The role of captives is changing. Traditionally seen as a cost-saving tool, captives are now increasingly viewed by businesses as an integral part of their risk framework and a key enabler of risk management. By thinking about using their ‘captive first’ before considering transferring to traditional insurance markets, organizations can better manage the financial impacts of severe events driven by climate change, supply chain disruptions and cyber threats.
So, how can your business keep pace with the emerging captive-first approach to risk management while optimizing ROI (Return on Investment) and safeguarding? At a recent Outsmarting Uncertainty webinar, Optimize your captive to finance increased exposures efficiently while boosting resilience, we offered answers and summarized the practical perspectives from Risk and Analytics captive specialists. Complete the form to catch up on the recording.
While a well-optimized captive can be a powerful tool in your risk management arsenal, it requires careful, analytical planning and ongoing, collaborative oversight by risk managers, finance and senior leadership colleagues.
If you’re considering widening the use of your captive, your first step is to determine whether your captive is over-capitalized. What’s the role of your captive and its current capital position? Conducting a strategic review with your captive specialists including risk appetite, current capital deployment strategies and insurance program structure, moves to clarify the adequacy of your captive's reserves and if you have a surplus.
We’ve seen a recent instance where conducting actuarial analysis revealed excessive prudence in reserves, allowing a captive to think about underwriting new risks and increasing existing ones without needing additional capital.
However, before extending your captive use, you’ll need a robust governance process. This should include detailed loss-reserving exercises and a wide-ranging look at both the risks your captive is retaining now and the implications of taking on more.
In addition to the level of capital you are holding, you should also look at the type of capital you are holding. It may be possible, and capital efficient, to diversify your investment allocation to generate additional returns, or to utilize alternative forms of capital that are less restrictive.
Understanding the risk your captive is retaining is about more than actuarial modeling. You’ll need to combine financial modeling with a deep understanding of both your captive's and group's risk appetites, taking into account wide-ranging risks; from underwriting risk, reserve risk, investment risk and more.
When considering the capital costs of current and prospective risks, it’s important to distinguish between regulatory capital and economic capital. As the name suggests, regulatory capital is the minimum required by regulators, while economic capital is a more tailored assessment of your risk profile, which is more useful for decision making and effective risk management.
Economical capital measurements can also account for the likelihood of having losses at different confidence levels, such as a one-in-100-year or one-in-200-year loss scenarios, which are crucial to taking informed, better optimized decisions on extending your captive.
When you evaluate the impact of adding new coverages to your captive, and also when you communicate the advantages to strategic leaders, you’ll want to highlight the diversification benefit: the advantage of underwriting a variety of risks, rather than concentrating on just one or a few.
By holding a portfolio of different risks, your captive may not need to hold as much capital as it would if it only underwrote one type of risk. As not all risks are likely to result in losses simultaneously, the likelihood of catastrophic losses across all lines at the same time is lower, enhancing the return on capital.
Diversification advantages can also extend beyond insurance risks to include investment risk, which is typically not correlated with underwriting risk, further enhancing the overall diversification benefit on offer.
Taking a captive-first approach, where your default position is to consider dealing with all risks via a captive before looking elsewhere, can maximize the diversification benefit and amplify its effect. This can ultimately increase return on capital and potentially reduce the need to inject further capital into your captive.
When considering extending your captive, it is a good moment to revisit the fundamental question of whether it’s fit-for-purpose. The foundation for any review will be a clearly defined purpose for your captive and a thorough understanding of the drivers of your risk appetite, as well as your group's purpose, objectives and limitations.
A good captive risk governance framework is one that’s aligned with these and with robust guardrails for monitoring and preventing ‘mission drift.’ This is something we see happen all too often for established captives, which without appropriate reviews and oversight can stray from their original purpose or slip into dangerous under-capitalization or inefficient over-capitalization.
Avoiding these inefficiencies and threats to financial resilience is likely to mean an elevated role for the risk function, regardless of whether the business reaches for a captive-first approach. Risk managers are likely to have the right skills to commission, lead and interpret financial modeling and actuarial analysis and enable the wider view of risk needed to optimize captive use.
With robust analysis, risk managers can speak the language of finance leaders, connect with risk owners across the parent group, and collaborate to integrate captive use into your enterprise risk management framework. In this way, you can lead the charge for better ROI and stronger long-term resilience against severe events using a consistently optimized captive.
To extend and optimize your captive and achieve better risk finance resilience, speak to our captive specialists.
