- Managing Director
Captives, for the last few years, have been set up for cost containment and that continues to be the case even in a soft market.
Charles has been a captive manager in Guernsey since 1994. Before this he was deputy insurance regulator in the Cayman Islands. This gives him the ability to view the captive market from both perspectives.
Alternative Risk Management – ARM – is an independent captive manager owned by management. We’ve been around as an independent manger for 10 years and have grown from a very small company to 33 staff and 150 clients, some of which are FTSE100. The majority of our clients I would class as mid-size UK corporates, and we have a smattering of clients from South Africa, Switzerland, America and France.
So our primary clients are mid-size UK corporates, ranging in turnover from £50 million to £250 million. Our primary source of business is the independent corporate broker, either from London or the regions. Typically our mid-size clients spend anything up to £2 million in premium a year – clearly some of that will go on reinsurance, so I’d say typical retentions in a captive or a cell for our mid-size clients is £1m a year.
In that regard we’re slightly different from our major broking competitors in Guernsey – their typical captives could be writing £5 to £10 million of premium in a year. That is the big difference. And I think probably we manage more protected cells rather than captives simply because of the profile of our clients.
Our clients underwrite nearly every class of business that you can imagine – predominately Material Damage, Business Interruption, Professional Indemnity, Employer Liability, Public Liability, Motor – although we write everything from Credit Insurance to Marine Cargo and Short Term Life.
Yes I think I have. Captives mostly for the last few years have been set up essentially for cost containment, “we’re paying all this premium, we think we manage our risk very well, why are we giving all this premium to the market and, by the way, if we take some risk can we have some control over the claims?” Cost containment for liability claims has been a big driver, and that continues to be the case even in a soft market.
Where we have noticed a difference, I would suggest in the last three years, is the use of captives for a profit. And that could either be a property owner or brokers themselves, who run very successful schemes but are up against maximum commission levels. They feel that the only way they can obtain more of the profit of what they are essentially underwriting for the market is to take some risk and put up capital.
So we’ve seen that as a trend, and I think that will probably become more of a trend looking into the mid-term, because as commission disclosures become inevitable in the market, some of these high commission structures will become untenable. The only way for the beneficiaries of those commissions to maintain some of that revenue will be to accept a risk-taking position. Of course, brokers have to disclose that they have an interest in the policy that is being advocated.
So yes, I do see a lot more of what I call the ‘profit side’ coming into cells and captives and indeed I would suspect that, for at least 10 per cent of our client base, profit is the primary motive.
Nearly every captive manager will say, “our problem in running a business is when you have a soft market it’s a lot harder sell to clients as opposed to a hard market – and we haven’t had a hard market for 10 years probably.” I have every sympathy with that view.
If the insurance market is stupid enough to offer rates where the burn is close to 100 percent or over, why would you self-insure? It doesn’t make sense. In those circumstances you have to hold your hands up and say, “don’t self insure, it makes more sense to go to the market.” So that has always been our problem. And, clearly, when you do feasibility studies, you have to be completely objective and professional, and if the client’s best interest is to stay with the market, then that’s what you recommend.
There are pockets of certain industries where the market is hard right now. To give you a couple of examples, waste recycling is quite big business now across the UK and there is certainly a propensity for fires within these waste recycling plants. They are becoming virtually uninsurable because there have been so many fires in these entities – it’s not a liability question, it’s a material damage question. I think the market is probably down to three insurers now. That’s a real, live issue for the owners of waste recycling plants.
I think the other really hard part of the market is self-drive hire. There has been an enormous increase in fraudulent claims, which of course goes on self-drive hire records until such time as you can disprove it or actually get it to court and win. And there again, not only are the rates going through the roof, new risks are virtually uninsurable.
So these are the sorts of areas that we can work with, alongside the independent brokers that we know, in trying to come up with a solution, albeit a very high deductable solution, but a solution nonetheless.
We are certainly seeing enquiries in both those fields. The other areas that we always see even in a softer market are ELPL type situations where you may be, for example, a retailer with a big exposure to the public or a business with a large manual workforce where there is a propensity for more claims, not withstanding good risk management.
The frustration that some of the clients have is that they pay their premiums over but they have no input into the claim. They know for a fact that some people are trying it on – for example, someone hasn’t had a holiday for a while so they might decide to put in a claim for a bad back. And what was, until last year, claims managers knocking on doors of various entities that may have exposures, for example, to noise induced hearing loss have brought notifications up to very high levels.
So those particular areas where there is propensity for egging on the claim and pushing up the cost of the claim are areas where particular clients are very keen to have an input into the claim process.
Guernsey has a firm but fair regulatory regime. Certainly some of the things are done very well here, we have a very responsive regulatory team – and, dare I say it, very knowledgeable.
One of the issues Guernsey’s faced is Solvency II and what were we going to do. You’re probably aware that there was a lot of lobbying that went on from the industry to the regulators and ultimately the politicians here. I firmly believe if Guernsey introduced Solvency II it would be a disaster.
