As another year begins, Captive Insurance Times takes a look into the future to see what emerging risks, regulatory developments and challenges 2022 may bring
If the emerging captive statistics for 2021 are anything to go by, the captive insurance industry looks set to continue its expansion and prosperity into the new year and beyond. Market conditions continue to be informed by the ongoing impact of the COVID-19 pandemic and the hardening commercial insurance market, providing a valuable opportunity for the captive industry to illustrate the advantages of captives as a long-term component of an organisation’s risk management strategy.
Capitalising on the current market conditions to improve the reputation of captives and provide educational resources on the sector is critical to position captives as a significant branch of alternative risk financing.
A recent market segment report by A.M. Best identified that tougher renewals in Europe has led to a wider use of existing captives to optimise an organisation’s risk transfer solutions, for example, increasing retentions or limits on existing coverage, or expanding into new lines of business. It is important for companies to exercise flexibility throughout insurance market cycles (particularly during hard cycles of increased rates and diminished commercial capacity), as well as hold access to reinsurance market capacity, the report notes.
Oliver Schofield, managing partner at Risk and Insurance Strategy Consultants (RISCS), explains: “Today’s complex risks often are hard or impossible for the conventional market to insure, mainly for good reasons such as the newness of the risks, meaning underwriters have no data and no history on which to base their judgements.”
Elsewhere, Aon’s annual Captive Benchmarking Survey noted that despite the rate of increase in commercial insurance pricing beginning to flatten out in 2021, companies are continuing to investigate their alternative risk financing options as the difficulty in placing loss-hit lines persists.
Charles Winter, head of risk finance and chief operating officer at Aon Global Risk Consulting, explains: “Whilst some areas of the commercial market are showing signs of stabilisations, it is still more of a reduction in the pace of change rather than a reversal of the higher process or more restrictive terms.”
He adds that this has an impact on captives, as higher commercial insurance prices strengthen the business case for a captive, providing appropriate premiums can be achieved for taking more risk.
Aon’s survey also identified a trend of captive owners retaining more risk on a sustained basis while retaining an appropriate level of cover to address medium-term economic viability and price increases in primary markets.
“In the last half of 2021, there has been a definite increase in enquiries relating to pension buy outs including reinsurance to captives. This is from a low base but shows employee benefits generally being a more mainstream part of the captive agenda,” Winter adds.
Looking at how these market conditions for the captive industry will develop in 2022, Debbie Walker, ??senior deputy commissioner at the North Carolina Department of Insurance, comments: “As with 2021, it is expected that the market conditions will be positive in 2022 for the formation and growth of captive insurance companies and their service providers.”
The opportunities currently available to the captive industry will foster mutual growth and development among service providers, including captive managers, auditors, actuaries, attorneys, and others, with Walker summarising: “Overall, the outlook for the captive industry in 2022 appears to be very favourable.”
Schofield anticipates that in 2022, captives will continue to address this exposure gap for their parent companies, as well as increase their aggregate portfolio retentions and access to the captive reinsurance market for multi-year portfolio solutions to provide longer-term stability in risk management planning.
Emerging risks
Emerging risks continue to play a significant role in the formation and expansion of captives, as they are by default designed to provide cover for an ‘unusual’ or ‘extraordinary’ risk to address current risk-related challenges.
Regardless of the type of emerging risk, it is fundamental for a captive to perform feasibility studies and risk evaluations, as well as exercise adaptability and seek quotes from the commercial marketplace if they select to transfer the risks.
“A benefit of utilising a captive insurance company is the ability for the insured to obtain the coverage needed with the terms and conditions that apply specifically to that insured’s situation.”
“It is expected that in 2022 insureds will continue to evaluate the risks they are or will be facing, and upon that evaluation seek coverages from their captive insurers to address those risks,” Walker affirms.
