Complementary Captives: The Key To Coverage Gaps

How using captives can complement insurance programmes and deliver tangible business benefits.

The current climate in the insurance market has made more businesses up their risk-retention strategies as well as turning to captives as a solution to some of the coverage gaps the industry is struggling to fill.

Hard market conditions in recent years have caused carriers to pull back on certain commercial lines, including employer’s liability, professional indemnity, D&O, environmental liability, natural hazards, credit risks and more. But it’s not just the current cycle alone that’s causing a capacity void across the industry.

The financial and operational disruption of the pandemic has made obtaining reasonably priced business interruption insurance much more difficult, for example. There’s also been a significant increase in natural hazard losses making it harder for businesses in vulnerable locations to protect their assets. According to Munich Re, costs related to natural catastrophes reached $280 billion globally in 2021 compared to $210 billion in 2020 and $166 billion in 2019. In the US, increases in some litigation settlement and judgment costs also helped to increase the cost and restrict the supply of some insurance covers.

Then there are those organisations who are finding it harder to source insurances because of the nature of the work they’re involved in. For instance, businesses who work with new technologies or within fledgling sectors like cryptocurrencies or cannabis. And of course, businesses within the fossil fuel industries that are finding it increasingly difficult to insure themselves within exclusively domestic insurance markets as the global race to net zero intensifies.


Using Captives to manage legacy risks

Many insurers and reinsurers around the world now face increasing pressure from campaigners and shareholders to move away from insuring risks linked to fossil fuel industries; and a growing number of insurers and reinsurers are withdrawing or refusing coverage. Examples include Lloyd’s of London asking managing agents in its marketplace to stop insuring thermal, coal, oil sand and Arctic energy exploration from January 2022; and announcing its intention to transition out of insuring or investing in such activities completely by 2030. Many insurers are also joining cross-industry initiatives such as the Net-Zero Insurance Alliance (NZIA), which aims to reduce emissions linked to underwriting portfolios and operations.

The reluctance of some insurance companies to cover these risks is also driven by practical considerations, such as the potential for fossil fuel industry businesses to be affected by litigation related to pollution and the negative effects it can have on the environment and/or communities. State and federal regulators have also expressed concerns about US insurance firms continuing to invest in fossil fuel businesses, as these investments could become ‘stranded assets’, subject to the risk of sudden write-down or devaluation. Increased regulatory interest in this area is discouraging some insurance companies from insuring risks related to these businesses.

Those that are still providing cover are sometimes now charging prohibitively expensive premiums to do so. Over the longer term it seems likely that it will become more difficult – even within the specialist London insurance market – to insure risks linked to oil or gas, as well as those linked to coal.

But those assets and the risks associated with them will require insurance cover for many years to come, even if planned investments in renewable energy go ahead, because many US consumers and industry will continue to rely on fossil fuels for at least some of the energy they use. There has been some suggestion that state or federal government may need to step in to insure some of these risks, but many businesses may feel that using a captive offers more control over their own risk management processes and strategies.


Complementing insurance and other risk management measures

Using a captive as a substitute for an insurance programme is not usually the best option. Instead, it should be used to complement risk management measures the business already has in place. A captive can be used to insure the otherwise uninsurable, but it can also provide additional capacity to help manage other losses that are only partly insured.

Once up and running, the captive can become a tax efficient profit centre within the business, by reducing the total costs of risk management over the longer term. It can also act as a hub for gathering useful business data related to newer types of risk. In some cases, using a captive can help a business secure better terms from insurers.

Using a ‘pure’ captive is more likely to be a realistic option for large enterprises, in part because it may require very significant commitments of capital and resources. Only if a company is in a position to make such a commitment over several years – and would be able to cope with the financial impact of a major loss early in the life of the captive – is a captive likely to be a viable option. If this is the case, a business should then consult expert advisers for help in risk identification, assessment and management; and development of claims processes.

But some mid-corps are using pure captives, with some swiftly growing technology companies finding this to be an effective way to manage new types of risk that insurers might find difficult to price. Other medium-sized and small businesses may collaborate, by using protected cell companies (PCCs) to create ‘rental’ captives they can use together. Others may work with insurance companies to create ‘virtual’ captives, a model in which the insurer helps to share cover for some risks with a captive it helps to create for the business.

Whichever risks a business does seek to insure via a captive, access to the full range of benefits that such arrangements can provide will only be available if the business is able to draw on deep risk management expertise. Ideally an adviser will also be able to provide technical capacity to help the business develop a strategy for creating and managing a captive. Advisers could also direct businesses over to other risk transfer measures that might be used alongside or instead of a captive, such as bonds or derivatives.

Alesco’s role in helping businesses that use captives is to streamline the property and casualty insurance programmes that will sit alongside captive solutions. Our sister company Artex can advise and assist on formation and management of captives, alongside other alternative risk management solutions. Both companies have developed market-leading expertise to help businesses find effective ways to manage their risks, when market conditions make it more difficult to do so via the more usual channels – while delivering the additional business benefits listed above. Using captives is not a viable solution for every business, but for some it could prove invaluable for many years to come.