Virtual captives: the best of both worlds

Captives are an efficient vehicle for companies to manage risk through the insurance cycle, but not every company can or wants to act as an insurer itself. Setting them up and winding them down can come with significant effort, that should not be underestimated.

A company must have “critical mass” in terms of premium volume in order to justify the cost that comes with establishing and operating a captive. In addition, to establish a captive a company must be prepared to inject capital into a non-core activity (reinsurance). The risk manager must not only convince the CFO with a business case, but also satisfy the requirements of insurance supervision as well as complex criteria for accounting and balance-sheet management. A company needs to produce a feasibility study and deliver a business plan, including the use of reinsurance, to the relevant regulator. Once established, a captive is subject to auditing, accounting and financial reporting regulations and requirements, which all come at a cost. Operational risk management must also meet the highest standards for analyzing and evaluating risks. In addition, there are ongoing administrative costs for the captive to take into account. A captive is a long-term play over various market cycles.

But what if a captive is not an option for your business? For such clients, Alternative Risk Transfer (ART) offers an innovative solution that combines the advantages of a classic insurance product with those of risk financing - a so-called virtual captive.

This solution combines the best of both worlds. It is essentially a hybrid solution of risk transfer and risk-retention. Companies can take on more risk themselves, getting coverage for risks that are difficult to insure or deemed “uninsurable” by the conventional (re)insurance markets.

Other advantages include better planning for corporate finances and full cost transparency. 

Put simply, a virtual captive is a multi-year contractual risk-financing framework designed as a going-concern (as a true captive is by default). It leaves a portion of the risks with the policy holder but reduces the P&L volatility from adverse events. The company pays an annual premium to provide for the risk of “owning” claims with a bonus-malus system. The contract is renewed for a further year if the cumulative loss ratio does not exceed an aggregated level. Both the financial (a double-digit million amount) and the time commitment (usually three years and beyond) are kept within manageable limits.

A virtual captive is a useful option for those businesses that find it difficult to achieve the desired cover and capacities in the current market environment. These are likely to be companies in critical, loss-prone sectors that have a very good risk management performance and are therefore confident they can take on more risks themselves. In order to develop and structure such a solution, and gain backing for it within the company, the risk manager needs solid technical underwriting know-how and financial acumen.

In principle, all risks that are insurable from a legal perspective can be included in a virtual captive from emerging risks to D&O and cyber risks. Multi-line solutions are also possible. They are even to be recommended because this enables risk diversification and therefore leads to lower volatility.

Alternative Risk Transfer at Allianz Commercial has already implemented a virtual captive for several of its clients in different industries. For Allianz Commercial, the focus is finding the right solution for the client, blending traditional risk transfer and risk retention using ART techniques.