In the annual survey by the Association of Insurance and Risk Managers in Industry and Commerce (Airmic), it was found that risks associated with the COVID-19 pandemic have significantly shaped the global risk profile in terms of risk management, crisis management and business continuity planning, owing to greater risk connectivity.
The survey found that the top three front-of-mind risks — business interruption following a cyber event, loss of reputational value, and failure of operational resilience — remain the same from 2020 in the ongoing context of an accelerated shift to a virtual economy, indicating that these risks may continue to emerge in 2022.
Specifically, ESG was identified as a key ‘hot topic’, with more than 40 per cent of surveyed risk professionals believing that climate change and transition risks will have a material impact on their organisations within the next one or two years.
The survey noted that insurance and risk management professionals and organisations are actively reviewing and updating their strategic approach to resilience in order to better address challenges arising from systemic crises, a trend which is set to continue into 2022.
Winter explains: “Longer-term, we are seeing companies in carbon-intensive industries look to captives and mutuals as the commercial market withdraws from providing coverage. There is time to plan whilst cover is still available but the direction of travel seems one way so those that do not consider the options risk future issues.”
The second ‘hot topic’ emerging risk identified in Airmic’s survey was cyber. Winter explains that the commercial insurance market is significantly failing to meet the requirements of premium rates, scope of cover and capacity for cyber risk.
“It is now rare to have a discussion involving captives without cyber being top of the list of issues for large commercial buyers. Captives are looking to take what would have been the entirety of primary layers as insurers retreat from risk or to provide a parallel tower buying back lost cover,” he notes.
Airmic’s pulse survey found that cyber risks are the most likely new risks to be financed by captives in order to address these coverage gaps, particularly as the COVID-19 pandemic accelerated the implementation of digital transformation programmes and the trends associated with cyber risks. This was affirmed by Aon’s 2021 Global Risk Management Survey, which ranked cyber as the number one risk globally across each surveyed region, industry and respondent type owing to the COVID-19 pandemic, which has highlighted the increasing importance of an organisation’s ability to manage long-tail risks.
Although Airmic observed ‘green shoots’ in the easing back of premium rate increases and cover limitations, as well as progress in cyber risk profiling, the cyber insurance market is likely to experience further disruption in 2022 as issues surrounding programme capacity continue into the new year.
RISCS’ Schofield says: “We expect captives to play a larger role in certain coverages such as cyber where capacity and premiums are challenged, as well as provide industry solutions to groups of businesses in the same industry group facing the same coverage challenges. We are actively working on three such projects right now in the energy, construction and professional services space, all of which will come to fruition in 2022.”
North Carolina’s Walker names business interruption as another significant emerging risk arising from the pandemic: “With the continuing threat of COVID-19, it is anticipated that captives will provide coverage to their insureds to address the impact of the pandemic, such as business interruptions.”
She adds other risks that captives may seek to address in 2022 as the effects of the pandemic continue include supply chain disruption, talent acquisition and retention, corporate governance risk management (including directors and officers liability), and the risk that new innovations will disrupt or make a business product or service obsolete.
Challenges on the horizon
Despite 2021 presenting many opportunities for the captive industry, insurance and risk managers enter the new year with lingering challenges.
The increasingly significant role of risk management teams within firms requires efficient internal communication between these teams and the C-suite to keep the latter aware of their risk exposure, reduced market capacity and the financial impact of increased risk retention during a hard market.
Schofield notes: “As the captive industry continues to grow, one of the biggest challenges will be ensuring that the traditional insurance market supports captives in playing a larger role in their own risk retention and will actively work with their clients rather than against their clients, which sadly we have seen too often in 2021.”
Winter adds that uncertainty around the future direction of the market creates challenges in decision-making and planning processes, as potential new captive owners are unable to accurately assess the real value it will bring to their organisation.
“The general trend of a raising of the barriers to entry in terms of premium tax rises and more rigorous application of national regulations continue to require close scrutiny to achieve the desired result,” he identifies.
