Optimizing risk: The value of captives and virtual captives in the LatAm market

Risk management has rapidly risen to the forefront of company priorities – thanks to the current economic instability and the ever-changing nature of the insurance industry

Businesses must now focus on two main goals: creating an optimal insurance plan with the best cost-benefit balance and customising their risk management investments to fit their specific exposures. This involves considering factors such as retained risk levels, the likelihood and impact of losses, and capital costs.

Companies using equity capital for risk financing must weigh the opportunity costs against expected returns in the capital markets or new business ventures. The preferred level of retention depends significantly on whether the company operates domestically or globally.

In this environment, organizations choosing a centralized risk management approach can leverage alternative risk transfer options, referred to as captives or virtual captives, to generate direct returns from their risk management activities. By partnering with insurers to share risk, companies can streamline the costs tied to risk financing throughout the insurance cycle, aiming to enhance risk quality and create mutual advantages for both the organization and its insurer.

In essence, a captive is an insurance or reinsurance company created by a parent company to manage its own risks. A virtual captive, on the other hand, functions similarly and efficiently. It involves a multi-year contract with an insurer or reinsurer, replicating the financial framework of a captive without requiring the entire setup process.

A virtual captive allows a company to outsource the setup and admin tasks, making it ideal for medium-sized businesses. They can essentially "rent" the insurer's infrastructure, accessing alternative risk transfer solutions without creating their own captive from the ground up.

These alternative risk transfer tools give risk managers the ability to handle a broader range of risks, helping to protect and increase the company’s value while making the entire risk transfer process more efficient. As a result:

• Loss prevention becomes a key focus for local subsidiaries since the parent company is directly involved in covering those losses.
• The company gains direct access to the reinsurance markets.
• Risk managers can capitalize on arbitrage opportunities, benefiting from favorable pricing, terms and capacity.
• Profits generated through the captive can be distributed as dividends to the parent company or reinvested. This can be used to boost underwriting limits or even diversify the business, such as offering B2C products to their own clients, strengthening the company’s self-financing capabilities.

There are several ways in which captives can be deployed.

An emerging market trend is the "gross reinsurance cession" structure, where a substantial portion of the program is ceded into the captive, the captive retains a portion of the risk and transfers the remainder to the international reinsurance market via retrocession.

Alternatively, “net reinsurance cession” structures only cede the part which shall be retained by the captive into the captive. In this case, the captive typically agrees with the fronting insurer on a set “maximum liability” for the contract’s duration, also known as the aggregate. The remainder of risk then either remains with the fronting insurer or is ceded by the fronting insurer to the reinsurance market.

In either case, a solid organizational structure is key to making these strategies work effectively. Indeed, it’s essential that the insurer maintains a well-organized and highly efficient operation. This means ensuring a continuous, transparent flow of data – covering both premiums and losses – while also carefully managing local programs, reinsurance and retrocession. It is particularly important to properly assess the risks a company is exposed to and analyse the solvency and cashflow position of the captive.

A key benefit of captives for companies operating in the Latin American market is their capacity to engage with reinsurers beyond the region, granting them access to markets in the U.S., Europe, and Asia. Particularly, this allows LatAm companies to capitalize on international market arbitrage opportunities, which come in three distinct types:

#1 – Price arbitrage
Price arbitrage involves taking advantage of price differences by purchasing the same coverage across both insurance and reinsurance markets at varying costs. Here, captives play a crucial role in reducing expenses by reinsuring coverage in markets with lower premiums. This is particularly relevant in excess layers where reinsurers typically operate with lower expense ratios compared to traditional insurers.

#2 – Capacity arbitrage
Capacity arbitrage involves leveraging discrepancies in available insurance capacity between primary insurance and reinsurance markets to secure better coverage. Captives enable companies to access higher limits from reinsurers, who often have a greater appetite for excess layers. This is particularly advantageous for industries such as manufacturing, energy and mining, where large coverage limits are essential yet challenging to obtain in the primary market.

#3 – Conditions arbitrage
Conditions arbitrage refers to how captives exploit differences in policy terms between traditional insurers and reinsurance markets, enabling companies to customize coverage that is often unavailable in the primary market. By utilizing captives, companies can craft policies with broader, tailored coverage that addresses gaps left by standard exclusions in traditional insurance.

These three arbitrage strategies—price, capacity, and conditions—can help captive owners optimize coverage, cut costs, and manage risks better. However, captives must weigh these benefits against the increased risk exposure, especially regarding credit risk and the capital needed for retained risks. With proper support, a thorough cost-benefit analysis is achievable.

Contact Swiss Re today to find the best options for your business, region, and industry.