Industry professionals discuss the current captive insurance market trends, causes of the hardening market, and the impact of COVID-19 on interest around alternative risk financing
Following around 15 years of soft performance in traditional insurance markets, consisting of stable premium pricing, lower underwriting criteria and relatively affordable insurance rates, the last few years have experienced a definitive trend towards a hardening market.
A hard market is characterised by several factors, including higher insurance premiums, reduced capacity, less competition among insurance carriers, more stringent underwriting standards, and general uncertainty and volatility in financial markets.
Pete Kranz, captive practice leader at Beecher Carlson, identifies that in this context of a hard market, there has been a significant pattern of pushback by umbrella and excess insurance markets against captives, noting: “Where it was historically easier to have captives participate in high umbrella and excess layers, including on a quota share basis, we are beginning to see some pushback which definitely gets my attention.”
Looking broadly across the captive insurance industry, Nate Reznicek, head of US distribution at International Re, adds: “Generally speaking, workers’ compensation still remains soft while commercial auto and general liability classes rise. From a trade perspective, it has made hard-to-place trades even more difficult to place, especially heavy transportation, general contractors and general liability for the habitational trade.”
“In some cases, rates in the excess market increased so dramatically that purchasing the coverage became non-viable, leaving many insureds potentially under-insured or unable to meet the insurance requirements within their agreements,” Reznicek explains. “Although it has long been a talking point in the industry, for the first time we are consistently seeing captives take a hard look at buffer layers as potential premium savings.”
Richard Smith, president of the Vermont Captive Insurance Association (VCIA), affirms that a hard market is beneficial to captive owners: “There has been continued robust growth not only in Vermont, but throughout the captive insurance industry.”
“Obviously, the continued hard market in the traditional insurance industry has fuelled this growth, but we saw growth trends even before the hardening — there was growing interest by small- to mid-sized companies seeking to get control over their risk.”
Creating a hard market
The landscape of a hard market has been galvanised by several significant factors, including heightened frequency and severity of natural catastrophes as a result of climate change, such as hurricanes, flooding and wildfires. According to Kranz, this has caused increased claims activity, diminished capital and scared insurers.
Smith concurs that such catastrophic events have increased rates on property and casualty lines, as well as impacted reinsurance and other alternative capital sources.
He notes that while capacity remains within these marketplaces, losses over the past few years have caused a ‘tightening’ to underwriting and pricing. In addition, investment returns due to low interest rates have prevented insurance companies from meeting their capital costs, therefore causing increased rates.
Kranz identifies a pattern following a year of such activity, whereby insurers release a handful of their redundant reserves — referring to reserves that are reasonably held for adverse years to transfer losses from the income statement to the balance sheet in order to mitigate the impact on capital and surplus — and the investment market’s support through capital injections.
“Two years of adverse losses later, and there has not been time to rebuild reserves, so the carriers do not have as much to release, the capital markets are more cautious, and premiums have increased,” Kranz explains. “In the third year of the hardening market, there are no reserves to release and the capital markets are balking, causing the carriers’ need rate to increase.”
Kranz notes that the current hardening market is interesting because it will not yield when pressed on rate increases by insureds and brokers. Where underwriters traditionally worked to balance rate increases while filling their capacity, the insurance industry is now instructed to only write profitable business.
He comments: “The hardening market is forcing more and more insureds to take on risk through increased retentions, and to really start thinking about how they finance risk.”
However, Reznicek points out that “hard markets are more than just a simple increase of industry pricing to offset losses. The price increase is being driven by significant reductions in the available capacity insurers are willing to deploy, but also by the fact that there are less insurers available due to changes in appetite”.
Another contributing factor to the hardening market is emerging cyber risks, sensationally demonstrated in the ransomware cyberattack on the Colonial Pipeline in May of this year. The current work-from-home model during the COVID-19 pandemic has also raised the vulnerability of many industries to cyber attacks.
Captives and COVID-19
The pandemic has exacerbated the stagnant economy and magnified operational obstacles and overall market volatility. A hard market will inevitably develop during a period of economic downturn, as insurance companies struggle with capacity, availability and higher retention, coupled with declining insurance capital and competition.
The parallel difficulty and expense of placing insurance in a hard market encourages companies to adopt a revised alternative risk management strategy by either forming new captives or expanding their existing captive structures.
Therefore, the COVID-19 pandemic has provided new opportunities for insureds wishing to include communicable diseases coverage, including contingent business interruption (BI), in their commercial property policies. Captives in particular provide the ability to add or modify coverages in order to best suit the insureds.
In this environment, the alternative capital market is perceived as beneficial to reinsurers because the cost between alternative and traditional capital has considerably narrowed, allowing reinsurers to utilise this as a negotiating tool when balancing captive insurer capacity and reinsurer capacity.
Smith says: “I believe that the uncertainty we saw regarding the ability of companies with BI policies to collect has made many organisations rethink their risk financing. A pandemic is a difficult type of risk to insure — many say it is uninsurable — however, we have seen organisations with captives use their flexibility to cover impacts from the pandemic where traditional insurers would not.”
“Furthermore, many companies that do not have pandemic coverage are looking to their captive for liquidity that may come in the form of large intercompany investments like loans and receivables, investments and subsidiaries, or projects.”
“Covering BI or other lines impacted from a pandemic is challenging, as it will surely need to be adequately capitalised. Longer-term, we will see captives issuing some pandemic coverage or wrap-around to commercial coverage to cover the next COVID-19 type event,” Smith adds.
Federal backstop
As companies look to include pandemic coverage in their offering, those domiciled in the US will be paying attention to the passage of the Pandemic Risk Insurance Act (PRIA).
