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Risk manager reflections, Part 1: Captives prove invaluable risk management tool

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Risk manager reflections, Part 1: Captives prove invaluable risk management tool

Captive insurance companies provide their owners with much more than tax advantages and insurance capacity. Long-time risk manager Alan Fleming reflects on how the use of captives has evolved over the course of his career.

Over a career that has brought me several roles in risk management, brokerage and regulation, I have been privileged to be at the forefront of developments in risk management and, in particular, captive insurance.

I believe the ongoing success and growth of captives will continue based on my experience with them. But it also has been my experience that history can repeat itself, so I would like to review some of the captive insurance lessons and innovations along the way.

It is well understood today that captives provide significant benefits in reducing the price of risk transfer and by providing access to the reinsurance market. But they also provide risk managers with a data base of knowledge of risk exposures, which permits an overview of all the major areas of the business that is unparalleled in other management systems. This is critical because risk management is about no surprises, not no risk. Of even greater importance is the way captives mitigate the volatility associated with self-insurance by smoothing the financial effect of surprises for smaller profit centers.

Imperial chemical industries

My captive insurance career began at Imperial Chemical Industries P.L.C., a chemical company that for many years was the largest manufacturer in Britain, until reorganization in the 1990s. During a 29-year career, I oversaw ICI's global insurance programs and was eventually managing director of IC Insurance which was responsible for risk management.

As an insurance professional, I gravitated to management of its captive insurance companies, which were almost entirely managed in-house. ICI's first captive, IC Insurance, actually was formed in 1927 in the United Kingdom in response to a lack of availability of insurance for shipments of explosives. Over the years, the U.K. captive's business expanded to include motor, property and employers liability coverage. IC Insurance also provided one of the first examples of employee benefits insured by a captive, as it provided household insurance and mortgage guarantee coverage for salaried employees of ICI.

I joined the company in the 1960s, just ahead of a massive expansion of products, such as new plastics, developed in the petrochemical industry. The direct insurance market in Europe at the time could not cope with ICI's increased property exposures. We found that other European chemical companies, like Solvay S.A. in Belgium, had similar problems finding sufficient coverage.

We looked to captive insurance to provide access to capacity via the reinsurance market.

Bermuda

Fred Reiss, an early innovator in captives, in 1962 had formed International Risk Management Ltd. as Bermuda's first captive manager with a strong risk engineering focus, and attracted support from such reinsurance companies as Swiss Reinsurance Co., Mercantile & General Reinsurance Co., Munich Reinsurance Co. and others.

In response to the property capacity crisis, ICI and Solvay in 1970 jointly formed a captive in Bermuda, managed by IRM. Its structure was simple, and one that has been duplicated in many joint venture captives since. There were three accounts—one for ICI, one for Solvay and one for their joint account. It was tax advantageous to both companies, but the main benefit was access to our internal capacity and to the IRM reinsurance program. The joint venture captive provided the first 30% of coverage for ICI's international property insurance program.

At the time we started the Bermuda captive, many property programs for major companies did not include any business interruption coverage. When we decided to start writing business interruption and all-risks coverage for ICI through the Bermuda captive we found that it allowed us to capture and analyze our loss history for this exposure over a few years.

Thanks to this kind of verifiable information, the direct and reinsurance markets followed this extension of property coverage to include business interruption risks. Indeed, the ICI captive's negotiations with the market and original policy wordings were largely responsible for introduction of all-risks coverage wordings in the United Kingdom.

New captives for global expandion

ICI was also one of the largest companies in Australia. Its main business there was petrochemicals and plastics but there were other significant businesses, such as paints, fertilizers and pharmaceuticals. Due to local politics, ICI operations in Australia had several disparate insurance programs with many brokers and insurers.

Devastating flooding in Brisbane in 1972 caused major problems for ICI. Our Dulux paint factory was under 12 feet of water. Local property insurers pulled out after that loss, leaving us high and dry (no pun intended). But thanks to the intervention of our U.K. captive, we were able to provide continuity of cover for ICI's operations in Australia.

