Property Insurance Captives Take on Added Value in Hardening Market

Many captive insurance company owners have used their captive as part of their property insurance program even in a soft market. Now, as insurance markets harden, a captive can take on even more value as part of a property program.

"Conventional wisdom is that captives are probably more appropriate for casualty rather than property risks," said Andrew Berry, chief operating officer and managing director at Strategic Risk Solutions (SRS). One reason for that perspective is that property exposures often represent large concentrations of risk, Mr. Berry said while moderating an SRS webinar on property insurance captives.

Property risk, he said, tends to be a low-frequency, high-severity type of exposure. "What that generally means for a captive is you're funding less of the risk out of the premium and more of the risk out of the capital," Mr. Berry said.

"The other nature of the property risk is that it's short-tail," Mr. Berry said, and doesn't provide captive insurance company owners the opportunity to accumulate incurred but not reported reserves as they would with casualty lines, preventing them from realizing the same accelerated tax deduction benefit they might experience with a casualty program.

"That said, captives are used quite extensively for property risk," Mr. Berry said.

Looking at the commercial property insurance market, John Warnet, senior account manager at FM Global, noted that the market has been marked by volatility over the past 20 years, with rates turning upward after loss events like the September 11, 2001, terrorist attacks, Hurricane Katrina, Japan earthquakes, the 2008 financial crisis, and Superstorm Sandy. Despite that volatility, however, before the current hardening market, rates had decreased by 30 percent since 2003.

"But over the last 3 years a number of factors have started to push the rates back up, hardening the markets," Mr. Warnet said. The frequency and severity of natural catastrophes have been a major factor in the hardening property market. "Wildfires have been in the news, but they've also become a significant factor for the property insurance market," he said.

"Recent events have also [contributed] an additional level of uncertainty," Mr. Warnet said. "The ongoing COVID-19 pandemic and civil unrest, we don't really know how that's going to impact rates yet, but it's likely to impact rates over the next few years at the very least."

Unforeseen supply chain vulnerabilities revealed as the pandemic spread have been another factor, he said. Many insureds who believed their supply chains were very robust and resilient to catastrophe were not able to adjust to disruptions resulting from the global pandemic event.

"The other thing that's very concerning to a lot of the industry is cyber losses," he said. These days, it's widely acknowledged that it's not a matter of if but when a business will experience a cyber attack, he noted. "A cyber attack could result in losses in every single policy on an international program," he said, something insurers hadn't seen in any peril prior to the pandemic.

Finally, due to continuing low interest rates, insurers can no longer rely on making a profit from their investments, so underwriting profit becomes essential, Mr. Warnet said.

Mr. Warnet said he's seen commercial property rate increases averaging 20 percent to 30 percent, with insureds with considerable loss experience or significant natural catastrophe exposures seeing greater increases and possibly capacity shortages.

"We’re seeing a trend in the reinsurance markets to limit capacity," Mr. Warnet said. "And we're also seeing significant rate increases for the capacity that they do make available." He said he's also seen reinsurers adding absolute exclusions in some cases for perils like communicable disease and cyber.

"Hurricane season is not done yet for 2020. It's been an active season, as you know," he said. "The wildfires continue. All of these things are going to continue to provide that upward pressure, likely into 2021 at the very least."

In the current market, there are several ways a captive insurance company can be used as part of an organization's property insurance program. Another panelist, Jesse Olsen, director at SRS Advisers, discussed several of them.

One might be an 831(b) micro-captive approach, Mr. Olsen said.

"When this part of the (tax) code was originally conceived, it was intended to help farmers address crop losses," he said. "That's a very, very similar profile in many respects to what we're seeing with some of the risks popping up regarding property in captives. So, there's some applicability here."

A captive could also be used to cover pandemic exposures. "There's the potential under a traditional captive structure that you could take on a substantial amount of exposure if you're willing to put up a lot of capital," Mr. Olsen said.

Another option would be to write a limited amount of pandemic risk in the captive, capitalize the captive adequately, and charge reasonable arm's-length premiums to build up surplus over a period of years, allowing the captive to increase the pandemic risk limit over time if it has a positive underwriting experience.

A captive insurance company can also provide a way to gain access to reinsurance markets, something Mr. Olsen said was more of a "niche" application during the soft market. Now, with a hardened market and reduced capacity, "we're seeing a rebound in the reinsurance access play, where there might be capacity out there that is often not US-based but willing to consider risks if they can do so through a reinsurance treaty rather than writing them direct," he said. "In many cases, a captive can be a solution to access that capacity."

Another use for a property insurance captive could be to gain access to terrorism coverage through the federal Terrorism Risk Insurance Act (TRIA), Mr. Olsen said.

"Captives, of course, are generally not going to be a replacement for commercial property insurance," Mr. Olsen said. "It's meant to dovetail, patch holes, provide risk financing, and other sort of benefits around building a better program, not a replacement program. You're going to need support of the marketplace in most cases to be able to utilize a captive."

As with other captive applications, a property insurance captive demands a financial commitment including adequate capital and appropriate premiums, as well as sound risk control, Mr. Olsen said.

"But there are a lot of areas where we see captives being very, very helpful," Mr. Olsen said, including allocating premiums among operating companies, accessing certain areas of the marketplace, TRIA, and building a better property insurance program.