Having access to the reinsurance market offers great advantages to risk managers of organisations with large and complex exposures. For one thing, access provides opportunities for arbitrage, allowing the risk manager to secure the best coverage at the best price by leveraging differences between the direct and reinsurance marketplaces.
Traditionally, reinsurance arbitrage involves an insurance company transferring its risk to a reinsurer at a lower premium than it demands from its policyholders, creating a chance to generate profit or at least mitigate costs. The opportunity for arbitrage therefore depends upon captive owners getting clear access to both direct and reinsurance markets, thus taking advantage of the competitive tension between both markets.
Form and Function of Arbitrage for Captives
But it’s important to remember that arbitrage can take several forms and is not based on price alone. Reinsurance underwriting can be linear, using historical data on the performance of an insurer’s portfolio as a whole, not on specific risks or assets.
With an appropriately diversified book, the rates then are often more predictable. But, with predefined target margins for reinsurers to achieve, they may not always be the cheapest around.
Arbitrage can also take place based on terms and conditions of cover and supply of capacity. For instance, a risk manager could create a more stable, secure and long-term risk financing strategy by combining captive utilization, direct insurance capacity as well as specific reinsurance capital.
The process of building a balanced, diversified, and data driven captive portfolio for the reinsurance market also offers an opportunity for arbitrage against the direct market. A neat way of thinking about this is that the captive acts as a fulcrum which risk managers can use to create that leverage between those marketplaces.
For captives, the benefits of arbitrage extend beyond the details of rate and policy language. Instead, sometimes the greatest benefit of reinsurance arbitrage is greater control.
Using a captive as a gateway to the reinsurance markets allows a risk manager to design more innovative coverage structures. For example, by taking on the first £20 million of risk and then using reinsurance to protect that layer, a captive gains more protection against volatility and more control over its long-term performance.
While captives are typically seen as cost mitigants, strategically adding reinsurance can create opportunities for long-term profit, eventually allowing the captive to become self-sufficient.
This, in turn, allows a risk manager to think differently about how to structure deals. When captives are used effectively to access reinsurance, there are more options for adjustment of net risk retention and layering of coverage.
A key advantage of arbitrage is the ability to bifurcate conversations with markets and thereby segregate capacity in the direct market vs the reinsurance market.
In practice, arbitrage can reduce the total amount of insurance purchased because moving more risk into the captive increases the attachment point for direct insurance. The better your captive performs, the more predictable its diversified portfolio becomes.
It helps the risk manager to bifurcate that conversation to avoid conflicts of interest. When the risk manager is setting their global insurance strategy they have greater control over Total Cost of Risk by operating separately in both direct and reinsurance markets. Keeping the deals separate creates leverage, and diversifies the risk capital source, and supplier base.
Impact to the Role of the Risk Manager
Risk managers face a continual challenge of insuring their company’s risk within a predictable budget over the long term. But risks are always shifting, and budgets change from year to year. Risk managers can maximise their value by being proactive in developing long term strategies to reduce and manage risks which are not as impacted by cyclical shifts in the risk environment or insurance marketplaces.
Utilising a captive and leveraging its unique identity to access multiple marketplaces helps to create that stability, but it requires getting buy-in from the C-suite if capital is needed for higher captive retentions.
During profitable times and after accumulating retained earnings, captives may choose retain more risk, thus retaining premium in the group and reducing premium leakage to the market. Conversely, at times more reinsurance may be required to decrease the capital exposed.
Through reinsurance arbitrage, risk managers have the opportunity to protect the captive’s financials through those shifts and continue to grow it over time. It provides an avenue to continually innovate traditional methods of transferring risk.