I was seconded to ICI's Australian operations and when I arrived and collated the details of ICI's total group insurance expenditures I found the figures were large and that local insurers had been making a lot of money on our business. I promptly recommended establishment of a local captive, which was accomplished by buying a local reinsurance company. We proceeded to consolidate and centralize the various insurance programs, using the new captive, and the result was savings of 30% on our total premium spend, or several million Australian dollars.

In addition to the coverage savings and efficiencies, we also strengthened ICI's risk management and loss prevention capabilities in our Australian facilities by transferring a risk engineer from our U.K. captive, IC Insurance, to Australia.

In the 1970s, ICI also undertook significant expansion in United States and Canada. We acquired a U.S company, Atlas Chemical Industries, which had its own established risk management function and that resulted in politics of merging different strategies. The U.S. company, for example, had no captive. In addition, significant unreserved liabilities emerged because of high deductibles in products and public liability policies. Because of these exposures, as well as workers compensation coverage requirements in the United States, ICI opted to establish a U.S. captive in Vermont.

During the 1980s, ICI's majority share in AECI Ltd., a South African joint venture company with mining company Anglo American P.L.C., brought similar issues to those I had dealt with in Australia. AECI had several fairly independent subsidiaries and multiple insurance programs. I helped to establish a captive insurer, which became the second onshore captive in South Africa. Its main contribution has been a uniting influence on access to data and to risk control initiatives. Our partner Anglo American was not initially enthusiastic about the captive but within a relatively short time span they became more so and eventually established their own captive.

Another benefit of captives to a global company is that ICI was able to use captives to provide difference-in-conditions/difference-in-limits coverage in awkward territories where the commercial market was reluctant to provide property coverage. Later, in the mid-1990s after part of ICI's operations were spun off to what became Astra Zeneca, we also used a captive to create a novel international trade credit program, which was based on significant captive retentions and reinsured in Lloyd's of London. It was an ideal risk management tool, as the wording was effectively the parent's own secure trade term rules: stay within company rules and the deal is covered; go outside them and it is not. As a result of this program the company saved several million pounds in insurance costs as well was able to provide coverage in several countries that traditional credit insurers had refused.

Taking on third-party business

The subject of writing third¬-party business in captives is one I have been very close to, and one that remains a topic of interest today.

When I returned from Australia to ICI headquarters in the United Kingdom, there was a major change underway in more favorable market attitudes toward self-insured retentions and captives. This change permitted a growing relationship between ICI and reinsurance markets, such as M&G Re, General Re, Swiss Re and underwriters at Lloyd's. With support from reinsurers, I became involved in establishing for ICI quota share and surplus reinsurance treaties that allowed the captive to underwrite some commercial third party business. This was aimed at participating in insurance profitability and also at smoothing our own variable loss experience.

We also shared business bilaterally with some other multinationals, such as Alcoa, Hoechst, Tate & Lyle, and also in the London market. Our own engineers evaluated risk both internally for ICI and for much of our non-related business.

Experience with large losses

Captives helped ICI respond to several major losses in the United States and Canada.

Losses from a 1982 explosion at a polythene plant near Edmonton, Alberta, could have been horrendous but the blast occurred in the morning and on a weekend, which limited the exposure of personnel though buildings four miles away were damaged. Captive involvement was helpful in influencing the attitude of senior management who, mistakenly, did not want to admit to some responsibility for the explosion (BP P.L.C.'s response to the 2010 loss in the Gulf of Mexico was a similar situation).

In 1989, a major explosion occurred in an industrial complex in Peterborough, England, where an ICI subsidiary's vehicle blew up while en route to deliver explosives to a fireworks manufacturer. The disaster started as a fire in the vehicle. Although the site was quickly cleared, the truck exploded and one fireman was killed, more than a hundred people in the vicinity were injured and many buildings and cars were damaged.

This was an auto liability claim to the captive but an excess liability policy applied so there was sufficient limits for ICI's liability exposure. However, there initially was a reluctance by the excess insurance market to allow ICI to admit liability. This was resolved relatively quickly by discussions involving ICI's lawyers, the excess liability insurer and ICI's captive, and urgent steps were taken to compensate victims. As a result, losses were limited to reasonable level.

