Captive insurance companies have been around long enough that their benefits are understood and valued. In addition to helping stabilize insurance pricing and facilitating direct access to reinsurance markets, they also provide coverage otherwise unavailable and effectively empower their owners with direct control over risks, claims, cash flow and investment opportunities. But despite the longevity of many captive programs, they have not been bulletproof.

"Captives have been affected by the economic crisis," says Andrew Tunnicliffe, chief operating officer for Aon Global Risk Consulting and head of Aon Global Insurance Managers (AGIM). "Political, regulatory and financial uncertainty as a result of the downturn has directly affected issues such as insurance market pricing, retention levels, and capital and collateral requirements."

Capital and Collateral Requirements

In the insurance business, strains on capital and associated collateral requirements have proved challenging for captives. Parent companies previously dedicated capital to potential losses without requiring a significant hurdle rate. Now they’re eyeing capital and questioning if it might be lying unnecessarily idle in their captives and wondering if they should use those capital resources to either reduce debt or invest elsewhere in the business. For certain recession-hit sectors such as manufacturing or banking, having cash tied up in a captive balance sheet has been called into question, putting more onus on the risk manager to justify the makeup of the captive balance sheet.

This scenario is further complicated by the investment inflexibility of capital in certain domiciles, with restrictions on the types of assets that can be held and which ones are permissible for solvency purposes. Increasingly, this situation is a challenge to captive owners, who are finding their investment options more limited.

Captives are also experiencing increased demands for collateral. Fronting companies that want to maintain credit ratings are demanding increased security for reinsurance purposes and in some regions are looking to basic risk aggregate gap calculations rather than the outturn of projected losses.

Collateral requirements present other challenges, as parent companies do not want letters of credit to impact their borrowing ability in the credit crunch, nor do they want to tie up additional cash resources. A strong partner (like AGIM) can often help by negotiating the most reasonable and methodical approach to collateral requirements.

Just as companies are scrutinizing captives, they must likewise assess the potential exposures presented by their counterparties. In the past, captives that needed a significant level of reinsurance could rely comfortably on one or two partner reinsurers; today, they may look to spread this risk among a greater number of providers. Vigilance is required in monitoring the credit rating of these counterparties. A more rigorous approach is also needed in terms of long- tail risks as any losses may take years to settle.

Captive Insurance Regulatory Changes

There’s significant political and regulatory uncertainty on a global basis. In the United States, there’s speculation that the new federal administration will be more active in pursuing tax legislation that would potentially affect onshore U.S. insurance companies that cede business to offshore affiliated entities. The intent of the proposed legislation is to target traditional insurance companies. Captive insurance companies may be included, though there are considerable lobbying efforts to make sure that they’re not.

In Europe, Solvency II is expected to be in place by 2012. This regulation is likely to result in increased capital requirements for insurance companies and captives, a circumstance that would increase the cost of doing business in Europe. Many captive owners are investigating the implications of Solvency II in preparation for its introduction.