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Using Captives to Insure Against Black Swan Events

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Until recently, a global pandemic was, in most people’s minds, little more than a compelling plot to blockbuster films and apocalyptic science-fiction stories. A disease drastically changing the way of life and business operations for people across the globe and inciting wide-spread fear, quarantines and stay-at-home regulations was unthinkable for most beyond the “prepper” community. Now, though, after weeks of lives overturned, hindsight is 20/20 (pun intended). Many business owners and executive teams now agree the threat was obvious. A black swan.

As popularized by finance professor and Wall Street trader Nassim Nicholas Taleb in relation to financial markets, the term “black swan” refers to a rare or low-probability event that deviates from what is normally expected but poses critical threat. The 2008 financial crisis, the 2001 Fukushima nuclear disaster, the 9/11 terrorist attack and the dot-com crash of 2000 are all considered black swan events. We can never know with specificity which particular black swan will come, but we can know with certainty that one eventually will. And, due to their severe consequences, we should therefore consider how to make sure our lives and businesses will be robust against them. 

Insurance for Black Swans

Third-party commercial insurance policies often include business interruption coverage. Business interruption insurance protects against losses sustained due to periods of suspended operation. With COVID-19, many businesses considered non-essential have been forced to close and numerous businesses that are still hanging on have experienced challenges to their revenue streams as a result of coronavirus restrictions. This is where this form of insurance comes into play. However, pandemics are not the only black swans that business interruption insurance would cover. It could also cover losses from unexpected events like natural disasters, cybersecurity attacks, terrorist attacks or fallout from climate change. Also, even if a business’s insurance policy does not cover pandemic disease through business interruption, it is possible that other policies might be triggered due to the chain reaction caused by the black swan, such as:

  • Supply Chain Interruption
  • Loss of Key Customer
  • Subcontractor Default
  • Property (e.g., loss of access to business premises due to quarantines)
  • Catastrophic Risks

However, third-party commercial insurance policies are not always enough. These policies are often riddled with exclusions that prevent coverage during the time it is most needed and can lead to a claim being denied. Commercial insurance for an asymmetrical threat like a black swan event can also be extremely costly or difficult to obtain. And in many cases, coverage is simply unavailable. For example, during the avian flu epidemic, many U.S. insurers added an exclusion to their policies, “Exclusion for Loss Due to Virus or Bacteria” (ISO form COP 01 40 07 06). Similarly, the insurance industry responded to SARS by adding exclusions to preclude coverage for losses triggered by business interruption.

Businesses need to review their insurance policies to identify gaps in coverage. Some may want to consider filling these gaps and strengthening their coverage by supplementing the third-party commercial insurance by pooling their risks in a captive insurance company.

Taking Black Swans Captive

A captive insurance company is a licensed insurance company that is usually owned by a related business or its owner. That company can then insure a wide variety of the related business’s risks—risks likely to be implicated in any black swan event such as supply chain interruption, loss of a key supplier or customer, subcontractor default, bankruptcy of certain counterparties, or losses from governmental actions like forced business suspension or quarantines.

Via reinsurance arrangements, the captive insurance company can then pool its risks with the risks of many unrelated business, usually including those in completely different industries. Some of those businesses and industries will no doubt be the beneficiaries of most any given black swan event.  

For example, some physician practices that specialize in elective surgeries have seen their revenues cut by half overnight due to states prohibiting such procedures in order to preserve medical equipment for use by those fighting COVID-19 on the front lines. But other medical practices have seen their revenues skyrocket as COVID-19 has spiked demand for their services. By risk pooling via a captive insurance company, the claims of those practices that are suffering will therefore be paid in part by those that are prospering. This loss-sharing will allow the former to stay in business and continue covering their costs (such as rent and salaries), thereby making the entire economy more robust. And next time around, the proverbial shoes may just be on the other feet. In some cases captive insurance companies may also receive very favorable tax treatment that also provides additional liquidity during times of crisis. 

Preparing for the Next Black Swan Event

The coronavirus has heightened awareness of the need for both risk management and strategic planning to prevent future crises from negatively impacting company financials and viability. Sadly, not all businesses will remain healthy and viable through this pandemic, and it is too late for those impacted by the coronavirus to insure those particular losses. But business owners and executives can take immediate steps now to prepare for the next black swan, whatever it may be and whenever it may come. 

Four Reasons To Stay The Course With Captives

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As the overall insurance market remains in a “soft” environment with rates generally decreasing, particularly in the workers compensation market, many captive participants might be questioning if now is the time to exit their captives and explore more traditional insurance options.

While this is an understandable response, one of the main reasons for creating your own or joining a group captive is a long-term commitment to a strategy of retaining risk in order to reduce costs over time.

Many companies historically turned to captives when insurance rates were high because they offered:

  • better control over claims handling and loss control efforts,
  • insulation from the cyclical swings and uncertainties of the commercial insurance marketplace, and
  • lower operating costs than conventional insurance models.

Additionally, there is a far greater return on loss-prevention and claim-mitigation investments. Though rates are currently dropping, here are four reasons why most business owners would still benefit from remaining with their captives.

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1. The Privileges Of Membership
Those companies that qualify are afforded benefits, including the possibility of reduced premiums and recouped savings over time. Keep in mind, one of the biggest drivers of value in being part of a captive means being insulated from future negative fluctuations in the market. Try not to lose sight of this, especially when rates drop and seem enticing.