That outcome was in massive contrast to Oklahoma in 1995, when a U.S. federal building was bombed using as part of the explosive material ammonium nitrate agricultural fertilizer manufactured by ICI. ICI ultimately was not held liable in the domestic terror attack — which damaged hundreds of buildings, killed 168 people and injured several hundred more — but its insurers and reinsurers could not unite with ICI's captive in the defence and, as a result, many millions of dollars were spent on legal costs.

Liability insurance

The acquisition by ICI of U.S. chemical company Stauffer Chemical Co. in 1987 brought with it significant environmental exposures. Thanks to the captive's involvement in reinsuring some London market business we identified this risk potential early on in the deal and informed ICI senior management. The acquisition proceeded, but thanks to our information on the exposures ICI was able to obtain a $60 million discount on the acquisition price.

While that at first seemed a valuable contribution by the captive, the U.S. pollution exposures that we had identified at Stauffer quickly turned out to be a lot worse -- several hundred million dollars worse. To limit the exposure, I was able to negotiate one of the first finite risk reinsurance deals with Swiss Re as reinsurer of the Bermuda captive to basically commute and contain these exposures for a premium of about $300 million. There was some risk transfer, of course, but the real significant benefits to ICI were the transfer of responsibility for management of claims and the upfront tax relief on premiums paid.

In 1985, a capacity crisis occurred in the global liability insurance market largely due to mounting asbestos and environmental losses and problems in the London excess-of-loss market at Lloyds, where many syndicates had built up reinsurance exposures that were not properly monitored.

As a result, our liability insurance programs went through a wrenching surprise. We had, for example, about $300 million of coverage on June 30, but only £5 million on July 1. Fortunately for ICI, the captive could provide sufficient interim coverage to meet our banking covenants.

Ultimately, solving liability coverage problems for ICI included participation through the captive in a newly formed excess liability mutual, Ace Ltd., and also in the Tortuga excess casualty facility that IRM had established in the Cayman Islands. We had to put equity into Ace (2% of its initial capital) to benefit from coverage, and the investment was sold after 2 years at a profit (clearly with hindsight it would have been better to have retained the shares).

Pool Re

In 1992, due to several costly terrorist incidents in London culminating in the St. Mary's Axe bombing, the U.K. insurance market decided to exclude terrorism coverage from policies. To make things worse, the market did not publicize this withdrawal. It was only thanks to the involvement of ICI's captive that we discovered this change by notification from Munich Re.

At the time, I was involved with the Association of Insurance and Risk Managers in Industry and Commerce, now known as Airmic, and we drew wider attention to the lack of coverage for British businesses. AIRMIC also coordinated a campaign to solve the problem involving the Corporation of London, the British Retailers Association, the Association of British Insurers and the British Insurance Brokers Association and organized meetings with the U.K. government.

The ultimate result was the formation of Pool Re, a U.K. government-backed reinsurance company that continues to offer terrorism reinsurance protection to insurers, backed by government funds if necessary. As it is a reinsurance vehicle, the existence of a captive insurer allowed the company to directly access Pool Re.

I served Airmic as executive director on a part-time basis for several years after this, but in 1995 left both that role and my position with ICI/Astra Zeneca to pursue new risk management jobs—first at Guinness P.L.C., which after 2 years merged with Grand Metropolitan to become Diageo P.L.C., and later at Railtrack P.L.C. Not only did those jobs include continuing to work with captives, but I also eventually served as a captive regulator and have remained closely involved with captive issues in other roles (see Part 2).

In summary, I hope you have found my comments about the development of ICI's captive programs interesting and relevant. I am absolutely convinced captives will continue to play an important role in risk management. In my career, I saw captives provide detailed knowledge about risk performance issues throughout the corporation. I also learned that a captive provides significant added value in the event of very major losses, when a company's initial response to losses and public concerns is critical and impacts a company reputation. It is easier to accept liability and quickly process claims if the insurance market is on board, led by a captive.

Alan Fleming, based in the United Kingdom, is a former risk manager, insurance regulator and risk management association chief. This article was written with the support of Hugh Rosenbaum, a retired principal of Towers Watson and editor-emeritus of Captive Insurance Company Reports, published by the International Risk Management Institute. He also is one of the founders and organizing partners of the World Captive Forum.

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