Malaysia: Managing Corporate Risks Via Captives

Aricle by Anthony Egerton

At the Jakarta chapter of Labuan IBFC's 25th Anniversary ASEAN Roadshow, Anthony Egerton, Principal Officer at Huntington Underwriting Limited, discussed the benefits of managing corporate risk via a captive. Below is a summation of his presentation.

Introduction

Globally, a captive insurer, or captive for short, has become a mainstream risk management tool for many large organisations. In fact, more than 75% of Fortune 500 companies worldwide operate with established captives today. This translates into billions of dollars' worth of premium flowing through close to 7,000 captives worldwide.

According to Anthony Egerton, Huntington Underwriting Limited's Principal Officer, Labuan IBFC has become an attractive destination for these organisations to set up a captive because of its tax efficiency. However, he strongly advises against organisations starting a captive solely for tax reasons.

The former Asia-Pacific President of specialist insurance market, Lloyd's of London, shared his experience with a presentation on 'Managing Corporate Risks via Captives' at Labuan IBFC's 25th Anniversary ASEAN Roadshow in Jakarta.

He explained: "You have to identify and understand what risks are exposed to your organisations, entities and associations. Think about the risks you're happy to incur, and the ones you want to transfer, mitigate or manage in a different way. Once a thorough enterprise risk management assessment is done, you can think about using a risk management tool like a captive."

So what is a captive insurer?

A captive insurer is an insurance or reinsurance entity wholly-owned directly or indirectly by an industrial, commercial or financial entity. It provides insurance or reinsurance coverage for the risks, assets and liabilities of its parent company.

While the parent company determines the amount of risk that its captive assumes and how much it transfers to other parties via reinsurance, it will often appoint a specialist, manager, accountant or administrator to manage the affairs of the captive.

Types of captives

There are four types of captives:

1. Pure captives
   These are single parent companies that underwrite the risks of their owner, which is either a single owner or an affiliate, exclusively.
2. Group and/or association captives
   Insurance companies or risk-bearing entities owned by a group or association. For example, in the marine insurance business, P&I (protection & indemnity) clubs gather ship owners to mutualise certain liability risks together. They collectively own the insurance entity.
3. Rental captives
   These captives are facility structures established by a manager or a third party, which are then rented to third party organisations. For example, there are Labuan protective cell captives where an administrator establishes a master cell and allows access for external parties to its subsidiary cells or "mini captives".
4. Diversified captives
   This refers to captives writing third-party business. As insurance is about the diversification of risks, a captive not only assumes its owner's risks, it also becomes a small risk base that the owner can diversify from by writing other non-related business. Historically, many captives who wrote unfamiliar businesses for other parties have suffered significant financial losses. This captive is not recommended and is also not permitted in Labuan IBFC.

Direct dealings with global reinsurers improve risk management

One main benefit for large organisations setting up a captive is the ability to deal directly with the large global reinsurers like Munich Re, Swiss Re or Hannover Re, instead of being restricted to the domestic market that may only have smaller insurance companies. The ability to tap directly into these larger balance sheets also increases the access to more sophisticated risk management tools.

Depending on the risks to which an organisation is exposed, captives may be used to finance certain more challenging risks. Though the risks may be traditionally uninsurable, it may still make sense to pre-fund them should they materialise through some insurance mechanism.

"If they are uninsurable in a conventional sense, the only way to insure the risks is to put them into your own insurance company and manage them within the captive," said Egerton.

He added that customisation allows organisations to control the coverage and manage multinational programs efficiently across many different territories.

Captive licence required for set-up

Before starting a captive, an organisation needs to first determine if such an approach is suitable and if the cost-benefit analysis makes financial sense.

"Fundamentally, it comes down to the amount of losses and claims; things that go wrong within your business on a regular basis on a year-to-year basis, rather than paying premium to the conventional insurance market and collecting claims annually. The traditional insurance process can be very expensive and inefficient. It's better to pool premiums into your own insurance entity, and pay losses as and when they arrive. The volatility in this pool of losses on a year-to-year basis can be protected through reinsurance," he said.