This bill establishes the Pandemic Risk Reinsurance Programme within the Department of the Treasury, which would allow captives to write pandemic risk with a federal backstop. Under the Act, general compensation will be provided to insurers incurring aggregated industry losses over $250 million as a result of a pandemic or disease outbreak.
Kranz describes PRIA as “a very interesting piece of legislation, particularly with respect to captives. Thinking about captives for non-physical damage BI coverage, one has to ask what the value is. For those chasing tax deductions, such as public accounting and actuarial firms, you cannot build up a reserve over time to ‘smooth’ the expense”.
He explains that building up a cash reserve in a captive depends on an individual organisation’s cash position, predicting that in several years’ time some captive owners may collect the profit and dividend or loan it back, thereby defeating the original purpose.
Reznicek agrees that the legislation certainly promises to be an interesting solution for pandemic exposures, observing that the federal backstop would be advantageous in providing a needed diversity of exposures over a larger subset of risks, both in terms of numbers and geography. This diversification would be beneficial for insurers, allowing them to confidently extend coverage while investigating opportunities to deploy capital elsewhere.
However, he highlights that the current proposed PRIA framework stipulates insurer participation on a voluntary basis, meaning that the benefit of additional extension of risk could be hindered by low adoption rates. Furthermore, ultimate losses as a result of COVID-19 will not be definitively known for several years.
The extent to which PRIA will benefit captives remains unknown, with Reznicek noting that captive insurers and other self insured structures, such as state workers’ compensation pools, require specific approval by the Secretary of the Treasury to be eligible for participation.
“There are other factors and potentially unintended consequences of the passage of PRIA in its current form,” Reznicek explains. “The bill would likely formalise acknowledgement that what was once considered a business risk for US federal income tax purposes would now officially be an insurance risk, all but eliminating an argument that the Internal Revenue Service has routinely made when challenging the legitimacy of micro captive arrangements for the cover.”
Therefore, in order to accurately assess the benefits of PRIA on captive owners, the industry needs to know whether captives will be included as insurers eligible to participate in the programme and what the programme covers, as well as specifics such as the triggers, allocated shares of losses and deductibles.
Kranz affirms: “We need these specifics to see if there is value in writing the coverage in captives in order to access PRIA like is done for the Terrorism Risk Insurance Act (TRIA).”
“Once we see those specifics, we will need to see how the markets respond. I am certainly anxious to see how it plays out!”
What next?
A continuation of the hard market will bring increased commercial insurance prices, inevitably causing more companies to consider forming captives as an alternative risk financing tool.
Smith remains confident, commenting: “The captive industry always thrives during a hard insurance market, so I see no reason that it will not do the same this time. Captives offer their owners control, clarity, and cost savings even in a soft market — the hard market only amplifies these benefits.”
Kranz notes: “The hard market has been pushing insureds to take on more risk, while the increase in risk retention has been pushing down from the large market, the middle market and into the small market.”
While previously smaller companies may have been somewhat limited to cell captives — less expensive and less complex to manage, these allowed smaller firms to pool their resources while segregating their assets from the risks of other members in the pool — Kranz says more insureds of all sizes are considering alternative risk financing options. Going forward, a continuation of the hard market will affect the landscape of the captive insurance market as financial professionals listen more closely to risk innovators about alternative structures and persist with their interest in such programmes.
Kranz identifies the current priority is traditional carriers with unused capacity, as well as reinsurers and capital markets, who must now deploy their resources to the multi-line aggregate structures in the alternative risk financing space.
He warns: “If the typical players do not step up quickly, someone else is going to fill the void. We are in an incredibly interesting time seeing truly innovative structures being utilised, and we could see some very different capital and structures developed to sit above and around captives as the risk financing picture gets flipped on its head.”
Looking ahead
Kranz predicts a further 18-24 months of busy activity in the captive insurance market, citing: “In the past few years, the hardening market persisted even with a strong stock market, so I do not see the market or economy dramatically slowing the pricing increases.”
If severe and frequent natural catastrophes endure, he believes the hard market will be prolonged even further. In addition, inflation, nuclear verdicts and ‘social inflation’ (increased insurance losses resulting from new tort and negligence concepts, higher jury awards, higher workers’ compensation claims and higher legislated compensation) may make the current conditions the new norm in traditional markets.
Kranz adds: “That said, captives were being formed before this current hardening and will continue after. I think the longer-term implications are that, based on how this market has been playing out, more captives will be utilised. Once you start rolling that ball it is tough to stop it.”
This positive outlook is echoed by Reznicek, who predicts that increased rates and lack of markets will continue to drive negotiating power back to the traditional carriers. He notes that this in turn will continue to provide the opportunity and motivation for smart insureds to limit their exposures to the volatility of the guaranteed cost market and enter into alternative risk transfer and captive insurance arrangements.
“I fully expect to see increased interest from existing carriers and the accelerated formation of specialty fronting carriers into the captive market to attempt to fill the need,” Reznicek says. “From a captive perspective, I believe that there is an increasing trend and desire for fronting carriers to actually take on risk instead of just providing paper. Value-added fronting, which was once arguably just a bit of puffery, could now actually begin to have meaning in the marketplace.”
Looking further into long-term consequences, Smith observes that the hard market will inevitably soften at some point — although when this will be is unknown, and he predicts that this will not cause captive owners to abandon their structures and fully return to the traditional market.
He ends on a positive note: “Over the past years there has been little increase in productivity in the traditional insurance market, and providers have been fat and happy for some time. Captives are the scrappy upstarts that have the will and flexibility to meet the needs of their owners in ways the traditional market cannot. What we will likely see is some leveling off on the growth, but once new captive owners see all the benefits of owning a captive they will be hooked!”
