Captives for BI

A Narrow Slice

Using captives for business interruption coverage is still rare but interest is growing.
By: | August 3, 2015

Business interruption is one of the most complicated exposures that companies face. And it takes so many faces: Does it cover supply chain interruption? Is it due to political upheaval, or a cyber event?

When it’s part of a standard property policy, business interruption coverage requires a physical event, like a fire or earthquake, to trigger coverage. When business interruption coverage is placed in a captive, however, the terms and conditions can be specialized to each individual organization.

If an organization wants business interruption coverage without the need for it to be triggered by a physical event, or if it wants coverage to begin immediately instead of dealing with a waiting period, a captive allows the organization to do so.

Experts believe, though, that globalization and supply chain risks amidst a world in upheaval may increase attention to the potential benefits.

But that doesn’t mean that it’s a popular way to transfer the risk. BI coverage is only a narrow slice of the captive market at this point. Experts believe, though, that globalization and supply chain risks amidst a world in upheaval may increase attention to the potential benefits.

“We do see it, but it’s rare,” said Ellen Charnley, managing director, and global sales and marketing leader of Marsh’s captive solutions practice.

“That doesn’t necessarily mean it will always be the case, but it’s not common to date.”

Charnley said that of the more than 1,250 captives in a recent Marsh benchmarking report, the brokerage has “literally a handful of clients” that write supply chain or business interruption risk in their captive.

One company that does see the value, said Darren Caesar, senior executive vice president and chief commercial lines officer at HUB International, is a large telecom client.

The telecom, which has a large number of offsite facilities, uses the captive to insure up to the first million in BI coverage, as well as excess coverage. It took the step when underwriters were unreceptive to covering the exposure, he said.

“In my experience and my colleagues’, we’ve only seen that captive used for business income and business interruption loss,” said Caesar.

In most cases, he said, business interruption coverage is “either a super-high exposure or it’s very low, and therefore, it’s not really germane to a captive,” he said.

An Unpredictable World

The sticking point for many organizations is that business interruption is unpredictable, hard to calculate and difficult to price.

For multinational organizations, though, it’s an unpredictable world. Of the top 10 global risks cited by the World Economic Forum for 2015, three of the top four most likely risks were related to geopolitical instability: interstate conflict, failure of national governance, and state collapse or crisis. The other, ranked No. 2, was extreme weather events.

Protecting against political violence is not a traditional use of captives, but interest is growing, said David Anderson, senior vice president, director, global business development credit, and political risk, Zurich.

“I think multinational firms are clearly more worried about the world than in the past.” — David Anderson, senior vice president, director, global business development credit, and political risk, Zurich

“Few do it, but there are a lot more who want to talk about it,” he said, noting that events in Ukraine, North Africa, Latin America and the Middle East have sparked concern.

“I think multinational firms are clearly more worried about the world than in the past,” he said.

“Obtaining political risk coverage in places like Ukraine can be difficult. There is some capacity available for certain projects in high risk areas, but it can be challenging,” Anderson said.

“Using captives for these types of exposures and partnering with insurers on the broader portfolio, customers can efficiently achieve prudent risk management.”

Strategic Planning

A company’s risk transfer strategy, said Charnley, depends on how sensitive the organization’s balance sheet is.

“If the loss is easily absorbed, I don’t see the need to fund into a captive. If the exposure is significant, I do think there is value to funding this over time, to smooth the volatility over time.”

It also adds visibility for senior leadership of the risks that are retained by the organization, she said. A captive can also assist a corporation which has multiple business units by providing specific coverage to match each unit’s risk appetite.

One difficulty in planning for a captive, she said, is that companies really can’t use historic losses to determine this risk. The exposure is “too volatile.”

Captives should always be thought of as a long-term strategy, said Steven Bauman, senior vice president, head of capital services, Zurich global corporate North America.

Generally, he said, companies “have to plan strategically to grow into the risk. They should start slowly and step up the risk; take up more risk each year and build up. You wouldn’t want to expose your captive in a first year scenario to a fairly significant business interruption loss.”

“You wouldn’t want to expose your captive in a first year scenario to a fairly significant business interruption loss.” — Steven Bauman, senior vice president, head of capital services, Zurich global corporate North America.

