Virtual Captives: A Simplified Solution for Risk Retention

A virtual captive is an insurance coverage solution that provides the benefits of a traditional captive without having to form a legal entity or deal with regulatory requirements. 

Essentially, it's an agreement with an insurer that acts like a captive—emulating its cashflows and other benefits.  

It is a structured multiyear solution that allows the parent company to fund part of its exposure via profit sharing or additional premium features. 

"The main benefit is that, being an insurance contract, it avoids the regulatory complexities, costs, and procedures usually involved in setting up a new legal insurance entity," said Andre Martin, head of alternative risk transfer APAC at Swiss Re Corporate Solutions. "Therefore, it is a faster, simpler alternative for corporations to achieve the same goal of retaining or funding more of their own exposures." 

Group versus Sole Captive Arrangements 

Virtual captives can be structured in various ways, and typically, they include multinational fronting. 

However, they are often more aligned with the sole captive concept due to the complexities of distributing funds in the event of a claim. They are also generally favored in this context, where a company has a substantial risk exposure and needs more customized risk retention without having to form a legal entity. 

In a group captive setting, further considerations are required as this would involve sharing risks and profits among all the participants as well as a joint liability.  

"Virtual captives are sometimes deployed by companies who are exploring various alternative risk retention options," said Alex Gedge, senior captive consultant at Hylant's Global Captive Solutions. "It can be a good starting point before moving to a formalized cell or captive. Typically, it would be done for a single parent, given the complexities of distributing funds in the event of a claim." 

Who Are Virtual Captives Best Suited For? 

Virtual captives are typically a good fit for mid- to large-sized financially stable companies with a premium volume in excess of at least €1 million that may not have the scale or resources to establish a traditional captive but still want to achieve similar benefits. They should also have robust risk management strategies already in place, typically in industries that face significant risks and/or evolving insurance needs, such as technology, construction, and manufacturing. 

Among those companies for which virtual captives are best suited are those that are seeking to avoid the cost and complexity of forming a traditional captive. It's also ideal for firms wanting to manage their risk exposure directly while using an insurer's financial strength for balance sheet management.  

"Generally speaking, virtual captives are for companies that are looking for an alternative risk financing solution and do not have the critical business size to finance their own captives," said Mr. Martin. "The main motivation for clients is usually to reduce total cost of risk or to have evidence of cover for difficult-to-insure exposures.

"The prerequisite is that the insured is able and willing to finance a larger part of its own exposure," Mr. Martin added.

Guglielmo Maggini, senior underwriter of alternative risk transfer at Allianz Commercial, said, "The main motivation that drives the decision to establish a virtual captive solution is that of a higher risk retention by the company, either because they can afford to (quality of the risk), respectively must, because of their inability to access reinsurance markets to offload part of the captioned risk. In exchange, they protect themselves against sudden market shifts and typically benefit from the positive performance of the risk.  

"Importantly, a virtual captive structure allows the insurer to continue issuing local policies with a low (working) deductible, where required to protect the policyholder's local subsidiaries. The increased risk retention is then implemented on an aggregated level under the global master policy." 

Advantages of Virtual Captives

One of the key benefits of virtual captives is the fact that they emulate the financial benefits of traditional captives through four main mechanisms. These are risk retention, bespoke insurance coverage, potential cost savings, and profit sharing, as outlined below.

Risk retention. Companies retain a portion of their risk, similar to a traditional captive, which can lead to lower insurance premiums in the long run and greater control over claims. 

Bespoke insurance coverage. Virtual captives allow for tailored insurance programs that meet the specific needs of the company, similar to what a traditional captive would offer. 

Potential cost savings. By avoiding the costs associated with establishing and maintaining a legal entity, companies can achieve cost savings while still benefiting from risk retention and customized coverage. 

Profit sharing. Any underwriting profit generated can be returned to the company in various ways, depending on the company's needs and risk retention horizon. 

Other advantages of using a virtual captive include no need for equity investment. As it's an off-balance sheet solution, there's no captive consolidation required from the parent, while there are also lower setup and operational costs compared to traditional captives. 

Virtual captives also offer greater flexibility in terms of both coverage and risk retention, with the multiyear structure providing long-term price and capacity stability while allowing companies to fund their own exposures through risk-sharing mechanisms such as profit-sharing agreements. There is also a reduced administrative burden and regulatory compliance requirements, as well as access to profit sharing subject to claims performance. 

Above all, because the insurer handles the captive's administrative functions, it can streamline the implementation of the captive and provide a quick exit strategy if needed. 

"By not having to align to an insurance policy, companies can distribute funds more flexibly based on need, as opposed to being restricted by regulation or wordings," said Ms. Gedge. "As such, it can be a good alternative for risks that are expensive or difficult to cover in the traditional insurance market.  

"Similarly, companies can save on costs associated with paying for traditional insurance by increasing retentions and reducing coverage. Cost savings here can be significant, given the costs of running insurance companies or buying ground-up coverage." 

Challenges To Consider

Despite the clear benefits that virtual captives can bring, they also have their challenges. The main one is the need for a strategic commitment by the parent to a higher risk retention strategy. 

Added to that, while they may be less complex than traditional captives, setting up a virtual captive still requires sufficient lead time, iterative discussions with the solution provider, and the expertise of local coverage specifics. They are also less flexible than the full control a traditional captive offers and depend on the financial strength and terms set by the insurer, which can impact the customization of any risk-sharing structures. 

"The main benefit of a virtual captive is the ease and speed of implementation," said Mr. Martin. "It provides corporations the possibility to fund or retain part of their risk at significantly lower costs and less complexity than setting up a captive or using a protected cell company."  

Ms. Gedge said, "It is not a perfect solution for a lot of companies, given the complexity of distributing claims payments across countries and subsidiaries as well as the lack of formal insurance coverage, but can be a good step on the road to alternative risk financing. Companies may lose control and additional support offered by insurers and third-party administrators. 

"There are also no formal coverages in place, so companies have to be comfortable with potentially paying out significant sums in claims and may struggle with some contractual requirements (for example, if a third party requires proof of liability or cyber insurance). 

"One of the key benefits of traditional captives is access to reinsurance, which virtual captives will not have. 

"Virtual captives do not have the same structures as traditional captives for long-term cost savings and building reserves." 

Conclusion

In summary, virtual captives provide a viable alternative to traditional captives, offering cost savings, operational simplicity, and risk retention capabilities without the regulatory complexity. They are a perfect fit for companies that need flexibility, financial resilience, and risk management solutions tailored to their needs in an ever-evolving risk and insurance landscape.