ERM and Captives - A Perspective on Risk

By Legare Gresham, FCAS, MAAA

Consulting Actuary, Bartlett Actuarial Group

'Reprinted from the March 2013 edition of Captive Review.'

Enterprise Risk Management (ERM) is defined as the process an organization uses to identify, assess, control, exploit, finance and monitor all sources of risk with the goal of protecting and creating value for its stakeholders.   While the concept has been around for some time, many companies are just beginning to get their arms around how to approach and integrate it into their own organizations.  There are many ways to approach ERM and many tools that can be utilized.  As part of an organization's overall ERM analysis, one option that could be explored is forming a captive insurance company.  A captive insurance company can be a valuable tool to help manage the risks identified by the organization. 

A captive insurance company can be used to fund risks faced by an organization for which it does not have traditional insurance.  Often these risks are difficult to obtain or very expensive in the traditional market.  They also tend to be considered low frequency and high severity.  This means they don't occur often but the losses are large when an event occurs.  In a program of this nature, usually the intent is to include many types of coverage.  By including multiple types of coverage, there is diversification of risk which ideally results in a total premium able to cover a large loss for any individual coverage in a given year.  It is generally unlikely there will be more than one event in any given year that could trigger a claim. 

As part of its ERM analysis, while the organization is reviewing non-insured risks, it should also review risks for which it currently purchases commercial insurance.  Depending on the nature of the risk and the risk appetite and risk tolerance of the organization, there may be value in replacing some portion of the commercial coverage with coverage in the captive or considering an excess policy.  There may be opportunities to include similar low frequency and high severity type coverages.  Typical examples of this are coverage for named storms or flood insurance.  While it probably isn't prudent to drop all commercial coverage, an organization could consider adding a large deductible to a commercial policy and using the captive to fund the deductible layer.  By including these coverages, there would be additional diversification of risk and additional premium.  Before putting any of these coverages in a captive, the organization should thoroughly review the savings in the commercial policy premium versus the amount of risk taken and be comfortable that they understand the tradeoff.  Having a good understanding of the organization's risk appetite and a defined risk tolerance statement can provide valuable guidance with these decisions.

Once all prospective coverages for inclusion in the captive are identified, it is crucial that the organization understands and is comfortable with the risks placed in its captive insurance program.  An organization needs to consider how it intends to manage and mitigate these risks at the parent company level.  While the captive is in place in the event of a loss, it is almost always better if there is no loss.  It is important to understand what would trigger a claim under any individual coverage and whether there is any possibility that one event could trigger a claim under two or more types of coverage.  Stochastic modeling of the program could provide insight into the most likely estimate of loss as well as an overall probability distribution.  It can be helpful to include various sensitivity analyses as well as stress test the program.  The organization should understand the assumptions behind each of the scenarios and likelihood of the events presented. 

An ERM analysis should not be done just once but should be an ongoing review.  As the organization evolves and changes, new risks may develop or exposure to a risk previously identified may disappear.  If a company already has a captive in place, the captive can be used to manage these new risks.  The amount of capital in the captive can also play an important role.  If the captive has had good underwriting results for several years, the capital should start to grow and provide support for additional coverages without needing an additional capital infusion.  It could allow for increasing the deductible on the commercial policies resulting in additional savings in the commercial market premiums.  Again, an organization needs to be sure it understands what additional risk it is taking on and be comfortable with it.   

Using a captive insurance company as part of its ERM framework can be a very valuable tool for an organization.  However, as with any other risk management strategy, it should be monitored and reviewed frequently to ensure it is providing maximum value to the parent organization.