Rolling with the punches

The conundrum of how to break the cyclical nature of the insurance market is as old as the market itself and, despite regular proclamations from market practitioners, it is unlikely a solution will be forthcoming any time soon. The challenge for brokers and insurers is to roll with the movements in the market, without letting them be overly destructive to their operations.

Similarly, for firms seeking insurance, the challenge has always been to get the best cover at the most competitive price and given the two sides of the same coin these goals represent, it is barely surprising the market is pulled to and fro with such force and regularity.

Alternative risk management through self-insurance or the creation of captives has long been available as a financial tool for firms, although it is really only in the recent past that it has gathered substantial momentum. Indeed, there is an argument to suggest it was not really until the 1980s when the captive market became a widely considered alternative as Aon's recent report: G500 The Captive Picture, makes clear. It states: "Conventional wisdom has it that more captives are formed during or immediately after a hard market, and this was perhaps true during the early years of the captive movement and, in particular, following the liability crisis of the mid-1980s, which saw the captive sector really take off for the first time (and resulted in the formation of XL and ACE by major global companies). However, the statistics show that the condition of the market has had relatively little effect on captive growth for the current G500 membership."

So, at the top end of the market, the insurance buying habits of the biggest firms may not be as directly influenced by market conditions as many people think. However, this does not seem to be the case as one slides down the scale in the UK market.

Looking at the effect of hard and soft markets, Jonathan Groves, head of the captive consulting practice at Marsh, is in no doubt that market conditions do have an impact on commercial firms looking at the alternative risk market. In 1994 there were 26 captives formed in the UK and by 1999 this annual figure had fallen to only seven. Into the next decade, and there were 27 captives formed by UK companies in 2002, although this had fallen to only 13 in 2004. Citing these figures, Groves says the rise and fall in the creation of captives by UK firms does, therefore, have a correlation with the hard and soft market cycles. However, he says this is not firms' only consideration in their decision to turn to a captive.

As he comments: "We look at a captive as a financial tool. It is not possible to take a 12-month view as this would result in continual chopping and changing. A longer-term view is essential." It simply is not possible for firms to make an immediate knee-jerk reaction to a hard market and look to set up a captive, as it will not always be the best option. However, it does seem that market conditions push firms into looking at their options.

Outside traditional markets

Indeed, this would seem to explain the difference between the attitude of the very biggest firms in the world towards insurance and those others in the UK. Those at the top end of the scale have perhaps a better understanding of how risk can be transferred and laid off and, given the premiums involved, will have spent more time investigating their options. As such, they are not swayed so easily by a change in the market and tend to take decisions with a wider perspective in mind.

For smaller firms, looking outside the traditional market may not be quite such a priority and in the past may not even have been considered. However, as hard markets bite and captive insurance becomes increasingly more mainstream, it is likely more will turn to it as an option, and be prompted at looking in the first instance by rising premiums.

It is not simply rising premiums turning companies towards captive formation. As the market hardens deductibles are also likely to rise while the terms and conditions of the cover in place may also deteriorate. For many firms they simply do not believe they are getting value for money and on further investigation realise they could provide their own cover at a more competitive price and continue to do so into the future.

Bob Powell, group technical manager at Oval comments: " I set a captive up for a client in the last hard market because they felt they were being unduly penalised for a couple of losses that were unfortunate and happened sequentially, but were completely out of context for the business. They were hit for six for no scientific reason."

Andrew Tunnicliffe, business development director for Aon Captive Services Group, also comments: "Slowly over time markets will have excluded certain types of coverage and so you have to think about the value for money that some covers offer and this also sometimes drives captive formation and participation because the extent of wording from the market is not always as wide or as robust as it has been in the past."

It is no surprise therefore that some of the most avid users of the captive market are firms where capacity for the risks involved is shrinking, or firms trying to avoid being hammered for a number of small but high frequency claims. As such many in the manufacturing, energy and pharmaceutical sectors turn to the captive market.

Multiple lines benefits

In the past, UK firms may have turned towards the captive market due to changing conditions in one particular area of their insurance needs. However, brokers should increasingly be looking to extol the benefits that having multiple lines of insurance held together in a single captive vehicle can have.

Stephen Cross, chief executive of Aon captive services group, says: "People that are not thinking towards the alternative market still tend to buy their coverage on an each line basis." However, once firms begin to investigate the options available they realise there is often no correlation between many of their risks and so it is unlikely that one loss will have an effect across different classes of business creating a really major claim. As such, Cross says carrying various lines of business in a captive will create a portfolio effect for firms, and many will see that even if one area of the captive does not perform particularly well, this will be negated to some degree by the performance of other sectors in the captive helping to smooth out costs.

While there seems little doubt that the biggest brokers in the market are well placed to offer clients advice on their captive options by dint of their resource, experience and expertise, there is also little doubt that some of the larger provincial brokers in the UK market should be able to offer a similar service to their own clients. As Stuart Reid, chief executive officer at Stuart Alexander, comments: "Many of the super provincials can do this just as well as the bigger players and for them to sit back and think the business is theirs by right would be foolish."

Neither is captive insurance only the preserve of massive commercial entities. It is increasingly becoming another financial tool for smaller firms to use to their advantage. As such these larger UK brokers are well placed to take advantage of the changing conditions and increasingly promote such services to their existing clients.

It is not simply the creation of captives for clients that brokers are looking at and many are establishing captives of their own. Given the soft market conditions, many have underwriting authority from insurers and it is only a small step to move forward and carry these risks for themselves.

Reid believes insurers have been a little slow to react to the threat this poses and comments: "The creation of a captive by brokers is a way of extending their influence in the market, creating new revenue streams and building on the job they have already done through the delegated authority agreements they have in place."

Certainly this is something Oval is considering and Powell says: "We are really only putting our toe in the water and we are not setting out to put all of our risks through the captive market." Nonetheless, he also admits it is an area of the market he has been tasked with exploring with a view to future expansion.

There seems little doubt that the cyclical nature of insurance does have an effect on the captive market and, although it may not lead immediately to the creation of new insurance vehicles, it does promote investigation of alternatives and particularly at the smaller end of the market.

In the coming years, however, it seems the impact of market conditions will lessen as the captive movement gathers momentum and increasingly firms begin to see the captive market as a viable option and not simply the preserve of major commercial institutions.

Brokers have a huge role to play in this and the moves they are currently making look set to be the foundations of real growth in the years to come.