This article was written by Travis Toemoe, Mandy Tsang and Astrid Sugden.
The global insurance market has been hard for corporate insureds for some time and that shows no immediate signs of changing. Those market conditions are being driven by the increasingly complex and challenging regulatory environments within which companies are operating, higher levels of community scrutiny, a rise in the prevalence of regulatory investigations and class actions, an increase in significant claim events and, of course, the impacts of the COVID-19 pandemic on businesses and economies across the world.
The desire on the part of insurers to manage their exposure has resulted in higher premiums (sometimes drastically so), higher deductibles, less generous terms, tougher underwriting measures and in many instances, limited coverage capacity in the market.
As a result of these conditions, corporate groups are increasingly choosing to utilise captives as an alternative to engaging with commercial insurers. Marsh has reported an increase of over 200% in the number of captives established in the first half of 2020 when compared to the number of captives established for the same period in 2019, with midsized captives with premiums between $5-20 million showing the most growth over the past 5 years.
Whilst captive insurance arrangements are not a silver bullet for all the difficulties corporate groups are likely facing in the current insurance market, they are certainly worth exploring given that they offer a viable alternative structure for insuring expensive or hard-to-cover risks and can have a number of advantages over traditional self-insurance arrangements.
What is a captive?
Captive insurance offers a means by which a company can effectively self-insure against certain risks. One option is to essentially establish an insurance entity within the corporate group structure.
Captives operate to provide a primary layer of cover for the relevant risk(s). They enable corporate insureds to customise the coverage required and insure hard to cover or emerging risks.
Captive insurance arrangements are typically structured in one of two ways:
- by establishing a captive insurer which is wholly-owned (either directly or indirectly) by its insured corporate group; or
- by participating in a sponsored (or “rental”) captive arrangement which is already established and is conducted through a third-party captive insurer.
The use of sponsored captives is particularly popular with corporate insureds that want to take advantage of the benefits offered by captive insurance arrangements, without having to provide capital up-front or deal with the regulatory requirements and administrative burden associated with the ownership and management of an insurer offshore. In other words, “try it and see”.
Given the complex insurance regulatory landscape in Australia, companies seeking to establish a captive insurer often look to do so in offshore jurisdictions such as Bermuda, Vermont or Singapore, where the regulatory requirements are less onerous and the process of establishing an insurer is typically less expensive. Depending on applicable regulatory requirements and other internal corporate considerations, captives in such jurisdictions can be established in as little as five to six weeks (depending on the structure adopted). The impact of Australian regulatory requirements on captives is an area in which corporate insurers should seek advice specific to their arrangements.
Why use a captive instead of traditional self-insurance solutions?
Traditional self-insurance involves a company setting aside capital specifically to fund potential future losses. By contrast, a captive insurance arrangement does not necessarily require a company to set aside capital up-front.
When used over a long period of time as part of a long-term insurance strategy, captive insurance arrangements also offer a range of other potential advantages, including:
- Improved and customised coverage terms - The terms offered by captives and their reinsurers are generally broader than through the direct insurance market.
- Greater financial flexibility and increased liquidity – Corporate insureds usually have flexibility in the manner in which they can look to capitalise a captive. One such method of capitalisation may involve the payment by the corporate insured of a premium to the captive. Over time, the premium paid can be used to capitalise the captive, as well as enabling payment of any claims which may arise. Any surplus funds which are accumulated by the captive over time can be used for a number of purposes, such as the payment of dividends from the captive entity to its parent. This may also enable the corporate insured to smooth fluctuations in the insurance market.
- Utilise the reinsurance market – The whole or a portion of the relevant risk insured by a captive can also be ceded to the reinsurance market, enabling the corporate insured to take advantage of reinsurance pricing benefits. Different structuring with reinsurance arrangements can also mean that return reinsurance premiums can be used to capitalise the captive and provide other financial benefits.
The use of captives is not without its limitations. While the practice of reinsuring the whole or a portion of a captive’s insured risk has historically allowed corporate insureds using captives to take advantage of the often more favourable insurance terms on offer from the reinsurance market, the current conditions in the commercial insurance market are beginning to have a corresponding impact on the reinsurance market. As a result, the terms offered by the reinsurance and commercial insurance markets are becoming increasingly comparable for some risks.
Which industries utilise captive insurance arrangements, and for what types of risk?
The financial services and health care industries are the most popular industries globally in terms of the number of captives and premium volume. However, industries such as manufacturing, retail/wholesale, construction and energy are also increasingly exploring the benefits which captive insurance arrangements can offer.
Risks commonly written by captive insurers include all-risks property, general/public liability, workers’ compensation/employer’s liability, marine/cargo, directors’ and officers’ liability and professional indemnity risks. Cyber risks top the list of new areas that regulators see captives insuring more frequently, closely followed by employee benefits and professional indemnity.
How can captives be utilised to mitigate the current difficulties in the D&O and PI insurance markets?
The utility of captives by corporate insureds to mitigate some of the difficulties they currently face in the directors’ and officers’ (D&O) is hampered by the fact that they can only be used to provide cover to a company for securities claims (which are traditionally covered under “Side C” of a company’s D&O insurance policy).
That is because companies and their related bodies corporate are prohibited by statute from indemnifying their directors and officers, either directly or through an interposed entity, against certain liabilities and costs. The relevant statutory prohibitions operate to preclude a company from using a captive insurance arrangement to provide cover for such liabilities and costs. This means companies remain dependant on arms-length insurers to provide such cover. Otherwise, officers may be left exposed without the ability to seek indemnity from either the company or under an insurance policy.
However, we are increasingly seeing the use of captives to assist in obtaining Side C and professional indemnity cover which have been the hardest hit. There are different possible structures – for example, if there is a high retention, in fill cover for this can be insured via the captive with traditional insurance to sit on top of cover provided by the captive.
We have considerable experience in assisting companies to establish captive insurance arrangements and have worked with a number of brokers to facilitate this.
“The 2020 Captive Landscape Report: Explore How Different Industry Sectors Utilize Captives” by Marsh.