In a PwC survey in which insurers and reinsurers rated industry risks facing the global insurance industry, cybercrime was ranked as the top risk over the next two to three years, as the remote working model has highlighted the vulnerability of firms to cyber risk.
In addition, the evolving type, volume and success of cyber threats has heightened cyber to both an operating and underwriting risk, as attacks can cause losses related to business interruption, as well as operational issues from the loss or corruption of data and reputational damage.
Cybercrime was followed by regulatory risk, as insurers indicated the belief that regulation has become excessive, onerous and bureaucratic to the extent that it may be a hindrance to business operations. Technology was also identified as a challenge to the insurance industry, with concerns around the ability of the industry to keep up with technological modernisation.
Other named concerns in the survey include interest rates, change management, competition, investment performance, macronomy and human talent. The latter is particularly relevant to the captive industry, with Walker noting that “a major challenge [in 2022] will be the recruitment and retention of personnel”.
She explains: “Prior to the COVID-19 pandemic, the industry was already facing challenges in the hiring of qualified employees, the recruitment of younger talent and the retirement of seasoned professionals.”
“Now the industry faces those same challenges, but in addition potential workers desire more flexibility, remote work opportunities, and a better work-life balance.”
“The insurance industry has been slower than some others to respond and provide a more flexible work environment. Going into 2022, the captive industry will need to make the industry appealing to the workforce by providing flexible benefits in order to recruit new workers and to retain staff,” Walker recommends.
Regulation
For the European captive industry, the ongoing Solvency II review promises a more reconciled implementation of the proportionality principle by EU member states, which is intended to “ensure that the practices and powers of supervisory authorities are proportionate to the nature, scale and complexity of risk inherent in the business of the insurer or reinsurer”.
This is especially relevant to captives as it ensures that regulatory requirements do not become so burdensome that they are an impediment to a captive company’s business operations.
In September 2021, the European Commission adopted its review package for Solvency II requirements, the capital changes of which Fitch Ratings believes will benefit the European insurance sector’s burgeoning interest in ESG investments. In 2022, the European Parliament and member states of the European Council will negotiate the final legislative texts based on the Commission’s proposals.
Elsewhere on the regulatory horizon for captives, International Financial Reporting Standard (IFRS) 17 is set to take effect on 1 January 2023, which Aon’s Winter describes as “the largest change on the immediate horizon”.
Issued by the International Accounting Standards Board, the new standard is designed to consolidate the way in which insurance companies (including captives) value and report on insurance contracts to promote greater transparency.
Late last year, Marsh recommended that captives be mindful of four specific areas that will be affected by the implementation of IFRS 17: contract boundaries and underlying clauses (such as a termination clause or re-underwriting clause); probability-weighted future cash flows of an insurance contract; entity-specific calculations of risk adjustment, risk appetite and compensation; and the contractual service margin.
Winter warns: “Given the nature of many captives’ portfolios, the changes may not be as pronounced as some other parts of the industry but there will be challenges for captives writing longer-term programmes and they will need to watch out for a mismatch in the accounting for the underlying risk assumed and the protection offered by reinsurance.”
He adds that it will be “interesting if the post-Brexit opportunities that the UK has will lead to any more favourable regulations for captives, particularly due to the trend towards locating closer to home that is seen in a number of geographies”.
Looking elsewhere in the global captive industry, Schofield anticipates that in the continued hardening market, more jurisdictions will follow Bermuda, Guernsey and Labuan to enable fast-track legislation for cell captives.
“There has been talk of captives redomiciling to the location of the parent and we will be keeping a watchful eye on that in 2022,” he adds.
From a US state regulatory perspective, Walker notes that the regulatory environment is on the whole welcoming of the industry in states with captive-enabling legislation.
“The states that desire to grow their captive industry will continue to develop their captive regulatory programmes by improving or updating their captive insurance laws and finding other ways to stand out from other captive domiciles in order to meet the evolving risk management needs of business owners,” she concludes.
