Capturing the benefits of captive insurers
Some years ago, many international companies would have been content in the knowledge that certain types of employee benefits were provided by their subsidiaries and perhaps that the financing of those benefits was sound. There have been a number of changes to the way in which organisations view the world, which have perhaps led to the development of more integrated structures. In our view, the principal drivers behind this seachange in attitude are risk and cost.
Concerns about the control of risk have led to increased co-ordination or indeed control, of benefit programmes around the world. The use of a reduced number of providers of insurance and investment services is a natural consequence of such increased interest in risk mitigation.
The other increased focus of today’s business world has been the drive to lower costs. Whilst the use of a reduced number of providers around the world may lower risk, it is unlikely to reduce cost without some changes.
Multinational pooling has been with us for some years and there are clear benefits to both a sponsoring employer and an insurance network. In particular, a pool will help an organisation understand its risks and will hopefully reduce costs in terms of pooling dividends. Some commentators refer to it as the last remaining free lunch in benefits.
The purpose of this article is, however, not to reflect on the past but to consider increased opportunities for companies to reduce costs, many of which are already possible.
The next obvious step is what might be called reinsurance to captive. This has actually been available for some years through certain networks and a number of companies have shown that such an approach can provide significant cost savings over and above conventional pooling.
Whilst the technical aspects may differ from case to case, the general principle is such that instead of local insurers retaining a significant proportion of the risk and reinsuring the rest to a reinsurer, they reinsure part or all of the risk to an insurance company owned by the sponsoring employer.
The extent of the risk transferred can be agreed upon by the parties and the extreme would be where effectively the local insurance company becomes a front for the captive, providing administrative services in terms of collection of premiums and payment of claims.
From the employer’s perspective, it now retains 100% of the profit from insurances after administration costs, although of course is exposed (albeit indirectly through the captive insurer) to 100% of losses. Stop loss insurance might mitigate possible losses to an extent. Clearly, such a step needs to be taken only after careful consideration of the risk profile of the workforce worldwide and a concerted effort at risk reduction and control from within.
Other advantages could be that the sponsoring employer is fully in control of what may amount to substantial reserves and also in the underwriting process which could be relaxed beyond that offered by a multinational pool. However, many multinational pools do offer virtually full control of reserves and underwriting conditions can be very relaxed.
Furthermore, as a pool gets bigger and premiums become more experienced rated insurers’ profits are squeezed in any event. Consequently, the real advantages of such an approach should be investigated fully, in that for many employers the extra cost savings in terms of reduced profits to an insurer may not be worth the extra effort of running a captive for life business. Clearly, the existence of a captive offering general business may sway the decision.
In implementing such an approach, some of the difficulties that companies have faced over the years in trying to implement a pooling arrangement remain and indeed others surface.
“What’s in it for me?”, is a commonly asked question. Under a pooling arrangement it is possible to repatriate some of the multinational dividend to local operations to encourage them to join the pool. Other aspects such as relaxed underwriting and potentially more leverage over the insurer to provide higher service levels can also be used as incentives.
Under reinsurance to captive route however, there is no multinational dividend to encourage participation, unless somehow profits from the captive are channelled back to local operations. However, it is possible to provide premium discounts up front. If, for example, a 5% reduction in overall premiums is anticipated, then this can immediately be passed on to the local operations by a discount of 5% on the premiums that they might otherwise be asked to pay.
There may also be tax advantages in setting premiums at certain levels. Careful management however is required if the captive starts to lose money and therefore requires an increase to the premiums being charged. This might be acceptable if the premiums only need to be increased to a point lower than the current market, but if premiums need to be increased beyond this level, then certain subsidiaries may wish to drop out of the arrangement and insure locally again. Inevitably, the companies who would wish to do this are those contributing more to the captive’s profits and a downward spiral could ensue. This whole process therefore needs considerable management.
Within the confines of Europe, the issue of whether this relatively convoluted arrangement is required arises. Armed with the statutes under the Third Life Directive, surely it would be possible for a European-based captive to sell risk products directly to associated companies in Europe?
The one hesitation in this area is clearly in relation to administration. Under the arrangement I have described above, the insurer plays an extremely valuable role as the collector of premiums and processor of claims. If we are selling risk benefits across borders who will fulfil this role? It might simply be the captive itself, if we are talking about simple products, although even for such products the additional amount of administrative capabilities that a captive may require over and above that usually needed will be quite significant. However, for an organisation of sufficient size within Europe, these additional costs may ultimately generate further cost savings.
We have by and large been discussing the financing of risk benefits. To a degree this concept could be extended to savings type contracts. Surely it would be possible to set up a captive insurer which then sells pension products to associated companies, either directly using the Third Life Directive in Europe or through a reinsurance type arrangement as described above? In this case there may well be significant advantages, especially in terms of control of assets that make this an attractive proposition.
Whilst multinational pooling can offer cost savings and indeed other benefits, companies operating captive insurers may see additional advantages in reinsuring some of their employee benefit coverages to that captive. However, we believe that careful investigation into the real benefits of such an approach should be made, including the retention of potentially higher risks and it is possible that an existing pool could reap many of the benefits.
Simon Gilliat is a senior principal with Watson Wyatt