, member-owned captives and other risk retention groups, and other forms of special purpose vehicles.
In fact, while single-parent (37%) captives still represent the largest share in terms of captive structure, multi-owner captives (32%) and other risk retention groups (22%) have progressively grown in recent years and expanded their business reach to multiple lines of risk.
When it comes to global employee benefits programmes managed and funded through a captive company, these indicators show that this is a relatively mature segment of the wider employee benefits marketplace, but on the other hand that there are still significant opportunities for growth in this sector.
The global employee benefit captive market therefore appears to have reached a sweet spot, whereby its fundamental key performance indicators, such as improved governance, savings in global insurance expenditure and risk diversification, are demonstrated, and at the same time this market is still quite sensitive to the need for innovation and consolidation of best practices.
While the foundations, key features, and main advantages and disadvantages of funding a global employee benefits programme through a captive have already been analysed at length in the past, the purpose of this note is to explore some of the more recent trends and areas for innovation, which stakeholders in the captive ecosystem are actually considering as possible future success factors in the evolution of the captive market.
Captive operating model
While variations do exist, in particular with reference to captives writing direct business in certain territories or operating on a cross-border basis within the EU, the prevalent structure of an employee benefit programme funded via a captive includes a network of locally licensed fronting insurers and one or more reinsurance vehicles that in turn retrocede the accepted risk to a captive.
Under this operating model, of particular relevance is the data reporting and financial settlement system established between each fronting insurer, the reinsurer and the captive in its capacity as ultimate risk bearer, or retrocessionaire.
The majority of employee benefits networks operate a reinsurance and retrocession protocol via quarterly portfolio statements.
Under this arrangement, which we can define as a retrocession by accounting period, each quarterly retrocession statement captures the experience of the local policies in force within that quarter, irrespective of their underwriting year.
This system does not provide granular visibility over the development factors of a generation of losses incurred within a specific underwriting year, since losses pertaining to different underwriting years for the same policy will be reported within the same quarterly statement.
Some networks instead are able to offer an alternative and complementary view by providing quarterly reporting statements by underwriting period, whereby each ceded quarter will include loss experience data pertaining to a specific underwriting year, thus providing visibility over the complete generation of losses incurred during each underwriting year.
This fundamental feature is really important because it allows captive operators, and in particular risk managers, to derive a number of portfolio KPIs which are standard fare in many other lines of risk, for example property and casualty programmes, but which are less common, yet not less relevant, in an employee benefits programme.
A network’s ability to report and settle retroceded risks both by accounting and underwriting year contributes to generating an additional comfort factor for captive operators who, historically, have a prevalent non-life professional background, and are therefore more familiar with such an operating model.
In particular, the ability to calculate accurate claims triangulations for each line of risk and summarise these into ultimate loss ratios by underwriting year is an important monitoring and forecasting tool to safeguard a captive’s technical performance.
The specific regulatory provisions in most countries have, over time, contributed to consolidate the range of eligible benefits which might be reinsured by a captive company.
While every country applies its own rules, we observe a practical dichotomy between the international market practice and the US framework:
- Non-US risks: Life/LTD/STD/Medical/Pension
- US risks: Med SL/Dental/Vision/Voluntary Benefits/STD/LTD/Pension/Medical
In the US, funding employee benefits through a captive generally falls under the US Department of Labor’s prohibited transaction class.
However, since the landmark Columbia Energy case, such framework has evolved with the introduction of the so-called prohibited transaction exemption (PTE), which in turn evolved into an expedited process for approval (formerly known as the ExPro).
In more general terms, employee benefits captive programmes have historically mainly included fully insured risk benefits, as opposed to retirement liabilities, because their rating methodology, contractual duration, relatively low impact of long-tail claims and predictability of claims patterns all concur to configure them as ‘desirable’ lines of risk within a captive reinsurance programme.
Recent regulatory developments, such as the upcoming full implementation of IFRS17, have provided further clarity on the classification of risk benefits as life or non-life insurance classes, with particular regards to standalone health insurance plans.
