So far, so good

Historically, soft market conditions in many lines of business, coupled with an abundance of excess capacity in the traditional reinsurance market, have proved favourable for captive insurers looking to retain less risk.

But many captives tend to adjust their reinsurance programmes and buying patterns depending on market conditions. When market conditions harden, it makes sense financially for captive insurers to buy less reinsurance and to retain more risk. However, despite a slight hardening on some lines of business of late, most captives are still buying the same amounts of reinsurance.

“Captives are generally not looking to take on more risk,” says David Gibbons, director of the captives practice at PwC. “They’re looking to place roughly the same type and level of risks that they had in the past.”

This is partly to do with the way the reinsurance market has responded to big losses. Following Superstorm Sandy, it might have been reasonable to assume that property rates would harden and captives would retain more risk. But because most of the renewals were in December, when the fallout from Sandy was still being assessed, it may take some time for those price rises to filter through and for captives to respond.

“Next year if there is a hardening in the property market, captives might look to retain more of their own risk, as the market may be less representative of their experience,” says Gibbons.

Regulatory changes could also be affecting the amount of reinsurance that captives buy. Following the Solvency II impact study, QIS5, several captives found that they have too much capital in the form of retained earnings, or in the form of equalisation reserves. These captives are, therefore, looking for ways to use this capital efficiently instead of repaying it as dividends.

One way of doing this is by increasing their retention levels. “In this case they need less reinsurance, at least temporarily,” says Urs Neukomm, director at Swiss Re Corporate Solutions.

However, there are also captives that do not have enough capital, according to QIS5. These will need additional capital and could buy more reinsurance. “The only reason this is not yet happening is the regular delays of Solvency II; as long as these captives can stay alive with less capital in accordance with the current solvency regulations, they tend to use this opportunity,” says Neukomm.

Safety first

The strategy of captives is also being influenced by the wider uncertain economic environment. It means that big buyers of reinsurance are also looking to play things safe, by remaining with reinsurance providers that they trust and that can offer them stability.

“Captives are staying predominantly with the carriers with whom they have had existing relationships. Credit ratings continue to be a deciding factor for many captives, where they favour the higher rated carriers: A- and higher,” says Gibbons.

Neukomm agrees that captives are becoming more aware of the ratings of the reinsurers they work with, as they look for more stability and security. And he adds that a reinsurer’s ability to provide additional services to captives is also becoming increasingly important.

“The rating of a reinsurance company is becoming more important, as well as the flexibility of reinsurers when it comes to aspects such as fronting arrangements, collateral discussions, and capacity for more exotic risk classes,” he adds.

Essentially, a captive’s choice over whether it reinsures some of its risk comes down to simple economics: does it make sense from a business point of view to cede risk to a third party? This means captives spend a considerable amount of time assessing their own risk appetite, according to Lawrence Bird, president of the Bermuda Insurance Management Association, a trade association that looks after the interests of captive insurers.

Captives need to be mindful that they have a limited balance sheet, and that they are stand-alone subsidiaries. This requires them to stand on their own two feet, because the parent company isn’t necessarily going to bail them out.

“That’s where the reinsurance market comes in,” says Bird. “This can be at a variety of levels and on an each-and-every-loss basis, or it could be on an aggregate basis. All the time there’s a lot of thought that goes into whether they should be buying reinsurance and what kind of cover that should be if they do.”

One such consideration is the type of company that the captive is insuring and the types of risk that it is looking to offset. If the captive is covering risks with the potential for higher but infrequent losses then it is more likely to seek reinsurance at a lower level. An example of this is property cover, according to Bird.

“It’s not entirely predictable,” he says. “There could be several losses in a year, or there could be a big loss every five years. So that’s when we’ll start to see people looking for reinsurance to get a bit of comfort there.”

Longer-tail risks can provide a little more certainty, as the level of losses that the captive is going to incur is likely to be predictable to some extent, and easier to access actuarially.

“It really depends on what lines of business the captive is writing, in terms of the coverage that it will seek,” adds Bird.

Location, location

Where a captive is based also plays an important role in determining the amount of reinsurance it buys. Those facing regulatory pressures, particularly those who are going to be affected by the new Solvency II regime, are adjusting their reinsurance buying accordingly.

“Next year if there is a hardening in the property market, captives might look to retain more of their own risk, as the market may be less representative of their experience.”

Dirk Schäfer, industry risk analyst at Munich Re, says that he has observed differences in the demand patterns of captives based in different regulatory environments. Many captives located within the Solvency II regime have already honed their reinsurance demand in order to optimise risk capital requirements.