Setting up a captive requires organisations to seek out a regulator like the Labuan Financial Service Authority (Labuan FSA) to apply for a captive licence. For all domiciles, insurance and reinsurance activities are regulated and require licences to carry out such activities.

Obtaining a licence may not always be straightforward, depending on the kind of risks the captive is planning to hold. Ultimately, the process of handling the risks is key. This needs to be done properly and professionally by registering a company with either a trust company or a company registrar, and then appointing a manager, an underwriting manager, directors and company secretaries before the captive can start writing business.

Rating adds value to a captive

An internationally recognised financial rating for a captive can boost its credibility. It is a technical detail often overlooked but worth exploring when setting up a captive.

A rating may be obtained from New Jersey-based AM Best, the only rating specialist agency in the world that focuses on the insurance and reinsurance industry. A rating from a rating agency such as AM Best will be highly beneficial to a captive and will allow it to demand preferential rates when negotiating with local insurers.

One example of an organisation with a successful rating is Energas Insurance (L) Limited, a captive insurer established by Malaysian oil and gas company, Petronas. In fact, Energas is the first Asian captive to receive a rating – an A (Excellent) - from AM Best (refer to the boxed section).

Reinsurance via a structured programme may be best

Based on Egerton's experience, placing the captive's reinsurance programme on a structured basis can be more economical and efficient. In the insurance and reinsurance business, such multi-year relationships are preferred as they focus on building a deeper level of trust between the insurer/reinsurer and their clients. This then translates into a better understanding between the parties which leads to more tailored coverage at, generally, a lower effective premium level.

In contrast, most traditional (re)insurance is placed for one year with the option of an annual renewal. If the client has an unfortunate run of claims or if the international market suffers some major catastrophe losses, both parties may have to deal with difficult negotiations for renewal, which will almost always lead to more volatile premiums and retention levels.

Egerton prefers to write reinsurance on a multi-year basis for a minimum of three or even five years as it helps spread losses over time, but always includes significant risk transfer. "I've done deals for up to ten years where we commit to take a certain level of risk over a fixed period of time, irrespective of what happens to the losses or to the international reinsurance markets. So if there's a major disaster in California or Europe, it doesn't affect your programme."

Often, a term aggregate deductible cover can be incorporated over or above the amount of risk a client is happy to retain each year within the structured programme. This essentially helps clients reduce the cost further.

Such multi-year structures can act as a form of additional equity capital or substitute for the captive. He added: "Ultimately, you have to put some capital into your captive for the risks it is retaining. One of the challenges for most organisations is that capital is expensive. You want it for your core business. This captive after all is only a risk-pooling entity. It isn't your core business."

Labuan IBFC's cost-effective appeal to captives

Labuan IBFC is an ideal destination to establish new ventures, including captives. In Asia, it is only one of two financial centres that offer captives.

Labuan IBFC's modern and well-developed infrastructure allows companies to immediately start their operations and conduct business fuss-free. This is evidenced by more than 40 captives currently domiciled in the jurisdiction.

In fact, there are more than 230 licensed insurance entities registered in Labuan IBFC and this pool provides a ready network of insurers, reinsurers and brokers for a new captive to tap into. In addition, Labuan IBFC is also home to a substantial retrocession market.

Egerton went on to stress that apart from a healthy risk management industry, it is as important that the regulators not only understand the risk management business, but in fact, facilitate the setting up of entities as best they can.

He added: "A flexible but business-friendly environment is essential when you're starting a new business, be it your own business or your organisation's captive. You need to get on with the business you're there to do, rather than worry about a lot of paperwork with the regulator and all the other back-office administration."

"Labuan IBFC is also surprisingly inexpensive. I spend some of my time on other businesses in Singapore and Pakistan. Labuan IBFC is somewhere between the two as a cost destination, although much closer to Pakistan but with the benefit of Malaysia's stability and with a location at the heart of Asia."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.