2. No “Take Backs”
Leaving a captive can be costly, and reentry is not guaranteed. Companies considering the idea of leapfrogging from their captives while rates are low and then jumping back in when the rates increase may face hefty repercussions. This is particularly true for companies that are members of group captives, when it’s possible that other members of the captive may not accept them back, particularly if they were saddled with absorbing the exiting member’s share of losses.

3. Preparing For That Rainy Day
If you jump ship from your captive, you will most likely have lingering financial obligations if losses deteriorate for the whole group, and you could be on the hook for an assessment. By remaining a captive member, even if you are paying more in premium, you are adding money to cover a possible deficiency from prior years. If actual losses turn out to be better than projected, you can recoup—via dividends or reduced future premiums—a greater percentage of those savings than you could from traditional insurers.

4. Control Your Destiny
The market forces that are creating lower rates right now—such as decreasing medical costs or legislative changes that result in lower workers compensation costs—are also positively affecting captives. By staying with your captive, you can enjoy the upside of improvements in claims as your own losses go down, resulting in lower future costs and the possibility of recouping additional profits.

Overall, captives provide more control than traditional insurers through greater return on loss-prevention and claim-mitigation investments and through access to higher savings. Cheaper market rates can create an understandable knee-jerk reaction that may cause you to consider leaving your captive but remember your initial motives for joining. Captives are great alternatives to traditional insurer solutions, and staying the course will most likely work in your favor.

Marsh Tracks Top Captive Trends

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The number of captive insurers continues to increase globally, from 5,000 in 2006 to more than 7,000 in 2016. Once formed primarily by large companies, the captive market has opened up to mid-size and small businesses. The industry is also seeing a trend in companies forming more than one captive, using them for cyber, political risk and other exposures, according to a recent Marsh report, Captives at the Core: The Foundation of a Risk Financing Strategy.

Organizations are seeing disruptions in a number of areas and are relying more on their existing captives, Marsh said. Because of their flexibility, captives are also being used to respond to market cycles and organizational changes such as mergers and acquisitions.

While North America and Europe still dominate in numbers of captives, other regions have shown more interest in the past three years. In Latin America, captive formation increased 11% in 2016, the study found.

Within the United States, there is more competition among domiciles and some of the newer domiciles are experiencing growth. The top-growing U.S. domiciles in 2016 were Texas, Connecticut, Nevada, New Jersey, Tennessee, and New York. Domiciles outside the U.S. seeing the most growth include Sweden, Guernsey, Singapore, Malta, and the Cayman Islands.
As organizations’ exposures increase in number, complexity and severity, shareholder funds generated by captives are becoming more important. According to Marsh:

For many clients, captives are at the core of their risk management strategy, going beyond the financing of traditional property/casualty risks.

Specifically, we are seeing an increase in parent companies using captive shareholder funds to underwrite an influx of new and non-traditional risks, including cyber, supply chain, employee benefits, and terrorism, as well as to develop analytics associated with these risks and fund other risk management initiatives.

Risk management projects funded by captive shareholder funds in 2016 included initiatives to determine capital efficiency and optimal risk retention levels in the form of risk-finance optimization; quantify cyber business-interruption exposures; accelerate the closure of legacy claims; and improve workforce and fleet safety/loss control policies.

For example, Marsh-managed captives used to address cyber liability increased by 19% from 2015 to 2016. Since 2012, in fact, cyber liability programs in captives have skyrocketed 210%.
“We expect to see a continued increase, driven in part by companies that are already strong captive users and by those that may have difficulty insuring their professional liability risks,” Marsh said.

Aon Introduces Single-Parent Captive Cyber Insurance Program

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With cyberattack listed as one of their top risks, organizations are looking for ways to mitigate their risk in a market where cyber insurance rates are quickly rising. According to the Center for Strategic and International Studies, the annual cost of cyber crime and economic espionage to the world economy runs as high as 5 billion, or about 1% of global income.

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This does not include intangible damage to an organization, however. Companies are purchasing more insurance to cover the risk. In 2014, the report said, the insurance industry took in $2.5 billion in premiums on policies to protect companies from losses resulting from hacks.

As a result, captive insurers are being used more and more for coverage.

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Aon said it is addressing shortcomings in traditional cyber coverage with a cyber captive program with capacity of up to $400 million. Companies looking to form a captive would undergo a review to quantify their cyber exposures.

According to Peter Mullen, CEO of Aon Captive and Insurance Management, the program is designed to help clients understand their risk profile. “Once this is understood, they are is in a better position to make decisions about how much risk to retain in their captive and how much risk to transfer to the program,” Mullen said.
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 “The program allows captives to purchase coverage up to $400 million on a reinsurance or excess insurance basis.”

The cyber captive program will be domiciled in Bermuda and is available to single-parent captives. The basis for coverage will be “a very broad form which includes coverage for property damage and business interruption following a cyber event,” he added.

“Building a large tower of limits can be hampered by differing policy terms and conditions and dislocation of rates at different layers in a program,” Mullen said. “Additionally, many organizations facing cyber risks that can result in physical impacts, such as property damage and business interruption, agree that a more comprehensive approach to cyber risk is needed.

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