19 July 2023
Alternative Risk Management:
Captives in Construction
Obstacles and challenges have beset the construction industry in recent years. Post-pandemic supply chain issues have rumbled on, with the Ukraine-Russia war fuelling the cost-of-living and energy crises, which in turn ushered in a global inflation problem. This backdrop of rising costs can lead to cost-cutting and exacerbate the risk exposure within any construction project.
Naturally, the unforgiving economic environment has also filtered into insurance with a “harder” insurance market, meaning alternative solutions to ensure effective insurance protection at the most cost-efficient pricing need to be explored.
Yet, construction companies inherently understand their exposures. The majority have robust standards and safety procedures in place to mitigate risk. Therefore, they may be more comfortable than most to absorb a greater portion of their risk to reduce the cost of their overall risk management/insurance programme. This is where captives come in, and the current insurance market conditions make this proposition more attractive.
Captivation
Captives in construction are not new, but their viability has grown dramatically in the last few years; barriers to entry have lowered globally, and they are no longer the reserve of major players.
Construction companies working internationally must navigate a complex legal landscape full of regulatory nuances. Certain territories require specific mandatory insurance, which can significantly increase a project’s overall cost. Without finding cost efficiencies, it can be prohibitive for contractors and developers to secure the appropriate insurance protection across their operations to enable them to work internationally.
Partnering with a firm that can offer a global captive solution that works across a company’s portfolio can help construction companies manage the complexity of their risks.
The captive market has traditionally been dominated by the US, and latest figures show US domiciles account for 52.4% of all global captives and North American offshore domiciles, including Bermuda and Cayman, account for 33.1%. EU Solvency II regulations has made it more challenging for captives to operate in Europe, but the hard market is fuelling interest in the region and change is afoot.
France recently passed a measure to permit the creation of self-reinsurance structures and Italy, Spain and Germany are following developments with interest.
Captives can be very effective in the European Union from the perspective of freedom of services. Once established in any EU Solvency II domicile, the captive can then issue policies across the EU, allowing for consistency in coverage.
Insurance regulation is complex and for global construction companies it is unlikely that their captive will be able to provide direct insurance to all of the territories where coverage is required. Partnering their captive with a fronting insurer will ensure the organisation enjoys compliant cover worldwide whilst respecting local market practices and regulations. The fronting insurer will then cede some or even all of the risk to the captive which will act as a reinsurer. This can reduce the regulatory burden and operating costs of the captive, which can then be located outside of the territory in question.
For a CFO of a large construction company, knowing the policy terms and conditions and security across a certain type of insurance are the same for all operations adds an attractive level of clarity and comfort.
The control a captive offers is a huge draw; they allow owners to design or influence tailored, comprehensive and responsive coverage, providing an opportunity to overcome some of the exclusions or restrictions that might apply in the commercial market.
With traditional insurers, a construction company may need to obtain a quote for each business line; in a captive situation the construction company can play a more meaningful role in the insurance process.
A captive’s premium will reflect a company’s unique exposures, whereas commercial market rates are based on pooled information and industry averages, typical exposures and a margin for profit. This can bring the perception that the top 20% of the construction industry are often left paying for the mistakes of the bottom 20%. Captive premiums are still based on commercial pricing but there is more autonomy to flex pricing and determine extent of coverage.
Captives operate on a par with commercial insurers and need to be run with underwriting principles at their foundation. Brokers and insurers are integral to captives in order to continually monitor and understand the value of risk retention versus risk transfer. The most effective captive strategy works alongside utilisation and analysis of the commercial insurance market; risk transfer to the insurance market remains a central strategy for risks too large to retain. By retaining a portion of owned risk within the captive, the construction company reduces the overall capacity being purchased in the commercial market; gives insurers’ confidence in their willingness to manage or tolerate their own risk, and the captive also benefits from the underwriting and risk engineering expertise of the commercial insurers participating on their programme.
Types of Captive
Limited Company
A stand-alone limited company, usually a subsidiary of the construction company.
Cell Captive
Replicates the operations of a single parent captive but within an existing corporate legal structure (a protected cell company). The existing structure allows organisations to share the administrative burden of a Limited Company without sharing insurance risks.
Group Captive
Common in the US where the captive is owned by multiple organisations who share risk. Outside of the US, the equivalent structure is referred to as a Mutual.
Long Term Investment
As with any risk bearing company, capital is required to support insurance activity. Insurance involves the acceptance of significant but measured insurance risk and will often represent a major departure from businesses more concerned with transferring risk. This is sharply in focus in the early years of captive development where the company may not have sufficient retained earnings to absorb adverse claims experience. Organisations will undertake a feasibility study to determine if a captive makes sense and assess the pros and cons of different structures before making an informed decision. Construction captives are used in a number of ways but are principally used for insuring the primary layer of risk or by providing quota share capacity across a programme. Excess risk layers continue to be placed in the commercial insurance market where there is more capital, appetite and capacity. Some captives can consider utilising capital to fill in gaps in excess layers of coverage, but these tend to be mature captives who have built up significant capital bases from primary cover.
The Broker's Role
Brokers and insurance managers working together are critical in the design and structure of a client’s overall insurance programme including the captive.
Gallagher have the ability to facilitate and arrange captive insurance operations and are the broker to many clients who operate captives, either independently or in association with the broking arrangements.
Artex Risk Solutions (Artex) is Gallagher’s wholly owned subsidiary for alternative risk and captives. Artex is licensed in more than 30 jurisdictions and is currently the world’s 3rd largest insurance manager with over 1,000 captives, cells and specialty programmes under management. Artex can be accessed through your core Gallagher management and service team or direct contact can be facilitated. Gallagher is here to help across the spectrum: Our team has a deep understanding of the complexity of construction risks. Gallagher provides the necessary resources, advice and guidance to ensure our construction clients receive a competitive advantage and comprehensive cover.
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