The past decade has been a transformative experience for financial practices across the globe. Leaders are challenged to decrease risks of loss on their respective balance sheets, while taking greater risks to strengthen their balance sheets in the long-term…a bit of an oxymoron, isn’t it? Hedging FX (foreign exchange) risks and managing cash flows have been the staple risk-management tactics deployed by finance and treasury organizations to protect the balance sheet. And while certainly effective, many have difficulties correlating product growth to cash and hedging practices.
As markets continue to evolve and mature, the perception of risk management, is rapidly changing. Firms benefiting from favorable cash positions and liquid portfolios are redefining the commercial risk and insurance market through selective placement and customized tools to mitigate the risk of balance-sheet losses. As organizations start utilizing their own data to quantify their own risks, the formation of captives and the implementation of creative insurance solutions continue to trend upward. Commercial insurance markets also benefit as strategic advisors, and through providing alternative risk solutions to facilitate their clients’ risk efforts.
We often fail to group risk with the other guarantees in life (death and taxes). Organizations both large and small now realize the danger of risk avoidance and are taking steps to tackle risk head-on by proactively assessing and managing them. Furthermore, firms have found ways to create immediate balance-sheet impact by converting traditional insurance into cost-savings mechanisms. Traditional products available through third-party insurance carriers are now absorbed by captive entities and subsidiaries. For those unfamiliar, a captive is simply a self-insurance entity owned by a risk-bearing party. This self-insurance mechanism is beneficial for a number of reasons:
Premiums paid by the parent company to its captive subsidiary are often discounted in comparison to market rates since premium calculated is based off pure risk. No commissions, rate loads or administrative fees.
Firms retain premiums (if premiums are exceeded by losses), whereas premiums paid to a third-party commercial carrier are not returned if losses do not occur during a given policy period. Many captive owners choose to reinvest the premiums paid net of losses, while others choose to allocate net-premium proceeds to insure more risk into their captive entities at a later time. Similar to insurance companies, many captives have investment portfolios used to optomize insurance proceeds, allowing the owner to benefit from yield on low-risk securities.
Captive entities covering defined percentages of third-party risk (employee benefits and/or risk outside of the captive owner’s direct products, liability or risk exposure) are subject to insurance tax-accounting provisions—allowing the captive owner to deduct premiums paid to its captive entity or subsidiary.
Conversely, if claims exceed premiums and reserves, the captive entity may very well operate at a net loss, which will likely have a notable impact on its balance sheet. For this reason, proper risk distribution and transfer are essential to running a captive entity. Organizations are investing in resources atypical of finance organizations to mitigate risk and generate cost savings. Actuarial, engineering, data science and underwriting are now critical trades needed to properly manage risk portfolios. Quantitative analysis, machine learning and big-data aggregation are now essential components to understanding exposures and insuring both traditional and unique risks. This is often seen in the tech space, in which many of the innovative products under development pose unique risks, and the same product may possess different variations of risk depending on how it’s built and why it’s used. For example, in most cases a standard commercial carrier can easily quote a reasonably priced auto-liability policy for a new fleet of corporate vehicles purchased by Company A. However, the market’s ability to provide coverage is likely to change if Company A’s new fleet of cars are autonomous with sole reliance on artificial intelligence to simulate human decision-making.
Although paying premiums into a self-insurance mechanism may result in lower insurance costs, successful captive implementation and risk management involves blended use of commercial insurance markets. Brokers and carriers in the commercial insurance market continue to play an important role in this space, as every exposure may not be insurable through a self-insurance mechanism. The captive market is an alternative risk solution with heavy dependence on the existing commercial insurance industry. Depending on the coverage type and jurisdiction, captive placement may not be a suitable means of coverage. Examples of this can be seen throughout the workers’ compensation industry, in which some jurisdictions around the world require coverage from a licensed insurance carrier. Insurance covering employee benefits also requires a blend of risk transfer from captive and licensed commercial carriers, whereas coverage may be structured on a fronted and reinsured basis. In this case, the captive reinsures all or a portion of the benefit and uses a licensed commercial carrier to issue coverage, administer policies and pay claims on it’s policy paper.
Firms looking for ways to use excess cash may elect to reinsure their high-volume/high-severity risks through their captive entities via a reinsurance arrangement with a commercial carrier. Captive placement for products including employee medical, dental and disability have been proven to be economically efficient solutions for firms with the right data, modeling and risk-management practices in place. In this case, the captive owner elects to reinsure the risk through the captive entity, in partnership with a commercial carrier that will serve as a fronting carrier to issue policies on its paper. This partnership is bridged by the insurance-brokerage community, which in most cases also serves as the administrator and advisor of all things captive. The administrative function is broad with depth, as it includes the accounting functions, claims administration, documentation and marketing of fronted programs.
The growth of the captive market, and alternative risk solutions have transformed the manner in which financial markets and organizations view risk in general. Finance leaders are integrating new professions into their practices to deep-dive into insurance and risk practices to drive balance-sheet growth. The transition of risk from commercial to captive coverage also provides the commercial market with the capacity to provide innovative, cost-efficient insurance products for clients in need of coverage. As risk continues to evolve with velocity, there will come a day when autonomous vehicles and projects of the like are considered “affordable” and “traditional” risks and totally reasonable to self-insure through a captive or commercial carrier, which brings about a more intriguing question: How do risk markets prepare for what’s next?