Summary
Labuan IBFC offers prospective captive owners a business friendly regulatory environment with a modern, well-developed and low cost infrastructure that includes access to the latest risk management tools and techniques. These include the possibility of developing tailored long-term, broad risk contracts. Globally, major reinsurers foresee an increased utilisation of these long-term, broad risk contracts, known as structured reinsurance solutions, which are able to integrate reinsurance into broader risk management and/or corporate finance strategy. Given the typical constraints under which most captives operate, these solutions may be particularly powerful in helping achieve their key objectives.
Introduction
In the Sigma report (No 5/2016)1 that was published to coincide with last year’s Monte Carlo Rendezvous, Swiss Re stated that:
“The reinsurance and insurance markets are becoming increasingly bifurcated, trending in two directions: commoditisation and increased retention of standard re/insurance risks; and increased utilisation of larger and more strategically-motivated reinsurance solutions… The use of customised (i.e. non-traditional) re/insurance has become more prominent in recent years, and the purpose underpinning reinsurance are (sic) continuously evolving.”
These market trends and emerging risk management tools are just as relevant to captive insurance companies as they are to mainstream insurers.
Structured Reinsurance Solutions
The term ‘Structured Reinsurance Solutions’ (SRS) refers to a bespoke approach to reinsurance involving an explicit combination of risk financing and risk transfer techniques. They involve a blend of reinsurance concepts with a profit and loss potential that is reasonably predictable to both sides and diversify risk across the additional dimension of time.
Whilst this approach does not really differ from traditional reinsurance in the long term ‘spirit’ of the relationship, the contractual terms clearly manifest the intent of the parties at the inception of the deal itself.
While SRS techniques have been widely used for several decades in developed insurance markets such as North America, Europe and Japan by most of the major reinsurers, they are now gaining considerable acceptance within the developing markets of Asia.
The major reinsurers refer to such solutions with a variety of adjectives in addition to structured, including customised, advanced and strategic, but they all include a number of similar ingredients.
The Sigma report2 identifies seven drivers for continued growth in the SRS segment:
- Insurers are becoming much more sophisticated in their reinsurance purchasing.
- Strategic reinsurance solutions can optimise risk transfer, enhance capital efficiency and support strategy.
- Customised reinsurance solutions can be more efficient, targeted and flexible than traditional capacity.
- Strategic reinsurance programs increasingly address capital management considerations.
- Reinsurance solutions can focus on enabling strategy and growth.
- Reinsurance can serve as an efficient, targeted and flexible capital substitute.
- The best strategies for success are based on long-term alignment between all stakeholders.
The very nature of these contracts permit both parties (cedant and reinsurer) full flexibility in defining and agreeing the terms of the contract, thereby not being limited in any way to the restrictions of traditional reinsurance where standard wordings, deductible levels and exclusions are inevitably used.
SRS are often used to manage the volatility in ‘baskets’ of risks, ideally those with limited or zero correlation. Such multi-line solutions can also incorporate risks where traditional market solutions are inefficient or unavailable for a variety of reasons.
This powerful combination of long term commitment and broad risk coverage make SRS suitable for contingent capital, surplus relief and captive risk management (or as ‘quasi-captives’), of which more later.
The growth and interest in these structured solutions is mainly due to the value created by enforcing a strong relationship between the two parties under contract. In SRS, carrying of risks and the sharing of losses (usually with high profit commissions in cases of low losses) aligns interest between both parties.
Another common characteristic of SRS is cashflow efficiency. Premium reserves and/or funds withheld mechanisms are often used to avoid unnecessary remittances between the parties together with the associated foreign exchange costs.
Similarly, within excess of loss contracts, deposit premiums are set at much more manageable levels than traditional covers. This recognises the ultimate repayment of some of these funds in the form of either claims or profit commissions.
SRS often work best where there is a strong component of risk financing to a programme, especially when assessed over a multi-year contract term. This can be the result of historical loss experience or just a high exposure to loss frequency that results in significant premium volume relative to the limit of liability. Often such covers are referred to as ‘working’ or ‘burning cost’ layers.
And yes, it is time for the industry to give back
The Chairman of Labuan FSA went on to say that the Labuan industry players that have benefitted through the years are also strongly encouraged to take a leadership role in assisting local businesses and the population towards achieving the aim of an inclusive growth for all. After all, true to the old adage, a rising tide raises all ships.