Once the captive is making an underwriting profit and investment income, and has built up its capital, it can afford to take on more risk in their captives around different lines of business, he said.

He also suggested partnering with insurers or other risk-bearing entities to cover some of the risks, since they are low frequency/high severity exposures.

“It comes down to the potential volatility,” he said. “Doing it with a captive means finding capacity to share the risk.”

Jeffrey Kenneson, senior vice president, business development, R&Q QuestManagement Services Ltd., said his firm has a sponsored captive that covers business interruption losses, with some members “paying multiple millions of dollars” for the coverage.

The mostly U.S.-based captive members run the gamut from law firms, a motorcycle manufacturer and a movie studio to a pharmaceutical company, architectural firm and fitness center, among others.

Instead of general business interruption coverage in smaller captives, what he has seen is BI coverage that has “morphed into some other coverages that you see more frequently,” such as loss of key vendor or loss of key employee.

Regardless of coverage, however, there must be a legitimate insurance risk, as opposed to a general business risk, he said.

For example, if a key vendor is unable to do business with an insured due to a factory fire, that would be a covered risk. If the vendor simply decides to break ties with the insured, such a loss would not be considered insurable, he said.

For the largest P&C captives, he said, he has not seen a great deal of interest in using captives for business interruption. “That’s a very narrow topic,” Kenneson said.

Risk Management Benefits

One of the ways a captive can help organizations is through the focus on resiliency and risk management, said Hart Brown, vice president and practice leader, organizational resilience, HUB International.

Hart Brown, vice president,practice leader, organizational resilience, HUB International

Hart Brown, vice president,practice leader, organizational resilience, HUB International

Because coverage in captives can be tailored to an organization’s specific needs, it helps better control costs and offers more control over risks.

He noted that risk management conversations related to building in operational redundancy and financial resilience tend to take place more often when captives are involved.

“When a captive comes into play, the company can write policies very specific to what the company needs in that time of crisis. … Claims can be very straightforward. We can reduce a lot of those challenges about how to recoup some of those financial issues that are lost and continue to be lost,” Brown said.

“You can pretty much write whatever you want in it,” Marsh’s Charnley agreed.
“That’s the beauty of a captive.”

The only caveats are that the captive must gain approval of the domicile regulator and the IRS.

“I do anticipate growth in the next few years in this style of risk,” she said.

“Not business interruption on its own, but among the bucket of trade credit risk, cyber risk [and] ERM risk. … Larger organizations seem keen to retain more risk these days.”

The first step to considering whether a captive should be formed for BI coverage, or whether such coverage should be added to an existing captive, is to identify the exposure and determine whether it could be mitigated by other means, such as through contracts or better vendor management, said Caesar of HUB International.

Then, companies must quantify the cost of the risk transfer and determine whether it makes sense to fund all or part of the exposure through a captive.

That’s not an easy task because of the unpredictability, since you need “some level of statistical probability you can work with in managing your own capital,” Brown said.

He also noted that business interruption coverage does not have “a very high acceptance within the market,” even without the use of captives entering the conversation.

Why? “I think it’s how companies prioritize their risk. Some are not able to look at the risk to prioritize and address the financial impact,” he said.

“It’s a difficult conversation to have unless they can get an assessment done and get a real sense of the financial impacts and decide which risks to retain and which not to retain.

“Because we know that the coverage is complex for business interruption and business income,” Caesar said, “the captive can be a very beneficial mechanism to transfer that risk. It can be very broad versus what you would get in the marketplace.”

Still, with pricing so soft in the insurance marketplace, and more insurer flexibility on terms and conditions because of that, it may be cheaper and easier to purchase insurance on the open market instead of forming a captive, or adding the line to an existing captive.

“If you could obtain large limit coverage in the open market for a very low price,” Kenneson said, “it wouldn’t make sense to put this through your captive. If you own your own captive, you are putting the captive’s equity at risk, and if you can get large limits in the open market at a very low premium, why take the risk yourself?”

The late Anne Freedman is former managing editor of Risk & Insurance. Comments or questions about this article can be addressed to [email protected].