This, in turn, poses new challenges in terms of establishing which is the most appropriate metric to assess the technical and economical sustainability of a captive programme: traditional life insurance indicators, such as a portfolio’s embedded value or the return on the risk-adjusted capital necessary to support a captive programme, might not be perfectly adequate to capture the peculiarity of a composite employee benefits programme.
Some indicators which are instead typical of the non-life segment, such as the net combined ratio and the ultimate loss ratios associated to a generation of claims in course of completion, have instead often been qualified as being more representative as KPIs for an employee benefits captive programme.
In addition to risk benefits, some captives have been exploring the opportunity to reinsure pension liabilities, mainly associated with legacy defined benefit pension schemes as a strategy to address the primary risks of a defined benefit scheme: investment risk, interest risk, inflation risk and longevity risk.
A captive programme to reinsure such pension liabilities is a complex proposition, which in its simplest form entails:
- Buyout of the pension liabilities, which are sold to an insurance company, discharging the pension scheme’s trustees from future obligations;
- Reinsurance cession of such pension liabilities to the parent’s captive;
- Deposit the corresponding pension assets in a custodian bank, with accountability over the investment policy retained by the captive’s investment committee;
- Optional purchase of longevity swaps to immunise the captive against longevity risk in the acquired liabilities.
Such captive retrocession programmes for pension liabilities might apply to both traditionally insured defined benefit pension schemes as well as self-funded arrangements.
When delivered successfully, this approach enables a captive to capture and re-invest the potential investment surplus, which, in a traditional self-funded or reinsured arrangement, would have been retained within the pension scheme itself or by the insurer.
Traditionally, stakeholders in the management and funding of global employee benefits strategies were to be found in competence areas such as human resources, benefits and compensation, and finance.
The additional challenges of implementing and managing an employee programme through a captive, as well as its impact on its parent company’s broader risk management strategy, have brought new stakeholders in the dialogue and business relationship with employee benefits networks and advisors, namely:
- legal and compliance
- risk management
- data and analytics
One key success factor for global employee benefits networks and intermediaries interacting with these competence areas is therefore to be able to manage a professional dialogue along multiple parallel paths, by embedding subject matter expertise in the above areas within the network itself.
Some networks today have structured their organisation creating dedicated centers of competence, staffed with market-facing professional figures who systematically interact with captives, parent companies and their advisors in order to address all the complexities of a captive programme, and in turn, positively contribute to decommoditise the market by providing a superior service and flexibility.
Nowadays, more and more captives are pursuing an A-equivalent financial strength rating (FSR), with specific criteria developed for the broader class of alternative risk transfer (ART) financial institutions, which includes captives.
This, in turn, has provided additional confidence and a degree of flexibility in determining the right amount and form of collateral.
In simple terms, a collateral is an amount or financial instrument that guarantees sufficient funding for future losses.
It is important to underline that, unless a captive is licensed to operate in the jurisdiction of an employee benefits network’s designated fronting vehicle, holding a suitable A-equivalent rating is not sufficient to waive the requirement for a collateral.
In commercial discussions, the necessity for a collateral is often a key topic and it is important to observe that this is a firm requirement for the fronting network because it would incur a regulatory capital charge if they reinsured a risk to a captive without an appropriate collateral.
Traditionally, a collateral used to be posted in the form of a parental guarantee or letter of credit (LoC).
Parental guarantees nowadays are seldom utilised, both because they represent an additional liability in the parent’s balance sheet and, quite crucially, because under certain circumstances they are deemed to undermine the fundamental ‘arm’s length’ separation between a captive and its parent.
Letters of credit issued by a federally chartered bank or equivalent financial institution are still the most popular form of collateral, however this is a costly solution, which in some cases can exceed the total cost of a fronting programme.
Therefore, we have observed the rise of alternative collateral options, which are progressively gaining acceptance:
- Reinsurance Trusts, also known as Regulation 114 Trust: Under this structure, a trust is established by the captive with the fronting network (or more appropriately, the designated fronting vehicle utilised by the network) as the beneficiary, and an accredited financial institution acts as the trustee. Funds deposited in a Regulation 114 Trust earn interest for the captive, and therefore this can be a more cost-effective form of collateral. An additional advantage of Regulation 114 Trusts is that they have an unlimited duration, whereas letters of credit are formally renewed annually (although often with an ‘evergreen’ renewal clause).
