Virtual captives: Versatile structures for a new era of risk

In today's uncertain environment, risk professionals face a growing array of complex risks. Geopolitical tensions, business interruptions, cyber incidents, and climate change are frequently cited as top risk concerns. At the time of writing, we've just seen typhoons Shanshan, Yagi, and Bebinca wreak havoc across APAC, serving as a stark reminder of the human and economic impacts of natural catastrophes.

As risks become more volatile and interconnected, businesses are also seeing an accelerated shift from tangible to intangible assets in their balance sheet, prompting risk managers to re-evaluate the fundamental structure of their insurance programmes and assess if these remain fit for purpose. One type of instruments that stands out in future-proofing corporate insurance programmes is a captive or a captive-like structure.

A traditional captive's main objective is to optimise a corporate's retentions by partially or fully self-insuring its parent's risk. It makes sense particularly if the corporate expects lower loss activity than implied by the commercial market premium, or if there is limited capacity for certain types of risks.

Although APAC's captive insurance market remains in its nascent development, we have observed growing sentiment and inclination towards captive structures as businesses seek to optimise their risk management efficiency and/or expand scope of cover for complex and emerging risks.

Establishing and running a captive, however, is no small task. Its complexity can take a toll on the organisation while the initial capital injection in the captive may weigh on the corporate's overall financial flexibility.

This is where virtual captives or partially funded insurance solutions come into play.

A virtual captive is not a legal entity, but a contractual insurance agreement that emulates the benefits and mechanisms of a captive. One key benefit is its ease and speed of implementation. Compared to a traditional single parent captive or a Protected Cell Captive (PCC), a virtual captive allows corporations and public sector entities to fund part of their exposure at significantly lower costs, without legal and regulatory complexities.

In the context of a multinational corporation, the parent company can fund its exposure through a virtual captive without subjecting individual operating business units to higher deductibles or cover exclusions.

Exiting a virtual captive is just as convenient as it is to implement it. The agreement expires like any other insurance contract and does not require any additional run-off solutions or portfolio transfers.

At Swiss Re Corporate Solutions, virtual captives are insurance contracts where clients fund part of their exposure via insurance premiums. This funding can be pre-loss, post-loss, or a combination of both. When losses are lower than expected, funds are returned to the insureds by way of Claims Experience Return mechanisms (or Low Claims Bonus). If losses exceed the initial expectation, additional funds are to be provided to the virtual captive carrier via Claims Experience Surcharge features (or additional premium).

Over the past few years, we have helped corporations and public sector entities in various industries to derive value from virtual captives and reduce the total cost of risk. These applications are across all industry sectors and insurance classes. We have transacted virtual captives not only for domestic, single country exposures but also for multinationals in combination with international master programmes.

Another benefit of virtual captives is to provide evidence of cover. Particularly, in the construction sector, a virtual captive can be an effective instrument to ensure compliance with contractual obligations should the required scope of cover not be available or affordable in the commercial insurance market. A virtual captive contract can serve to provide the required protection and pay any claims to the project, with the project sponsor or principal funding such specific exposures or individual perils.

Given APAC’s rising exposure to climate change and other risks, virtual captives are instrumental in enabling the region's infrastructure¹ development. Adopting such innovative vehicles to extend coverage where it may no longer be readily available commercially could prove critical to the region’s future development and resilience.

While a virtual captive is an innovative alternative to a captive, there are also limitations. Compared to regular captives or PCCs, virtual captives sometimes offer less flexibility in terms of scope of cover. As partially funded insurance contracts, virtual captives require an element of risk transfer and therefore must be aligned with the insurer's fundamental risk appetite and underwriting standards.

Furthermore, in case of a virtual captive where there is substantial post-loss funding, the insurer will be exposed to credit risk, which may require contractual mitigants or even collateral, potentially reducing the efficiency and cost benefits of the instrument.

Overall, we expect virtual captives to become increasingly attractive for organisations seeking robust protection strategies amid an evolving risk landscape and market uncertainty. Yet, regulatory frameworks can vary considerably across APAC markets, hence corporates need to proceed with caution and seek partners that can provide appropriate guidance.

Swiss Re Corporate Solutions' deep international experience and proven track record in Alternative Risk Transfer (ART) solutions places us in good standing to help corporates address emerging risks and extend protection. Virtual captives are one of a range of solutions in our ART toolkit. New solutions, and new mindsets, are needed in an environment where risks are evolving and accelerating. We support companies throughout this journey – first with a keen understanding of our customers' motivations and challenges, and then tailoring a solution to effectively meet their specific needs.