Using Captives To Manage Supply Chain and Business Interruption Risks

Editor's Note: Hylant Global Captive Solutions contributes this Thought Leadership article examining the role of captive insurance in addressing supply chain and business interruption risks.

Companies spent the better part of the last 2 decades adapting the way they brought their products to the marketplace. Driven by philosophies like just-in-time manufacturing and increased globalization, the supply chain attracted growing attention. Suppliers consolidated, reducing alternatives for buyers as they delivered increasingly sophisticated components and technologies from far-flung locations.

Then COVID-19 surfaced and changed everything. Coupled with extreme weather and political volatility, the pandemic exposed the fragility of those supply chains. For example, people in the market for new vehicles discovered they weren’t available. North American auto plants would be only too happy to build those vehicles, but the computer chips they needed couldn't get to their loading docks because of meltdowns in transportation.

Geopolitics played a part, too, whether it was Russia's invasion of Ukraine or violence over allegations of a stolen election in Brazil. Business leaders became all too aware of factors beyond their control affecting their day-to-day operations.

Of course, risk is an inherent part of business, and leaders have long recognized the value of mitigation. Your production plant in America's heartland is well insured against fires and extreme weather events, so you don't lose much sleep worrying about those risks. But what can you do if that plant is forced to suspend production because of a typhoon halfway across the world, two containers aboard a ship that can't get into Long Beach, or the chaos following a hotly contested election in a shaky South American democracy?

As companies watch their peers grapple with the aftereffects of sudden, unforeseen events such as those described here, they're taking a fresh look at how to mitigate risks they may not have previously considered. Proactive risk leaders see the potential problems these events create and are eager to protect their organizations from the repercussions. Other companies are finding themselves forced to address coverages because their insurers have stepped away from those risks or have adopted exclusions that essentially leave the companies hoping for the best.

The new supply chain and business interruption issues are drawing attention to a strategy that's long been used to address unique risks in a host of other industries. Companies are exploring the role creating a captive insurance company can play in heading off losses.

Issues related to supply chains and situations like extreme weather are potentially catastrophic for companies. Because these situations haven't received much attention in the past, companies may not have immediately recognized the exposures they create, or may have assumed their existing insurance coverage was sufficiently comprehensive to cover the risks. As insurers have found themselves facing bigger claims, they've added limitations and exclusions that push losses back into the company's hands.

This changing environment is creating coverage gaps for companies, and unless they (and their insurance brokers) are closely monitoring policy language at renewal, those gaps may not be obvious. The companies that are savvy enough to spot the added risks, however, have turned to a proven strategy—deploying some form of captive insurer.

Take situations involving a critical supplier. An automaker that had to pause production may have depended entirely on one chipmaker in one location. If something happens to disrupt that chipmaker's ability to deliver those microchips, it's not as though a dozen other chipmakers are capable of picking up the slack (and corporate procurement makes any change long and frustrating). When the typhoon hits, the new national government embargoes exports, or the prized containers are sitting at anchor just off the coast, the automaker faces a costly interruption.

To protect itself, the automaker works with its insurance broker to identify those potential exposures and take a hard look at how they may affect day-to-day business. Then the broker helps the automaker establish a captive insurance company to shoulder the financial burden should one of those losses or interruptions occur. The captive gives the company a formal tool with which to manage the risk, along with the other advantages associated with captives.

The justifications for starting a captive don't necessarily have to involve potentially catastrophic losses. Companies may have existing coverage to protect functions such as supply chain operations or business interruptions, but a closer look at the coverage may lead to a realization there are smaller, but still meaningful, gaps where risks have not been adequately addressed.

A decade ago, companies starting captives primarily saw them as a way to smooth out volatility in pricing, properly accrue for already understood retentions, or produce financial benefits and similar advantages. Today, a growing number sees captives as a necessity to keep the business operating and financially sound in the face of unpredictable events. The best way to begin the process is to have a broker study a schedule of insurance to determine where you're not already protected and need to be.