Innovative risk protection through captive insurance

Whether it be increasingly difficult-to-insure risks like cyber incidents, business interruptions, supply chain disruptions or natural events, tougher access to insurance protection for certain industries, considerable premium increases, more rigorous risk exclusions or sharply rising retentions – companies in various sectors are facing growing challenges when it comes to protecting themselves against risks with the conventional coverage provided by traditional insurers.

Against that background, 'captive insurance' has been attracting more and more attention: captive insurers make 'alternative risk transfer' possible, in combination with greater independence from the conventional primary insurance market. There are estimated to be between 6,000 and 7,000 captive insurers worldwide – with the number trending upwards over the past few years. A study recently published by PricewaterhouseCoopers' German branch found that roughly one-third of the companies surveyed had an interest in establishing a captive insurance vehicle in the next two to three years.

What is captive insurance?

Captive insurers are insurance undertakings set up and wholly owned by one or more entities with the sole purpose of assuming the risks arising to the parent(s) and other group entities from their business operations. Captives offer full-value insurance coverage and can supplement, or even replace, third-party insurance solutions according to the insured's needs. From a regulatory perspective, a captive insurer requires a (re‑)insurance licence and is subject to continuous compliance with the regulatory requirements imposed by the European legal framework under 'Solvency II'. These requirements pertain to the captive insurer's own funds (the minimum capital requirement and the solvency capital requirement, known as Pillar I), its risk management system (Pillar II) and supervisory reporting obligations (Pillar III).

There is a variety of design options available for developing needs-specific solutions for companies of different sizes, sectors and regional orientations. These options range from models for both primary insurance and reinsurance, to onshore and offshore schemes, all the way to mechanisms for financing only the owner's or parent group's own internal risks (called 'pure captives') or for diversifying a risk portfolio by accepting risks in addition to those placed by the parent(s) and any affiliates (referred to as 'diversified captives'). For medium-sized enterprises in particular, strategies that do not involve establishing their own genuine (re)insurer are also worth considering, like rent-a-captive models and 'protected cell captives', which make it possible for insureds to bear their own risks via contractual arrangements with third‑party insurance companies.

Beyond that, companies can also concertedly fill gaps that the conventional insurance market does not cover adequately by forming a joint captive, otherwise known as a mutual captive or association captive. For example, a collaboration of international companies recently founded the insurance undertaking Mutual Insurance and Reinsurance for Information Systems (MIRIS) to enable its members to access cyber insurance capacity.

What advantages can captive insurance offer?

Despite the regulatory hurdles, captive insurance can offer a wide array of benefits. In addition to making up deficits in the risk coverage offered by the conventional insurance market by providing needs‑based solutions tailored to the specific exposure of the insured, a captive insurer can strengthen the insured's independence from third-party insurance undertakings. Moreover, captive insurance may afford access to the reinsurance market with favourable outcomes in risk pricing. These features can enable insureds to achieve greater autonomy in their risk protection and risk management, which can also translate into stability in their risk costs.

Similarly, captive insurance can be beneficial in relation to insureds' balance sheets. Unlike setting aside provisions for retentions, with a captive, insureds provide for their risks off their core balance sheets. This protects the core balance sheet from losses arising in insured events and can yield tax advantages. And not least of all, captive insurance has the potential to improve cash flow at the group level because paying the premium does not result in any outflow of cash at the group level.