If carefully designed and managed, a captive is a tool in the risk manager’s toolbox for large companies that can help build resilience to future transformation risks as a result of climate change, amongst other things.
Captive insurance solutions offer a sustainable and flexible way for large companies (turnover more than 500 million EUR) to protect themselves against the growing, often unpredictable risks posed by climate change and other global challenges. It is critical for risk managers to consider these solutions today when developing their risk management strategies for tomorrow.
The dynamic changes in large companies’ risk landscapes have continuously revealed the limits of traditional insurance solutions, whether through lack of capacity, or wording exclusions, or unproportioned price increases. Climate change, with primary and secondary transformation risks in tow, is expected to become an increasing challenge for corporate leaders and their risk strategy in the future.
Primary transformation risks are physical climate risks that derive directly from global warming. Extreme weather events such as floods, storms or wildfires can cause substantial damage to companies’ assets and often lead to business interruptions. Recent disasters, such as the August storms in Slovenia, prove this.
Secondary transformation risks are speculative and involve risks and opportunities. They arise from the adaptation of business models (products, applications, processes, techniques) to climate change and thus lead to a change in the risk landscape. For example, the implementation of closed-loop systems, such as recycling and upcycling models, often changes requirements for quality management, logistics structures and liability potentials.
Production processes will also have to be adapted to climate related challenges. The shift in vegetation zones can trigger the risk of drought and bottlenecks in the supply of cooling water. Extreme weather events can lead to power outages or damage to public infrastructure, resulting in production disruptions whose causes are beyond the company’s own control. From the perspective of the affected company, this is a so-called “non-damage business interruption” which is traditionally difficult to insure against. If it is insurable, then it is only related to a narrow exclusion regime and a price far above loss-expectancy.
For risk management, it is essential to recognise the impact of transformation risks on the assets and to improve the resilience of the company in addition to eliminating weak points as best as possible.
When traditional risk transfer fails…
In the future, it will be an even greater challenge for the insurance and reinsurance market to meet its economic, social, and ecological responsibility and provide society and the economy with sufficient cover for transformation risks.
Worldwide natural disasters are already leading to premium increases in traditional insurance solutions. Solely relying on a NatCat-Models provider will not solve the problem of affordable capacity. The situation will continue: high risks will provoke limited capacity for high margined prices.
However, large companies have options. There are proven solutions available to leave the classic risk transfer behind, or at least partial solutions that can be shaped into alternative options.
Managing tomorrow’s risks sustainably and flexibly
Alternative risk transfer (ART), for example through captives, offers sustainable and flexible solutions, especially where traditional risk transfer reaches its limits. Among large companies, we are increasingly observing a shift in the mind-set towards alternative, innovative risk financing models.
Captives need a long-term commitment (7-10 years at least) by the owner. A captive can be developed over time by further adjusting its flexibility if changes are required by the risk landscape. An equalisation reserve will stretch potential claims payments over time. This is a significant advantage compared to ownership via operating cash flow or balance sheet funds.
Systemic changes such as climate change or geopolitical developments will gain further importance and lead to strategic change.
Background
A captive is an independent re-(in)surance company owned by a corporate company. Worldwide, there are about 9,000 captives in about 70 domiciles. Popular captive regions for European companies are Luxembourg, Ireland, and Malta. About 80% of captives are established as reinsurance companies. In this set-up, a professional primary insurer takes over the usual duties via a fronting arrangement.
Strategic reasons
Financial reasons for alternative solutions
Mix the old with the new! Our best practice approach
An intensive examination of the company and its risk profile is always the starting point for change. This includes identifying new, future risks and transforming existing risk profiles into a comprehensive risk landscape with a focus on operational risks, but without limiting them to traditionally insurable risks. Based on the strategic risk forecast of this agile risk management methodology, transformation risks are anticipated at an early stage. This allows suitable cause and effect-related measures (e.g. the identification of an adequate risk transfer) to be initiated in good time. In addition, existing solutions are analysed for effectiveness and cost efficiency.
A risk quantification and simulation by a qualified analytics team forms the basis for an initial assessment of whether ART, e.g. in the form of a captive, can represent an effective solution for the interaction of insurable, partially insurable and non-insurable risks of future risk potentials.
With modern methods of modelling risks, the so-called “sweet spot” (optimal ownership capacity in interaction with classic risk transfer) can be worked out in an “ART pre-study”. If two or more insurance programmes and non-insurable risks are included in the alternative risk transfer, individualised modelling with customised parameters is necessary to consider diversification factors. The insight from the modelling for optimal risk management provides a realistic estimate of the total costs to be expected. This includes the costs within the basic deductible, the self-support via ART and the risk transfer beyond this via classic insurance markets.
In a next step, the structuring of the solutions, the analysis and evaluation of the captive vehicles and the various domiciles can be carried out in detail via a supplementary feasibility study.
The key to everything is patience!
Captives are not a quick fix. In principle, it is important to see a captive as a long-term form of risk financing, because the positive effects are often only visible after a few years. This is especially true when it comes to hedging traditionally uninsurable transformation risks.
The threshold value above which it makes economic sense to operate a captive as a long-term risk management instrument and to carry out the necessary contractual implementation is related to the (future) exposure. In the overall view, the smoothing effect, and the flexibility to be gained in the hedging of substantial – also traditionally non-insurable – risks and the constant increase in independence from the volatile insurance markets usually prevail.
Not infrequently, however, it is precisely this “long-term nature” and the fact that the operation of a company’s own “insurance” is outside its core competencies and thus “alien” to it that are obstacles to the company manager’s decision-making process. In any case, the in-depth examination of transformation risks and the possibilities for overcoming them, also within the framework of a feasibility study, ensures more transparency in the group-wide risk landscape.
If carefully designed and managed, a captive is a tool in the risk manager’s toolbox for large companies that can help build resilience to future transformation risks as a result of climate change, amongst other things.
About Gert Wellhöfer
Gert Wellhöfer is Master of Insurance business and has been working in the industry for about 35 years. He was responsible for the global management of the Allianz Captive as well as consulting international clients on their ART topics. In 2021 he joined Ecclesia Reinsurance Broker where he took over the positions as Managing Director.
Helga Koller
Strategic Sales Manager GrECo International AG
T +43 664 883 805 10
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