Following on from our previous blog ‘Exploring Captive Solutions in a Hardening Market’ we decided to highlight the top three considerations to drive efficiency by controlling costs.
Recently formed captives often use third-party service providers to run their day-to-day business operations, including core activities such as claims handling. However, this should be reconsidered as the captive matures and its business volume increases. According to the Rough Notes Company in its ‘Captive claims management’ article ‘Bottom line, effective claims handling will be critical to the ongoing success of the captive...captive owners frequently delegate their authority to either the captive manager or outside claims professionals, this typically is not the most effective way for the captive to achieve long-term success’, Michael Moody continues ‘because claims account for the lion’s share of a captive’s expenses, best practice claims management is the one tangible area where captives can quickly distinguish themselves from most traditional insurers’.
There are three areas to consider when driving efficiency by controlling insurance costs, that will create value for the captive and its respective corporate parent:
1. Financial – ‘Reduce cost of risk by capturing profitable premium that would otherwise be paid to commercial insurers.’
2. Strategic – ‘Improve group purchasing power, control customer, supplier, or employee insurance costs.’
3. Operational – ‘Centralise control of insurance, capture underwriting and performance management data, and improve group control of claims.’
It is key for the captive to work with adequate technology, enabling the captive to be in control of its data and to be in the position where they can:
‘Obtain conventional insurance from a third-party insurer, retain some of the risk “on balance sheet” and purchase insurance above a tolerable limit, whilst retaining a portion of the risk in a captive insurance vehicle and purchasing insurance above a tolerable limit.’2
The chart below shows the ideal distribution of the cost of risk between captive retention and purchasing insurance from third parties resulting in an increased captive profit.
By following the ideal ‘cost of risk’ strategy discussed above, a captive insurance company can also improve its buying power and consequently control the cost of insurance for its customers and/or employees.
In the paper ‘More for less: 5 steps to strategic cost reduction’ PWC points out how vital it is to distinguish between good and bad costs and making the necessary investments into the good costs will help drive efficiencies going forward.
In the same article, concerning service providers, PWC points out that ‘third party service spending largely fails to reflect the value it generates. Weaknesses include poorly managed arrangements or simply outsourcing an inefficient process without tackling the underlying weaknesses first.’ It continues stating that ‘front-runners are rethinking how they operate (e.g., Lean, robotics, etc.) before engaging with service providers.’ McKinsey discusses this further in its paper ‘The productivity imperative in insurance’ where it talks about the ‘Four categories of levers’ to improve productivity for insurance carriers i.e.—'deepened functional excellence, comprehensive simplification, an end-to-end business model transformation, and enterprise-level enablers.’ Whilst a captive insurance company does not have the complexity of some of the large commercial insurance carriers, at least the first three leavers should also be considered by captive insurers.
In the paper ‘More for less: 5 steps to strategic cost reduction’ PWC continues by stating that ‘in respect of transactional processes (in underwriting, claims handling and finance) representing the core activities of a captive, PWC states that those typically are ‘littered with low value transactional processes which often rely on heavy manual workarounds including re-inputting of information into multiple systems.’ These are obviously ‘bad costs’, whilst ‘good costs’ are costs invested ‘moving to robotic process automation (RPA) and straight-through-processing (STP)’, popularly used in payment processing as well as the processing of securities trades.
Whilst captives may only be looking into aspects of RPA and STP to gain efficiencies, it pays to investigate the digitisation of claims, policy administration and finance.
Investment into technology does not need to have the scale of investment seen in large commercial carriers, however, with the appropriate technology in place, i.e., a state-of-the-art policy and claims administration system, the need to invest in additional systems is limited. Some of the systems available would also deliver credit control and financial reporting, designed to capitalise on the digitisation of the transactions in the value chain. Another functionality that state-of-the-art systems provide is the ability to give an in-depth insight into the data, including loss triangulations, P&L views from asset level through to the top-level captive view and the ability to provide predictive analytics.
When a captive has managed to achieve improved efficiency by controlling its insurance costs, as described above, it can then look forward and decide the future strategy of the captive. It can consider whether to improve the value and profitability of the captive by increasing its portfolio of business and widening its access to reinsurance markets by obtaining an official credit rating. AM Best describes in its ‘Captive Review Book’5 from August 2020 the value of such a rating and the process on how to obtain it. /,
At Eurobase, our view is that captives are continuing to outperform commercial market peers amid new opportunities, and this trend is likely to be ‘ongoing for many years to come’. New and existing captive insurance companies will likely underwrite more volume and new lines of business. This is driven by key coverage (such as Business Interruption, Cyber, and D&O) provided by the commercial market being limited, unavailable or too expensive.
To summarise, forward thinking companies can make captive strategies work throughout their lifecycle, from early captive management through to one or more self-managed captive vehicles. Using technology to deliver operational efficiency is critical to provide better returns and importantly risk-management in uncertain times.