When premium prices skyrocket in a hard market, business entities often seek reprieve from alternative risk transfer. This allows entities to insure more of their deductibles. They could do this through self-insurance (keep more deductibles), by joining a risk retention group where they pool premiums with similar entities to cover specific risks, or by setting up a captive insurance company. Hard markets tend to increase the appeal of captives in particular.
“I think we can all agree that we are in the middle of one of the worst hard markets in history,” said Jim Swanke, senior director and risk management consultant at Willis Towers Watson. 'You have to go all the way back to 1985-6 to find an equally bad time. I think today's hard market is the worst because of its duration; it seems to go on and on, and it is clear to me that we are likely to experience at least another 12 to 18 months of harsh market conditions. "
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Within WTW, Swanke acts as a trusted advisor to executives and WTW clients in the field of insurance and captive programs. He is also chairman of two inmates in Vermont, USA, and is a lecturer on captive insurance at the University of Wisconsin – Madison, USA. He recently delivered a talk at RIMS Live 2021 entitled "Breaking the hard insurance market with an optimized captive" in which he debunked the topic of captive enhancement.
“Fortunately, we have captives as an instrument to break through the tough market conditions. We used prisoners in the mid-1980s and we use them today, ”said Swanke. “Organizations without captives go through processes to determine whether or not a captive can isolate them from the harsh market conditions, and whether or not captives are feasible. Meanwhile, organizations with inmates are undergoing repeatability studies to determine if they should do anything more. "
The conundrum faced by captive owners is figuring out which levers to push and pull to optimize their captive's position, according to Swanke. Those levers include increasing the captive risk assumption, adding or subtracting captive coverages, rethinking their captive investment policies, and figuring out the best forms of reinsurance confirmation – especially if the captive is used as a platform to access reinsurance.
"Looking at all of these levers alone and in combination makes it difficult to optimize a captive," he said. “One of the limitations to be aware of is that organizations today are not inundated with cash, and so there are many organizations that are hesitant to put more capital into their captive. Knowing what capital is available and what else can be added to a captive serves as a limitation.
“Finally, in a tough market, we all know that tight timescales complicate decision-making. It looks like our insurance quotes are coming at the eleventh hour and so we have little time to look at all the levers we can push and pull to optimize the captive. "
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Swanke suggests simplifying the captive optimization approach. He encourages captive owners to manage the risks in their captives with the same mindset as they do in their own investment portfolios. For example, it is well known that adding uncorrelated risk to an investment portfolio reduces volatility and allows for optimization of results. According to Swanke, this practice also creates an efficient boundary of risk versus return to guide investment decisions.
“Risks in a captive can be managed in the same way as each of the captive risks depends on whether it has correlations with other captive risks, much the same as investing in an investment portfolio "he added. “The most important thing to understand is that you really need to look at how captive risks interact. It's the secret to both optimizing internal results regardless of market conditions and creating the efficient boundary of "cost of risk" versus "residual risk" to guide your captive decision making. & # 39; & # 39;
In today's harsh market, unlike the similar situation in the mid-1980s, captive owners have access to software solutions and financial models to help them analyze the different combinations of levers and when to push and pull them. Swanke suggests compiling a matrix of the different captive risks to clearly see how they are correlated with each other because, he emphasized, it is critical to understand the diversification benefit of uncorrelated risk & # 39; Recognize and understand and how they affect capital adequacy. .
"By focusing on the interaction of risks and understanding the diversification benefits, the decision can be made about which levers to push and pull to achieve captive optimization during difficult market conditions," he said. "What we recommend to our clients is that they build financial models ahead of time to try to understand how captive risks interact to evaluate alternative structures, including changes in captive risk assumption." s, adding / subtracting coverages, changes to reinsurance attachment points while understanding the impact on equity and surplus.
“Fortunately, today we have software technology that we didn't have in the mid-80s. That software technology enables real-time decision making, allowing for last-minute quotes from insurers. So you can get this software technology, you can. load all your losses in advance, your exposure units, your trend factors and so on, so that when those prices come in at the last minute, you can put that in the software and look at multiple portfolios that can be evaluated simultaneously – and makes for better decision-making. "