Virtual captives: an innovative risk solution in a post-pandemic world

The world has been irreversibly changed by the COVID-19 pandemic in many ways, including how risk is perceived and managed. To cope with these sweeping changes, insurance/risk management firms and their clients must be ready to innovate.

After a prolonged phase of softening with inadequate pricing levels, commercial insurance rates started increasing since 2018 across most market segments and regions. Whilst a number of factors, such as heavier-than-expected insurance losses, claims inflation and a persistent low interest rate environment, are behind the current market hardening, the COVID-19 pandemic has added to and accelerated this trend.

The pandemic has brought about additional strain on insurers’ financial performance, with an increase in the number of claims, mostly caused by event cancellations, business interruption and credit and surety claims. Over the past 12 to 18 months, we have seen several insurance markets exiting or severely reducing their appetite for certain classes of business and exposures. This has translated into price increases, reduced scope of coverage and limited capacity. Notable examples are liability with US exposures, D&O, certain construction classes and some property exposures, like bushfires or floods.

As a consequence of the unexpected severity of COVID-19, a general observation is that corporate risk managers are becoming both more alert and aware of risks. Many are revisiting their risk registers looking for gaps in cover and possible exposures they might have underestimated in the past.

New solutions gaining popularity

Risk managers have been increasingly turning to new solutions to manage current and emerging risks, and the pandemic has further solidified that trend.

Broadly speaking, the suite of solutions available to address the current challenges can be classified into three categories: (i) structured solutions that provide longer term certainty of price and capacity; (ii) flexible solutions that can fill the gaps in traditional insurance programs; and (iii) cost-efficient solutions to optimize self-insured retentions.

The first category includes multi-year solutions which provide guaranteed capacity over time, price stability and generally include pain share or gain share elements that allow the insured to participate in the performance of the insurance program.

One type of structured insurance solution that is gaining increased attention is the virtual captive proposal, allowing the insured to fund a larger part of their own exposures. It is essentially an insurance agreement emulating the benefits of a captive without formally setting one up.
Andre Martin, Head Innovative Risk Solutions, APAC Corporate Solutions

What are virtual captives and what value do they deliver?

Virtual captives are different from regular captive insurers in that virtual captives are not formal legal entities. Instead, a virtual captive is an agreement with an insurer that acts like a captive – emulating its cashflows and other benefits. It is a structured multi-year solution that allows the parent firm to fund part of its exposure via profit-sharing or additional premium features.

The main benefit of a virtual captive is that, being an insurance contract, it avoids the regulatory complexities, costs and procedures usually involved in setting up a new legal insurance entity. Therefore, it is a faster, simpler alternative for corporations to achieve the same goal of retaining or funding more of their own exposures.

Key considerations

Clearly identifying the problem and understanding the insured’s goals is critical as this may include longer term certainty in a volatile environment, filling protection gaps, or optimizing self-insured retentions. When contemplating captives or virtual captives, corporates must have the willingness and financial capacity to retain and fund part of their losses. As such, the solutions developed must be tailored to address the unique business challenges faced by corporates.

This article was first featured on Corporate Risk and Insurance on 3 Jun 2021.

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