- Funds withheld arrangements: While technically speaking a fronting programme administered at funds withheld is one of the possible reporting models, a more extensive application of such a model can be adopted as an alternative collateral option. Under such option, the fronting network would retain, or withhold, all the risk premium necessary to cover any current and future losses, as well as debit the captive with all required technical reserves to fund unexpired losses. Any available premium margins would be released to the captive only after the pre-agreed loss obligations period has expired.
Regardless of the options chosen for the collateral, it is crucial to correctly determine its amount, with a theoretical principle stating that this should not be lower than the total outstanding loss reserves (therefore including reserves for incurred claims as well as incurred but not reported claims), while most networks taking the total annualised ceded premium as a proxy for this metric.
Straight-through processing and application programming interfaces
Digitalisation has been one of the macro trends in the insurance world since the last decade, and local insurers, employee benefits networks and advisors have all been investing in digitalised processes and technological solutions to evolve their value proposition and improve on the accuracy and timeliness of their captive reporting processes.
These solutions are often delivered as cloud-based software-as-a-service (SaaS) platforms, which allows them to be funded as operational expenses rather than capital expenditures with hefty future amortisation issues, and the efficiencies gained through these platforms can result in more competitive terms for the fronting fees charged to a captive.
Straight-through processing enables data sharing across multiple points and stakeholders in a fully automated manner, therefore reducing the risk of errors, the related administrative costs and improving reliability and timing of data transmission.
This is particularly efficient in the context of administration and data reporting of any B2B business venture, and is a significant step forward towards a ‘generation 2.0’ employee benefits programme managed through a captive.
Straight-through processing can shorten the timing for quarterly captive retrocessions and virtually bypass the risk of human errors in preparing a captive quarterly statement as well as any reconciliation of technical and accounting items such as loss reserves, incurred but not reported claims and administrative fees.
Application programming interfaces, often described as the ‘currency of the digital world’, are instead specialised software that, in very simple terms, allow different technological platforms to seamlessly communicate with each other by creating front-end agnostic digital ‘bridges’ between them.
The introduction of efficient application programming interfaces has the potential to revolutionise not only the current best practice but also to practically introduce self-service to many captive transactions.
Application programming interfaces are particularly important in connection with the additional management information, insight on data and analytics that captives have been working with in order to gain a deeper understanding of the trends and KPIs of the risk they are liable for.
Employee benefits networks have been addressing these needs by developing costly, sophisticated dashboards to provide context and meaningful information on specific lines of risk, such as insured health plans, by showing metrics which are not typically captured in a quarterly retrocession statement, for example with claims utilisation by diagnostic category and benefits class.
Some networks are developing such dashboards for other lines of risk, such as short- and long-term disability, focusing on other parameters, such as inception and recovery rates, disability incidence by cause and adequacy of disability reserves.
All these, albeit often sophisticated and at times interactive, are still ‘gen 1.0’ tools, at risk of obsolescence because they rely on a design established at source rather than the specific needs of a captive.
Investing in smart, efficient and flexible application programming interfaces appears to be a much more future-proof and customer-centric strategy because it enables a captive to have direct, secure and unfiltered access to large, often unstructured data sets held by employee benefits networks, and in turn to consolidate such data into reports produced by the captive’s own operating platform, according to its own data analysis requirements.
Simply put, captives nowadays must be given adequate tools to access directly the raw data that is relevant to the risk they reinsure, without the often costly, at times limited, interface represented by a network’s suite of reporting tools.
This next generation of risk management tools developed by networks to support a captive’s activity is therefore likely to be focused on developing smart, efficient application programming interfaces that allow for a seamless, protected connection between a selected, accessible section of a network’s database.
In turn, this will contain all and only the information of relevance for a corresponding captive, and the captive’s own administration and reporting platform, in order to enable near-realtime data transmission and unlimited opportunities for data analysis.