The COVID world has stimulated thinking around the nature of risk and the significance of unexpected and severe external shocks. This has coincided with the firming of the insurance market after a long soft market cycle. There has consequently been a renewed focus on the role of captives in risk management and risk financing.

The range of captive involvement is potentially broad:

• Commercial price increases, retention increases, capacity shrinkage and coverage restrictions create a void that captives can fill by supplementing the coverage provided by the market. We could term this a tactical response.
• An examination of the nature and management of risks faced can reveal how a captive can enhance risk financing in a more strategic way.

Consideration of both approaches is timely:

• Market conditions and COVID uncertainties have increased the appetite to extend captive use for currently insured risks.
• Considering recent events, risk managers and their organizations have re-examined the scope of risks to which they are exposed, bringing into scope risks for which insurance may be scarce or even unavailable, but where risk financing may be desirable.
• The risk profiles of professional service firms have been changed by external shocks and the complexity of service delivery has increased in some areas.

This article will examine:

• What advantages can be captured by captive expansion?
• What risks might be considered and what are the decision criteria?
• A 3-step process for design and implementation.

1. Advantages of an Expanded Captive Role

Captive utilization is of course context specific. The probable generic benefits are:

• Tactical applications can ease the effects of market cycles.
• There may be a limited insurance market for new and emerging risks, but an insurance proposition can be designed for captive application.
• Adding additional risks to an established captive creates an increased spread of risk and may thereby deliver diversification of capital benefits.
• Consideration of new underwriting will stimulate an exercise in risk identification and assessment.
• Placing a risk into a captive creates an incentive to quantify it.

Balancing the needs of stakeholders, tax and regulatory considerations, all play a role as discussed in Retaining Risk in a Captive – Considerations for Professional Service Firms.

2. What Risks to Consider and Some Decision Criteria

It makes sense to start by considering risks that are already covered and review the experience. What is the tolerance to expand the captive based on past results?

Building incrementally could begin with covers that are peripheral to Professional Liability, cyber for example, especially viewing the recent changes in insurers’ coverage terms for those covers relating to information and network security risks.

One might avoid risks where there is plentiful and affordable commercial capacity. Historical experience shows the benefits of moving incrementally to avoid short term volatility and to build capacity over time. We suggest some design criteria below: also, see, Your Captive Needs a Strategy.

Considering the risks

• Two sources for potential captive risks are one’s own risk maps and external surveys. Risks identified in such exercises may be insurable, or partially insurable, while others may have characteristics of insurable risk.
• Captives can provide solutions for emerging risks for which insurer response has been slow. In that respect so called Non-Material Damage Business Interruption (NMDBI) has gotten a lot of attention. Reputation is also a risk in that category.

Categories of risks that might be considered are:

• Risk where cover does exist in the market. Intellectual Property exposures are an example. There is some cover within a PI policy and there is a niche insurance market.
• Risks outside of the scope of existing covers. Some regulatory risks fall into this category.
• Risks that have insurable characteristics but are not conventionally insurable. The costs of engagement or investment failure may be candidates.
• Partially covered interruption risks. Some risks are clearly insurable but others such as technology system failure may only be partially available.
• Risk where cover does exist but there may be gaps. Bodily Injury and Property Damage arising from professional services.

Coverage can be broadened over time as the risk is understood and incident data emerges.

Decision criteria

Before getting to design, it is worth considering where commercial insurers get it wrong:

• Pricing too low
• Under-reserving
• Slow to react to change
• Rapid expansion of risk assumption
• Lack of expertise and understanding of the risk

The key criteria are perhaps the protection of the core purpose and historical funding of the captive.

3. Three Step Process for Design and Implementation

Step 1 – Risk Identification

Accessing one’s own data and external resources such as surveys and using a roundtable or workshop can be employed to investigate the major risks facing the organization, and the degree to which risk financing exists or can be designed.

Step 2 – Design Process

• Desirability: Is there need or demand for the cover?
• Feasibility: Can the coverage be articulated, defined in policy language, and priced?
• Viability: would the designed cover respond to the risks faced, and be adaptable to changing conditions?

Step 3 – Underwriting Strategy

• Based on the above exercise, determine the triggers, and write the policy language.
• How to price without adequate historic data? Create scenarios that can be used to assess frequency and severity.
• Feed the scenario results into a model. Access any suitable external data to support the model. Consider the aggregation potential.
• Build up net retained limits and adapt pricing over time.

In other articles we have explored retention and pricing strategies and indeed adopting a strategic long-term approach to building the captive as a key risk financing tool.

As the world of risk continues to evolve more opportunities for captive use will evolve. The key considerations are constant. The captive represents a pooling of risk. Protection of the core purpose and historical funding are vital objectives.