“Even if reinsurance is always used as a substitute for risk capital, it appears that applying rigorous models highlights these effects,” Schäfer says. “In addition, the most sophisticated captives show an interest, hitherto neglected, in areas such as asset-liability management.”

The reinsurance demand of a captive depends very much on its size and level of sophistication. Smaller and comparatively new captives are often interested in whole account covers above their specific retention levels. The larger and more diversified a captive is, the more it develops a certain risk appetite. In these cases, the captive transfers to the reinsurance market the risks that do not fit its risk appetite.

“The risk appetite can generally be described as favoured combinations of lines of business and layers. In addition, larger captives have a more pronounced interest in deals which help optimise their cost of capital,” says Schäfer.

The degree to which a captive presents an opportunity to reinsurers also greatly depends on what kind of captive it is. A pass-through captive accepts a full placement, which is then 100 percent reinsured. These captives buy mostly 100 percent quota share and don’t retain any net risk.

A gross cession captive accepts a full placement, and then buys an excess placement, so keeps a net retention. These captives need to buy a lot of excess cover, as well as sometimes requiring stop loss cover on their retentions. Then there is a net writer, which is a captive that essentially just writes the retention and the parent purchases the insurance on an excess basis. These captives tend to use very little reinsurance, apart from on a stop loss basis, if the net writer captive is accepting a lot of sideways risk on its retentions.

Opportunities ahead

Despite uncertainty over the volume of reinsurance that captives may buy, they are still likely to provide significant opportunities for reinsurers in the future. Because captives can offer their parent companies significant benefits, more captives continue to be formed.

This is providing a steady revenue stream for reinsurers, according to Ryan Ralston, senior consultant at Spring Consulting and board member of the Captive Insurance Companies Association (CICA). “Captives have become a force to be reckoned with in the reinsurance market,” he says.

Chris Jacks, head of corporate solutions at Allianz Risk Transfer, agrees that more captives are being created. He adds that captive managers are becoming more innovative in how they use their captives, and what their captives can do. “This leads to the need for more reinsurance,” he says.

Another reason for captives’ popularity with reinsurers is the direct access that they provide reinsurers to parent companies through their captives. Reinsurers see this as an opportunity of developing a relationship with the parent, according to Ralston.

This interest goes both ways. Many parent companies actually set up captives with the intention of gaining access to larger reinsurance companies, according to Bird.

“It’s a good mechanism sometimes for the parent company to be able to access reinsurance markets that they wouldn’t normally be able to. At this point a captive becomes very useful, because suddenly a parent company or the company’s broker can approach larger reinsurance firms that they want to work with.”

This kind of interest is also often due to parent companies feeling that the traditional insurance markets do not have the capacity to offer the exact cover that they require. An example of this is when insurers refuse to cover certain aspects of a business, and so the company needs to take things into their own hands, in order to get those risks covered, and for those risks then to be transferred to the reinsurance markets.

“There are often examples of insurers excluding certain risks from their cover,” says Jacks. “Some of those exclusions can be added back into the captive. We’ve been involved in a lot of situations where we have provided support through writing that policy for the captive and fronting it. We then put it into the captive, often with the other traditional insurance placements that are flowing through the captive, and then we can provide a stop loss across all of those lines on a multiline and multiyear basis.”

A hard market? Not for a while ...

One of the most hotly debated topics of discussion in the insurance industry in recent years has been predictions over if and when the next hard market will arrive. A hardening in the insurance market would have substantial consequences for the captive market.

But according to those in the know, while a hardening of rates is likely to happen at some point, it is hard to predict when.

“At some point, probably in the not too distant future, there will be another hard market,” says Alan Fleming, chair of the captives group at the Association of Insurance and Risk Managers (Airmic).

“In my life time there have been about three hard markets over the years and it’s quite a long time now since the last one, which was in the 1980s. Since then it’s been very competitive in the insurance industry. At some point it will change, but I don’t think it’s changing yet.”

Variety is the spice of life

No two captives are the same and each can present its own particular challenges and opportunities to reinsurers looking to provide coverage. Sometimes this means dealing with small, niche outfits, and other times insuring large multinational corporations, according to David Provost, deputy commissioner of captive insurance in Vermont.

“It could be a single parent company or a hospital, or the reinsurer might be covering a pretty large group structure. It’s still a single line of business with a limited, specific customer base,” he says.

However, in general, the overall skills required to underwrite a captive’s risks are the same as those needed to do business with the traditional insurance market. This is the view taken by Peter LeResche, director at Aon Global Risk Consulting.

“I wouldn’t say that you need to be a specialist reinsurer to reinsure captives,” he says. “Obviously any reinsurer is going to be concerned about the fundamentals of the captive: who’s managing it, where it is domiciled and what its financials are like.”