One of the ways is to uplift the job prospects of local talents by offering innovative technical and industrial training such as the fit-for-work online programmes in the financial services industry. Indeed, leaders of industry, could offer apprenticeships and mentor key upcoming local talents towards ensuring the needs of succession planning are met.
As Chairman Muhammad pointed out, “As we move forward, we need to be more focused on the outcomes we want for Labuan. We want a more balanced growth. A clear step forward is to formulate clear and measurable targets, and to review them consistently. We must ensure that the benefits we obtain outweigh the incentives given by the Government such as the revenues foregone from the notional tax incentives offered.”
While stressing that it is a communal duty to advance the welfare of the society, Chairman Muhammad also pointed out that a new economic model must be designed to contribute to the local community in a more beneficial manner.
“Without doubt, it is our collective duty, as an industry whether as regulators or industry players, to advance the welfare of society through a more inclusive economic development. The success or failure to achieve this will reflect on us all as a collective,” he said.
Captive Insurance Companies
Essentially, a captive insurer (captive) is a wholly-owned insurance company that insures the assets, liabilities and other risks of its parent company. It will usually be domiciled in a jurisdiction, like Labuan IBFC, where taxation, solvency and reporting requirements are less onerous.
The captive will often be managed by specialist companies that act as its accountants and/or administrators. However, much of the decision-making around how risk is retained by the subsidiary company and how much is transferred to the conventional reinsurance market is undertaken by the parent company.
75% of the world’s Fortune 500 companies are parent owners of captive insurance companies. Total captive premium income exceeds USD14 billion per annum with more than 5,000 captives established worldwide.
With its robust and internationally recognised regulatory framework, Labuan IBFC is a favoured destination for major Asian corporations looking to establish captives. It provides for both cost and tax efficiency, with a highly developed and efficient local infrastructure and access to more than 80 of Malaysia’s Double Taxation Agreements.
Of course, all offshore business activity has attracted the attention of regulators and fiscal authorities in recent times. The leaders of the G20 group of countries committed to implementing the Base Erosion and Profit Shifting (BEPS) framework in November 2015.
This Organisation for Economic Co-operation and Development (OECD) initiative has since been expanded to a further 80 countries. It aims to close gaps that allow corporate profits to ‘disappear’ or be artificially shifted to low- or no-tax environments.
Captives and international insurance and reinsurance arrangements have not only been caught up in BEPS, they have been singled out.
Hence, increasingly, such arrangements will have to demonstrate adherence to the ‘substance over form’ accounting principle. This principle seeks to ensure that the tax consequences of a transaction or arrangement are ascertained by determining the economic substance of that transaction or arrangement rather than its strict legal form.
With its highly developed local infrastructure and regulatory commitment to ensuring compliance with these international developments, Labuan IBFC intends to keep itself ‘future proofed’ and relevant as a leading captive domicile.
This local infrastructure includes many of the major reinsurers, reinsurance brokers, captive managers and other risk management advisors.
Hence, Labuan-domiciled captives have access to the full range of risk management tools and techniques, including the latest developments such as structured reinsurance solutions.
An adequately capitalised risk management tool
SRS can act as very efficient forms of capital to captives, given their ability to absorb a broad range of risks over multiple accounting periods. By definition, insurance is usually not a core activity of a captive’s parent. The captive is merely a risk management tool, but one that needs to be adequately capitalised, and from which long term stable earnings are to be expected.
The amount of capital will be dependent upon the range and longevity of the risks retained after conventional reinsurance. However, in any organisation, there is an opportunity cost of capital, which in many cases, the captive may struggle to attain.
Hence, there needs to be a delicate balancing act between risk retention, minimum capitalisation levels and earnings volatility. This is where the particular characteristics of structured reinsurance solutions are proving most valuable.
Indeed, long term, cashflow efficient protection across a broad (could be the entire?) range of retained risks, with the ability to share in the upside via the profit commission mechanism, are increasingly the ultimate tool of choice for risk managers looking to manage their captive effectively.
And Labuan IBFC’s well-developed, comprehensive and cost-effective eco-system of risk management solutions provides risk managers access to these tools via a range of experienced advisors.