I think in a pragmatic way, the regulators here have come up with a ‘Solvency II-light ’; when it’s implemented it will move towards a risk-based capital model. But rather than foist on us forty or fifty pages of new modelling, it seems to have gone about it in a very pragmatic way. So it’s definitely risk based and it definitely takes into account the various risk factors that any insurance company – captive or otherwise – faces.
We’ve run a lot of modelling on our clients and it’s generally come up with what you’d expect. Captives that are fully funded have a very low capital requirement, whereas those that are writing direct business have a much higher one. So whilst one can always argue about the percentages that the regulators ask us to put toward various risk scenarios, I think by and large they’ve got it right, and I think that kind of regime with that kind of pragmatism will do Guernsey good in the future.
It has inevitably for ARM put some pressure on our management teams. Pre 2008 when you were getting a 5% return, let’s just say you had reserves of a million pounds, that return was coming in at £50,000 a year, and of course that paid for the running cost of the captive. Now you’re down to less than half of one percent, that return has disappeared and there’s more focus on the cost of running a captive – and that’s the right business reaction.
It means fees are more under pressure and getting fee increases is harder. I think the surprising thing is, speaking with reference to my client base, they still seem to be wedded to having cash assets. We have very few clients that have moved even to a money market fund, let alone a gilt fund.
Some of that is the influence of the non-exec directors who feel, probably quite rightly, “we’re taking underwriting risk. Do we want to take investment risk as well?” I think the other side is the inherent conservativeness of the board members, “we could have a claim up to our maximum retention at any point in time – we need to be liquid rather than semi liquid.” It does surprise me that more of our captives in particular don’t look at spreading their assets into other asset classes.
Yes. Class 1 is cash and near cash, class 2 in things like equities on a recognised stock exchange, gilts, bonds that have A or AA.
I think the new solvency regulations that will begin in perhaps a year or a year-and-a-half’s time will give a lot more emphasis to the quality of the assets and will risk-weight various assets in a more emphatic way the lower down you go quality wise
8) Is it the case that, because of the size and nature of your clients, there is less tendency to push back the money into large treasury operations?
Yes, I would say they don’t. To the FTSE clients we have, loaning money back to treasury makes a lot of sense and several of them do that. With our mid-size clients, the tendency is to keep the cash here and keep it for rainy day. Of course doing that probably helps them now fiscally or tax wise – not that there has ever been a reason, in my opinion, to set up a captive or a cell for tax – but given the recent changes in CFC rules, I think some of our clients now see a bit of icing on cake that they’ve never seen before.
There are two things.
One. I’m a great fan of Guernsey PLC – we’re part of it. I know there are a couple of managers here that are doing good things with Insurance Linked Securities. I think that’s fantastic for Guernsey. There is that angle and I’m very pleased to see those managers prosper.
We, on one particular client, are doing something similar but not quite the same where we’re getting cash-backed reinsurance agreements – with a group of investors behind that cash. It’s not ILS per se but it’s similar, and it’s quite exciting for us.
We are seeing more of a trend towards brokers themselves owning protected cell companies, so that where they’ve got a larger client base, they can actually recommend to clients that they go into their own wholly-owned protected cell company. We will manage the process and be the manager, but for that particular broker it maintains the USP of the broker and maintains their name and brand. I think we will see some of the bigger brokers set up their own protected cell companies to offer that service to their larger corporate clients.
The other development is the Security Trust Agreement which Barclays has developed in Guernsey. This is an alternative to a letter of credit and has positive benefits for clients. When a captive or cell has to put up a letter of credit to a “front” company they will put cash in blocked account to secure it. However they also have to pay claims as they fall due. This gives the captive or cell a cash flow squeeze.
With a Security Trust Agreement how it works is that the captive or cell settles funds into the trust for the benefit of the front company. The front company normally has a Letter of Credit, if the captive doesn’t pay its claims, it will call down the Letter of Credit – end of the story. With a Security Trust Agreement, the front company agrees to be the beneficiary of this trust, the funds are settled by the captive, up to the aggregate amount of risk that it’s taken, and then as claims are presented during the year to be paid, the trustee settles those claims directly to the front company out of the monies in the trust.
So let’s just say your aggregate was £1 million in any one year and during the year the captive/cell has to pay £300,000 claims. Under the Letter of Credit scenario, you’d have a Letter of Credit worth £1million, tying up £1million of cash, so you’ve got to find money to pay £300,000 worth of claims as they fall due. Under the trust arrangement, because the front is covered in its entirety for its £1million aggregate from the captive, the front company is happy to know the money is there and therefore the claims can be paid from the trust bank account to themselves. So it’s a way to prevent the client having to find extra money to pay claims, albeit it’s already provided funds for a Letter of Credit up to the aggregate.
I’m pleased to see that the Security Trust Agreement is gaining ground and that there are a number of front insurers that will now accept it.
