In Challenging Times, a Captive Can Provide Balance Sheet Protection

As they deal with the COVID-19 pandemic and the accompanying economic downturn, investment market volatility, and a hardening insurance market, organizations can look to their captive insurance companies to help protect their balance sheets.

"We are all seeing things we really have not seen before. Renewals are out of control, capacity is shrinking, and in the property insurance world, you're definitely needing more players to fill your limits of liability," said Gary Rimler, senior sales executive at Dempsey & Siders. "Short on capacity when you try to finish your property placement, think about using your captive as a solution.

"Reinsurance costs are escalating, especially retrocessionals and investment portfolios are being taxed by the difficult investment market and low interest rates," Mr. Rimler added, speaking as moderator of a panel titled "Using Your Captive To Protect Your Balance Sheet" at last month's Virtual Vermont Captive Insurance Association 2020 Conference.

David Shluger, senior multiline underwriter at Zurich North America, noted that companies typically use a captive to take risks off their balance sheets, with the captive ceding some of that risk to the reinsurance market to achieve stability and reduce volatility.

"What else would we think about, and why might this not be enough any longer?" Mr. Shluger asked. The captive insurance company can open up opportunities for the parent company to retain risk in an innovative and more economical way, he said. It can also open up new opportunities to look at the total cost of risk (TCOR).

"When looking holistically at the risk you're taking and the costs that you're either absorbing or spending in order to manage that risk, there may be opportunities to save money and/or achieve better coverage," he said.

The first step in using the captive to protect the balance sheet is for the organization and the captive to determine their risk appetite and their risk threshold, two different concepts, Mr. Shluger said. Risk appetite is what the organization is willing to consume from a risk standpoint, he said, while the risk threshold is how much risk the captive can bear beyond the risk appetite before losses get painful.

The starting point in that process is looking at the organization's current risk transfer programs and how it's placing reinsurance to determine if there might be changes that might make sense, if the organization can retain more risk, and if it might have opportunities to reduce costs.

Ultimately, the organization should try to reach a point of optimal risk retention, that point on a graph where the curve of retained losses and the cost of capital intersects with the curve tracing risk transfer costs. The optimal retention is unique for every organization, Mr. Shluger said, and alternative risk transfer techniques can be used to increase the optimal retention and lower the organization's total cost of risk.

Taking on that optimal retention without taking on risks that might sink the captive relies on some sort of stop-loss coverage, Mr. Shluger said. "I like to think about (stop loss) as sort of the emergency brake for a runaway train," he said. "It's critical to your strategy to put in place something that helps balance that additional retention."

He outlined three potential stop-loss approaches.

• Captive aggregate stop loss—"As it sounds, it's there to stop the losses of a captive," Mr. Shluger said. It can be achieved through reinsurance with a stop-loss provision that would drop down once the captive hits its annual aggregate limit or on a stand-alone basis through a separate stop-loss policy distinct from the captive's reinsurance coverage that kicks in above an aggregate limit.
• Multiline "integrated risk program"—"It really is ideally suited to serve the captive," Mr. Shluger said. In such an approach, in addition to the captive insurance company's maintenance retention per occurrence for each line of coverage, the captive also takes an additional level of integrated retention across those lines with an aggregate limit. A layer of integrated reinsurance sits above that retention layer providing per occurrence and aggregate limits. "That integrated risk program will drop down if the integrated captive retention is exhausted," Mr. Shluger said, adding that an additional excess of loss layer could be added above that integrated reinsurance layer.
• "Structured retention" reinsurance—"This is a way for the captive to take on additional retention on what we call a first-loss basis," Mr. Shluger said. In the first loss, in addition to its standard retention, the captive takes an additional layer of retention with excess reinsurance above that. If there was a subsequent loss in the year, the captive would take only its standard retention, with structured reinsurance filling the next layer and excess reinsurance above that. "Effectively, what you've done is you've front-loaded a lot of your retention into that first loss," he said. "That lets the reinsurance costs really come down."

Mary Ellen Moriarty, vice president, underwriting at Educational and Institutional Insurance Administrators (EIIA), noted that EIIA formed two captive insurance companies in Vermont in 2002 to serve the risk transfer needs of private liberal arts colleges and universities.

The captives were formed with an initial capitalization of $3 million. At the end of 2019, they'd grown their surplus to $31 million. "Normally, that would give the fuel to take on more risk, but as the markets had been continually soft for so long, the market didn't push us there," she said.

Now, however, as the market continues to harden, "We've got friction everywhere, friction for every line of coverage," Ms. Moriarty said. Those friction points offer opportunities to find ways to provide members more efficient risk transfer, she said. EIIA is in the process of analyzing its various lines of coverage to see if they can find such new efficiencies.

Kyle Hales, actuary and partner at Perr & Knight, noted there could be both benefits and risks associated with increasing retentions.

Benefits could include reducing TCOR, greater control over claims, realizing benefits from favorable changes in loss frequency, and benefiting from loss mitigation techniques. Risks might include needing to increase the amount of capital in the captive to address the greater retention, making the captive more susceptible to adverse increases in severity, and less control over reinsurance renewal premiums.

There are other considerations as well, Mr. Hales said, including premium-to-surplus requirements. "We also want to see how does this fit into a larger insurance picture," he said. "Are there other retained pieces, deductible amounts that the parent may be bringing on board that don't flow through the captive?

"The optimal solution is always individualized," Mr. Hales said. "What works for one captive will not be ideal for others." Also, what works at one point in time might not be the ideal solution in the future, he said.