Expanding the Captive Frontier Can Produce Significant Benefits

Strategic risks are among the most threatening to many organizations but are an area where creative thinking and captive insurance can help organizations address perils and improve performance.

Moderating a session titled "Expanding Your Captive Frontier" as part of the recent Business Insurance Virtual World Captive Forum, Chris Mandel, president and managing consultant at Excellence in Risk Management, LLC, described what he called "the VUCA world." ("VUCA" means "volatility, uncertainty, complexity, and ambiguity.")

"The VUCA world is that world of volatility, uncertainty, complexity, and ambiguity that we tend to live in increasingly in this day and age," Mr. Mandel said. Navigating that world successfully requires anticipating the unpredictable, adapting to the unexpected, maneuvering through challenges, being decisive, and being ready to change course as needed.

"This, in my view, is the landscape of modern risk management," Mr. Mandel said.

Within that world, "Strategic risks are the ones that are most destructive," Mr. Mandel said. He cited a study of companies that lost 50 percent or more of their value that found that 68 percent of the time the loss was the result of strategic risks. Only 13 percent of the time was the cause operational risk, 6 percent the result of legal and compliance risks, and 12 percent of the time directly related to financial risks.

Strategic risks can have the greatest impact on an organization's success, Mr. Mandel said. "So this is where risk management should play, whenever possible."

In addressing such risks, "There's very creative ways in which captives can and should be used," he said.

Organizations looking to do so should begin by knowing their risk universe, Mr. Mandel said, starting with risk identification to determine how the organization can expand its captive's horizons, followed by understanding what's financed and what's not and the efficiency of the existing financing structure, then consider alternative structures. The ultimate goal is optimizing the risk financing portfolio, he said.

As organizations manage risk for organizational performance and outcomes, they can achieve creative solutions in part through captive insurance by marrying captive financing strategy with risk identification, risk financing, and a risk portfolio perspective, Mr. Mandel said.

Al Rhodes, president of SIGMA Actuarial, said that as organizations consider creative captive insurance approaches, a total cost of risk analysis can help them determine the most comfortable path for the captive parent.

And he noted the benefit that can be achieved by adding new risks to an existing captive. If the new risk is uncorrelated to those already being written in the captive insurance company, it should create a portfolio effect, Mr. Rhodes said.

"If you add uncorrelated risk, you are hopefully lowering volatility," he said. "Not every coverage is going to have the bad year in the same year, so you're spreading out volatility."

Another panelist, Courtney Claflin, executive director, captive programs at the University of California, agreed with the benefit of optimizing a captive insurance company portfolio with as many lines of coverage as possible.

"I want as much diversity as I can because the basic example of insurance is the haves subsidize the have nots," he said.

Mr. Claflin described the university's experience expanding its own captive insurance frontier.

The university began by placing most traditional lines of coverage in its first captive, formed in 2012. "Stage two was, 'Hey, we're an insurance company, we can do all sorts of different things,'" Mr. Claflin said.

As it became more creative, the university began using a captive structure for entrepreneurial and third-party risk such as reinsuring employer- and employee-paid life insurance and entered into strategic risk financing agreements such as quota share reinsurance participation with syndicates, reinsurers, and fronting insurers.

Now, among the captive insurance projects under consideration, the university is working on a pension longevity swap and considering whether there might be more efficient ways to finance certain medical plans.

"What's really interesting about this is that a lot of these ideas come from my board of directors and other people at UC," Mr. Claflin said. Having seen and participated in the success of using a captive insurance company for traditional coverage lines, now those leaders at the university are wondering how else the organization might benefit from a captive insurance approach.

Mark Marshall, director, risk management, at Extra Space Storage, described a similar path with the captive insurer his company formed in 2006.

"The purpose of that was first to provide tenant insurance coverage to our customers," he said. "From there, customers asked for other things they wanted covered," prompting Extra Space Storage to add such coverages as flood and pest.

Next, the company added general liability, workers compensation, employment practices liability, and wage and hour coverages to the captive. Then, when excess earthquake coverage became prohibitively expensive, after analysis Extra Space Storage began writing higher layers of its earthquake risk in its captive insurance company.

"We're continuing to look at different options that help us grow," Mr. Marshall said.

Mr. Claflin noted that the university's broad use of captive insurance has allowed them to build a surplus that's proven critical in the current hard market. "This year, we needed it more than the University of California ever has because this was the worst renewal season ever," he said.

The captive insurance strategy has generated $400 million in new revenues or savings for the University of California in the past 4 years, Mr. Claflin said. "And we need it," he said. "We need that because to try to get through a marketplace like this without that kind of a surplus, we're too big, we'd put ourselves in danger.

"We're not a for-profit organization. Our intention is to give every dollar back to the university system," Mr. Claflin continued. "We have a really disciplined way of doing that. We've already returned over $100 million in the last couple of years, and we're going to continue to do that."

But, in the current market, having access to that surplus to address risks for which viable insurance options might not be available in the commercial market is vital, he said.

"I think this hard market is going to have some lag, and I just want to make sure that these new revenues and savings and financial efficiencies that we've produced as a risk financing platform are there when we need it the most," Mr. Claflin said. "And that's right now, frankly."