Only Barclays are promoting STAs in Guernsey as far as I am aware. One of our largest clients have worked very closely with Barclays over the last year, there’s been a lot of time and effort spent on both sides and I know the client is very happy with the outcome of this Security Trust Agreement and what was put together.
As captive managers we must be aware and actually promote the very best cutting-edge tools to cut costs for our clients and make the whole process more efficient.
We’ve been fairly overwhelmed with new business enquiries over the last two to three months. I think part of it is down to economy turning a corner, a lot of people who may have heard of captives or cells just said, “look, we haven’t got the funds to invest in it, let’s park it.” And as their fortunes revive, so these potential plans come out.
Another reason is, a lot of brokers are far more aware now of captives and protected cells, and they want to introduce the concept to clients so they can make an informed choice. Even if it’s not right for them now in a soft market, who knows where the market will be in two or three years’ time. And the broker has then done their job. It might not be right for the client now for a whole host of reasons, it might be right in the future or it might never be right – but they’ve done their job. And for some of the brokers that we know, going in with a fresh idea to an account that they want to attack will often give them the chance to get their foot through the door – and hopefully get them a new account in time.
So a lot of my time is spent going around with brokers, seeing current clients and explaining how it’s done, or seeing potential new clients and saying, “if your current broker hasn’t talked to you about this, perhaps now is the time to talk about it.”
I am very rosy about the future because I think the level of new enquiries has been almost unprecedented. Of course, in our business, you only ever convert 10 to 20 percent of your enquiries, but I do think that’s very encouraging and I’d like to think that some of my competitors here are having the same sort of thing happening to them.
We have looked at it and we have some knowledge, we have a close relationship with one of the advisers to the cyber market. I think there are three issues.
One, at this point in time – it may be changing – but it’s still cheap as chips to buy the cover.
Secondly, one of the issues is to penetrate the market. When you make that suggestion to a risk manager or finance director, the first thing they do is call in their IT director. The IT director will say, “we don’t need it, our firewalls are as safe as you can get – why waste your money?” It’s a defensive move – human nature, I think.
The third area, on bigger clients if you genuinely have a very bad breach, your exposure could run into the scores of millions. There’s a new European Union directive coming that will dramatically increase the costs of cyber breaches to redress third parties. At this time, there are plenty of insurers that write cyber but the actual capacity they have is limited. You could get a £1million, £2million, £5million, maybe a £10million policy, but what if you need a £50million policy? It’s very difficult to get the capacity at the moment.
So the market has got to take a real knock, then the rates will shoot up. Those knocks are coming, it’s question of when. When it happens and rates start to go through the roof, or very large deductibles start to be imposed, that’s when you’ll see cyber liability taking off and hopefully going into protected cells or current clients’ captive programmes.
Not groups of companies. We’ve been involved with some housing associations – the problem is that most of those go out under EU tender, and the timeframe to get quotes, particularly from the reinsurance market, on a large housing association is completely unrealistic. So whereas we may have a very good proposition, unless you can get the reinsurance market to give you a quote within the time that is stipulated, it is very difficult.
We are also seeing other quasi public sector corporations come in and look in particular at protected cells. I do see public sector as being the next logical choice to look at cell insurance.
Grouping together is a very good idea if you’re in the ‘profit centre’ part of the captive scenario. It makes sense to band together because your loss ratios are very stable – if you’ve got a big enough population, you can virtually guarantee what your loss ratios are going to be. Therefore by coming together in some type of captive or mutual you are going to minimise the costs and maximise the profit.
Where your issue is cost saving, so, “I’ve got a lot of claims and I’m paying an appropriate premium”, it’s very difficult for companies – particularly competitors – to come together and share their claims in one entity. Simply because, if a competitor has a massive claim, they’re going to take some of your premium to pay their claim. Companies might not be prepared to do that for their competitors.
For companies in the same industry, the PCC structure is perhaps a more logical way to go – providing they’re of the size to warrant it. So each company has their own protected cell, it’s ring-fenced, and in that regard you may get the benefit of group purchasing power for a reinsurance programme. But each protected cell will take its own primary layer risk and sink of swim with that particular primary layer.
There is definitely a move towards profit centre. Until the market hardens in most areas, the cost-saving model is there, but it is far more difficult because, if the client’s been broked properly in a soft market, your burning costs are going to be somewhere near or just below Gross Premium Income. So what’s the point?
Whereas the profit motive – we all work to a profit motive. Extended warranties is a profit motive and worth looking at, property owners where their commissions are coming under scrutiny, they’re going to have to look at captives and cells – retaining the profit that they used to have, albeit they’ve got to take risk to do that. Also brokers with very successful schemes where they are on maximum commissions. Some of these schemes even after commissions run at 50 percent loss ratio, so they’re thinking, “I do all the work, I bring in all the clients – can I take some of the risk and get some of the reward?”
So yes, I do see a move towards profit, but the cost containment will come into its own as rates harden.