Capturing the moment

Captive forms of insurance have proved popular in recent years and are increasingly seen as standard options in overall commercial insurance programmes. No longer are they the preserve of the world's largest corporates and, while the majority of captive schemes are run by the global brokers, they are evermore accessible to provincial and national brokers in the UK market. Indeed, those not offering such solutions to their clients are likely to be asked why.

Not so long ago the use of a captive vehicle was often driven by the desire to take corporate money offshore and mine the tax benefits that such a move could bring. For others, there was also the temptation of using a subsidiary insurer to smooth profits by keeping insurance costs out of the parent firm's accounts. Many of these practices have been stamped out by The Treasury and legislation such as The Companies Act. Now, captive insurance is increasingly standing on its own two feet as a viable option in light of the economic and commercial benefits it can deliver to a firm looking to manage its risk.

Looking at the shift that has taken place, Bruce Kesterton, chairman of Thomas Miller Risk Management UK, comments: "Over the last three or four years there has been a hike in insurance rates and deductibles, while some covers have almost disappeared. It is making much more economic sense, as a straight commercial proposition, to run some insurance through a captive vehicle.

"Risk management has been much higher on the agenda over the last few years and, once you start looking at risk management for both operational and financial risk, you start to see the logic of some of the areas being dealt with by a captive."

A degree of risk

However, while captive insurance may have moved into the limelight, it has not yet stolen the show. The captive market offers firms the opportunity to place a degree of risk onto their own balance sheet and, normally, as part of an overall solution.

Rarely will a captive vehicle handle all of a firm's insurance risks for a number of reasons - it is hugely capital-intensive and it is unlikely to be the most cost-effective way of providing the insurance needed in all classes. In assessing where a captive will be of value, analysis of what risks can and should be handled in-house has improved dramatically in recent years and information on utilising such an option as part of a firm's overall insurance solution has become more widely available.

Rory Moloney, managing director of Aon subsidiary IRMG, comments: "Probably, the criteria used to be scale and so the Fortune 2000 companies in the majority of cases will have a captive. What we are seeing now is the extension of the concept as it has become better understood and more sophisticated and that has led to two things. One is that the scale required has dropped, so that medium-sized firms and smaller corporates can also use captive structures."

He continues: "People are also becoming more aware of their risk profile through the use of such things as actuarial techniques, and that is being better integrated with risk-transfer needs and so the decision between retention and transfer of risk has become better."

In simple terms, firms better understand the risks they can manage on their own through a captive and those they have to insure traditionally.

Explaining the basic process IRMG would go through with a client in coming to the proportion of risk it should hold through a captive, Moloney says: "We look at the corporate balance sheet and understand the risk-bearing capacity of the firm and, from that, look at the individual lines of business and understand the profile and volatility associated with those lines of business. The next step would be to look at the market and the pricing that the market is offering for taking that risk off the firm's hands. The final decision would then be to optimise that risk-retention transfer decision as to how much a firm is looking to retain or transfer."

Clearly, establishing a captive will not be worthwhile for a small family-run grocer, for example, but it is no longer just the multinationals that are buying into the idea. Although size is a consideration, risk profile and premium levels are often more important. Nick Wild, managing director at JLT Risk Solutions (Guernsey), comments: "If you have a large company that has fairly mundane insurance risks and, therefore, fairly low levels of insurance premium, then it may not make sense to them even though they are a very large company in their own right.

"If, however, you have a company with high levels of premium either because they are in a very risky business or have assets placed in extreme risk or they have a very bad loss experience, then the premium levels rise and you get to a point where captives start to become a viable option. I have rarely seen a captive working in what I see to be a financially viable way when premiums are less than £1m and, even at that level, I think it is quite difficult and, realistically, it can be more like £3m."

Protected cells

However, the captive proposition has also developed and it is no longer necessary for firms to establish their own wholly owned captive entity to self-insure. The use of protected cell companies has grown enormously, offering firms lower entry costs and the need for less sizeable risks, as Wild explains: "Each individual cell has its assets and liabilities segregated from all of the other cells and, if you have a protected cell company, you have a single legal entity, but you can create specific cells into which you put specific assets and liabilities. If you were a small to medium-sized company and would like captive insurance but do not have the scale or want the expense of running your own insurance subsidiary, you can go to one of these protected cell companies, rent a cell and place your insurance business into that."

The bonus is the lowered entry costs involved, although a degree of control is lost from the management of such an entity. As the proprietor of a single cell and not the whole insurance vehicle, firms going down this route will not be able to dictate overall decisions as to where the protected cell company is domiciled or who does its audits, and it is a matter for brokers and clients to resolve as to whether the cheaper costs are worth the loss of overall control.

At the moment, Wild believes there are around 5000 captives in operation across the world, of which he believes up to 4000 may be managed by the global brokers in the market. However, this is not to say that smaller broking houses should rule it out as a service to their clients.

Undoubtedly, there are difficulties for the smaller firms, as Kesterton explains: "I think that most of the brokers do not have the expertise and it can be quite a complicated and expensive thing to set up and you can end up with a 'chicken and egg' problem. Your first client says they would like you to set up and run a captive and it is bound to be uncompetitive and uneconomic as it will cost several hundred thousand pounds a year to set up an office in an offshore jurisdiction, staff it to a level acceptable to the local regulator and get the appropriate licence, and you may only be just generating a six-figure sum at most in managing fees."

However, by using independent or broker-tied captive management houses, smaller brokers can soon find an economically viable route to market.

Alec Finch, managing director at Alec Finch & Co., says the firm does not do a huge amount of business in this market, but that it is an important part of the overall proposition and demand ebbs and flows with premium rates in the market. He comments: "It is not something that we do particularly often and we have helped a number of clients where the need has been apparent."

Currently, he says, the captives he has set up are organised through relationships that are in place with independent captive management houses, although he claims there would be no problem in dealing with those run by the larger brokers should it be in the best interests of the client.

As he says: "If the proposition worked for the client I do not think I would have any difficulties in going to one of the big brokers. We would have to have a direct relationship with the captive management operation. I would not want to go into the local office and funnel everything through them - I would not envisage that as a proposition at all. However, we respect the integrity of those businesses sufficiently to say that, if they had a proposal that worked for our client and it was coming from the captive management business, then we would be very happy to work with them."

To date, Finch says he has not collaborated with other similarly sized brokerages to see if there might be something they could offer to their combined clients. However as a member of Unitas, he says the idea has been mooted on more than one occasion that a solution should be developed for clients carrying homogeneous risks. This undoubtedly has its problems and it can be difficult to bring and keep firms together in such an arrangement where the poor insurance performance of one can have a detrimental effect on the others.

Increased collaboration

However, for those looking to get further into this market and meet the needs of their clients, increased collaboration is certainly an option. Peter Staddon, head of technical services at the British Insurance Brokers' Association, certainly agrees and says: "There is no reason why brokers could not work together to see if they have similar risks on their books to which they could offer this type of solution. There would be one or two issues to deal with in terms of confidentiality, market share and so on, but the idea is sound and why shouldn't they pool the reserve."

The options for both brokers and clients in the captive market are extensive and, once a captive vehicle has been set up, firms can adjust the amount insured through it to create the most efficient insurance solution on an ongoing basis. While it will not suit every commercial risk, there are many for whom the lowered entry costs and better risk-management techniques will allow access to a better insurance solution than they currently have.

For brokers who feel ill-equipped to offer such advice to their clients, there are avenues open to get the expertise they need, and those not prepared to examine them may find their clients do and go elsewhere.