Category Risk Management

Risk Management - How retailers can benefit by forming a captive insurance company

04 November 2010 Aon
Steyn McDowall, AGRC Executive, Aon South Africa

Steyn McDowall, AGRC Executive, Aon South Africa

Consumer spending, the lifeblood of the retail industry, is depressed in today’s business climate. Job growth is anemic, and revenue projections are difficult, at best.

There is no question that globally, the financial services industry, including the reinsurance sector is being forced to “tighten its belt”. In the wake of the financial crisis, many reinsurers’ ratings have been downgraded and the cost of stable security is increasing.

In its essence, Insurance is merely a source of finance to pay for losses, if and when they occur. Risk transfer to an insurer is subject to conditions but there is the advantage of stability in settled law and practice. For larger organisations, insurance tends to be more a “loss-smoothing” device rather than risk transfer, because claims are likely to be reflected in increased premiums. It is most obviously a case of “Rand swapping” in high frequency/low severity risks.

As a result, many retailers are seeking to control cost and increase revenue, and one way to achieve those goals is by creating a captive insurance company, says Steyn McDowall, AGRC Executive, Aon South Africa.

What is a captive insurance company?

There are two types of captive insurance companies.

Single parent captives are owned by a single entity, and exist primarily to underwrite the risks of their parent and affiliated companies. Under controlled circumstances they may be permitted to underwrite risks of unrelated parties. Under generally accepted accounting principles (“GAAP”), the financial results of a captive are consolidated with its parent for reporting purposes. That single-parent captive may or may not elect to underwrite the risks of its customers, suppliers, employees and/or unrelated entities.

The other type is a group captive insurance company.

Heterogeneous group captives consist of members from a variety of industries potentially having little in common except for their belief that they are better-than-average risks and that, long-term, this status is likely to cost them less than participation in the commercial insurance market. Captive members typically engage in limited risk sharing, usually in the lower layers of coverage. While members engage in limited risk sharing, the anticipation is that members will be responsible for their own losses over time.

Why would a retailer want to form a captive insurance company?

Major retailers know they are going to have a lot of workers’ compensation claims, property claims and customer slips and falls on their premises. They realize that is a part of their cost and to a certain degree they should retain some of that risk for their own account and just pay those losses. In many cases, retailers keep some of that risk for their own account in the form of a deductible or self insurance, but they all purchase some type of insurance above that to protect them from catastrophic losses. A captive insurance company can be an excellent mechanism for keeping some of that risk below what is deemed catastrophic.

In times of ever more stringent regulation of the insurance industry, captives are not exempt from the scrutiny of regulators or insurance markets. At the same time, captive owners are becoming increasingly adept at understanding and managing the various risks their captives face. Accordingly, captive owners have become more confident in retaining their risks.

How can retailers determine if this is the right decision for them?

The best way to determine whether a retailer should consider a captive would be to conduct a feasibility study.

A captive feasibility study would include examination of:

• Objectives.

• Insurance and loss history of parent, over a 5 year period.

• Spread of exposure.

• Operational implications of a new captive.

• Loss control capability.

• Level of risk to be retained on each exposure.

• Sufficient premium volume for captive.

• Co-operation of direct and reinsurance markets is available.

• Tax position and likely developments.

• Quantitative data will include: current arrangements and related loss experience; range of exposures; projection of captive performance under various conditions; and comparison with other risk financing options.

An Aon shadow rating provides an independent opinion on the security of policyholder claims, as well as a comprehensive view of captive risk. A shadow rating thereby helps risk managers and captive owners understand, monitor and manage captive risk. In addition, it provides a consistent platform for effective communication with third parties, such as regulators, brokers and rating agencies. Our rating approach is based on maximum transparency, ensuring the client understands the rationale behind every rating factor. This renders the Aon shadow rating an invaluable tool for risk management.

A shadow rating aims to provide a holistic view of captive risk in order to determine the security of liabilities to policyholders.

Specifically, the following questions will be addressed:

• What is the risk profile of the captive?

• What are the critical rating factors for the captive under consideration?

• What is the overall risk bearing capacity of the captive?

• How much capital does the captive need to effectively support the risks assumed?

• How much capital is required to support risks under various scenarios?

• What measures can be taken to proactively manage risks in the captive?

• A shadow rating is a very versatile risk management tool. It addresses client issues such as: How do regulators, rating agencies and other third parties view the captive in terms of policyholder security and counterparty credit risk?

• What characterises a highly rated captive and what would have to be done to achieve a high credit rating?

• Is the captive’s risk profile optimal with regards to required capital or is there potential for excess capital to be released for other uses?

• Preparation for and support with an interactive rating by a recognised rating agency such as AM Best, Standard & Poor’s, Moody’s or Fitch Ratings

• Manage parent company’s expectations with regards to risk transfer and captive’s risk bearing capacity

• Plan retention levels and assess the potential impacts on the captive, as well as the parent, in order to avoid unexpected consequences in the event of adverse developments

The review begins by analysing the relationship between the captive and its parent to determine the degree of parental support the captive can expect. The following steps involve a detailed analysis of qualitative and quantitative captive risk. Emphasis is given to quantitative underwriting as well as asset risk. Required capital is then compared to capital available.

What are some pitfalls to avoid when creating a captive insurance company?

Make certain you have everybody on board in your own organization who would potentially be weighing in on the decision process. Make them part of the due diligence team. That way, once you begin the process, you don’t find someone in your own organization obstructing forward progress because they weren’t involved in the decision process. The due diligence team can involve tax, finance and legal experts within your own organization. Get everyone on board to look at the issues with a team approach.

Negative aspects include

• Governance concerns when appearance of transfer masks risk retention.

• Tax benefits have been much eroded.

• New developments such as protected cell captives are not fully tested.

• Narrowness of portfolio of exposures.

• Costs of establishment and operation.

• Reliance on outsourcing e.g. fronting by direct market, claims handling, survey services.

• Management time spent on captive administration aspects.

• Opportunity cost of capital tied up in the captive.

What’s the next step?

Once you go through the feasibility process, devise a plan of operations for the captive insurance company, depending on which domicile you determine to be the optimal choice. Then select staff to manage and administer the captive, including outside accountants and attorneys. In the domiciles that have enabling legislation for CICs, there has developed quite a large cottage industry of the professionals needed to manage these companies. Running a company can be done on a very cost-efficient basis. Once you’ve selected the people to help you manage the company, you obtain a license to operate in that domicile and make the necessary capital contributions required of the insurance company. Then, you may enter into a reinsurance agreement, in which your captive insurance company purchases insurance to protect itself.

Evaluating an organisation’s risk appetite is an integral part of any Risk Management framework. Risk Bearing Capacity is an objective measure of risk appetite, defined as the measure of financial capacity to sustain larger-than-expected losses: the amount of loss the company can bear over and above the planned / budgeted risk-related costs. Any corporate retention strategy should be examined in the light of its risk appetite.

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