- Quicker to implement than traditional captives
- Can be used for short-tail and long-tail lines of business
- No need for upfront capital with a virtual captive
- Virtual captives can begin the journey to a PCC or pure captive strategy
Virtual captives are being utilised by a many companies as an alternative option to more traditional captive structures.
There is no strict definition of what constitutes a virtual captive with the term loosely defined in comparison to legal entities such as a single parent captive or a protected cell company (PCC).
In practice, a virtual captive is as an insurance contract that provides many of the benefits of a pure captive without the need to go through the – sometimes long winded and capital intensive – process of formation.
A virtual captive is typically a multi-year contract where the risk is financed over time.
Companies also use virtual captives to write short-tail and long-tail risks, and firms can decide to set up a virtual captive for each line of business or combine them into one programme.
“Essentially, you draft a contract that outlines the terms – such as what percentage of losses or premiums will be allocated to each party, and how the flow of funds will work,” Judah Dobrinsky, director of risk finance at XN Captive, tells Captive Intelligence.
“The contract specifies how everything will attach, how risks will be shared, and how funds will move between parties, however the risk is typically retained on the fronting carriers balance sheet.
“It’s a more flexible, less formalised approach to the captive model, but it operates on the same fundamental principles.”
Grant Maxwell, global head of alternative risk transfer at Allianz, emphasised that a virtual captive is not technically a captive.
“It’s quite different from setting up a traditional captive,” he says. “It’s more of an intermediate step between simple insurance contracts and a full captive.
“Why would companies choose a virtual captive? For one, it’s much easier to set up than a traditional captive. Clients do not need to put in capital, and they do not have to manage the captive.”
Maxwell says that even with a cell captive, they still must deal with management and capital requirements.
“With a virtual captive, they simply enter into an insurance contract with an insurance partner, and that’s it – they avoid the complexities of management and ongoing operational responsibilities.”
Maxwell adds one feature that really justifies the name ‘virtual captive’ is when it is viewed as a “going concern” structure.
“For example, we might set up a three or five-year transaction, but with the option to automatically extend over time,” he says.
Maxwell explains this makes it even more like a traditional captive because it does not have a fixed end date.
“If it’s performing well, it automatically extends, which adds a level of continuity,” he says. “I think this auto-extension feature is something unique to our approach when we talk about virtual captives.”
In an insurance programme, the primary layer is where a company would typically apply a traditional captive to take on some of the risk.
“In the case of a virtual captive, instead of using a real captive, you have an insurance contract that covers the virtual captive layer – let’s say, for the first $20m,” Thomas Keist, chief commercial officer at SRS Altitude, tells Captive Intelligence.
“The insurance contract then outlines the conditions that apply for the first $20m of the coverage under the programme.”
Keist said a virtual captive is typically applied within an international insurance programme, “where it makes the most sense”.
He highlighted that instead of using a virtual captive, a company could introduce a deductible of $20m for the corporate entity.
Keist said the challenge arises, however, when a corporation has an international programme covering multiple locations, “perhaps 35 or even more across the globe”.
“While the $20m deductible may not be an issue for the corporation itself, it can be a significant problem for subsidiaries, such as one in Asia, that may not have the financial capacity to retain $20m in losses,” he adds.
This is generally where a virtual captive would come into use as the subsidiary would have direct access to the funds through the contract.
Glenn Ellis, a UK-based independent consultant with experience as a risk manager and fronting partner, tells Captive Intelligence that in the case of a global, multinational programme, there are processes that need to be followed that can sometimes make it difficult to pay a loss locally with a traditional captive.
“In today’s market the case for a virtual captive is perhaps more widespread, for example in a global, multinational programme, there could be constraints that delay timely reimbursement to the local unit, or the multinational programme itself might be structured in a way that makes it impossible to reimburse the local entity for the full loss,” Ellis explains.
“This is where a virtual captive could be considered.”
During his time at telecommunications giant BT in the 1990s and early 2000s, the decision as made to set aside funds on the balance sheet for specific property losses relating to the BT network.
“This was termed an ‘uninsured loss provision’; that idea was later developed and refined, in partnership with a global carrier, to determine agreed criteria and parameters which formed the basis of a policy wording,” he says.
“The guiding principle was to improve the overall management of certain self-retained exposures, including of course risk financing, and the global carrier would agree that arrangement as a ‘virtual captive’. And should claims exceed the virtual captive retentions, the global carrier would also provide excess of loss coverage.”
Lines of business
Keist says a virtual captive approach can work for most lines of business, whether short-tail or long-tail.
“Short-tail lines are obviously simpler to manage, while long-tail lines are a bit more complicated because they require the commutation provision,” he says.
“For example, after the end of the three-year term, we could enter into a commutation agreement with the client. In this agreement, we would sit down, agree on the outstanding losses, and deduct that amount from the low claims bonus.”
The remaining bonus would then be paid out in exchange for a full and final release from all future liabilities.
Keist says some lines of business are particularly challenging, such as directors and officers (D&O).
“But for most other lines – such as cyber, marine, property, professional indemnity, and general liability – it’s definitely doable,” he says.
A company could set up a virtual captive for each line of business, or they could combine them all into one virtual captive contract.
“Conceptually, combining lines of business in a virtual captive is possible. However, the challenge lies in the execution,” Keist says.
“Virtual captives themselves are not particularly difficult to design, but the real challenge is in implementing them effectively.”
Keist notes that virtual captives are often part of an international programme, and when multiple lines of business are combined within a virtual captive programme, the complexity can increase significantly.
He says this is especially true when dealing with master policies, local policies, and variations across different lines of business.
“The execution becomes complicated because each line of business might have different local policies and master policies, making the overall structure harder to manage,” he says.
Maxwell highlighted how Allianz sees both short-tail and long-tail risks being placed into virtual captives.
“Some virtual captives cover just one line of business, while others are more cross-class,” he says. “Ideally, though, it’s best to include multiple lines of business, as this provides diversification – just like you would get with a traditional captive.”
Maxwell says that what’s important is that the lines of business included in a virtual captive are “meaningful” to the company, both in terms of exposure and premium spend.
“There’s no point in including small risks or those easily covered by traditional insurance,” he adds.
“Typically, companies start with larger lines like property or product liability – coverages that are crucial, have significant exposure, and involve high premiums.”
Maxwell explains the need often arises when a company cannot obtain the coverage they want through traditional channels, which leads to setting up a virtual captive.
“Over time, the captive can expand to cover additional lines of business,” he says.
Pros of virtual captives
Vittorio Pozzo, director for Europe & Great Britain in the captive advisory team at WTW, tells Captive Intelligence that virtual captives have their pros and cons.
“I believe they are a valuable tool, especially for organisations that may not have the scale to invest time and money immediately in a cell or a pure captive and are at the same time after an easy-to-implement and quick solution to fund or retain part of their risks in a cost-effective manner,” he says.
“These organisations may want to explore risk retention strategies to reduce insurance costs, lower the total cost of risk, or find capacity and pricing stability over time.”
Maxwell says he typically sees companies follow a journey when exploring alternative risk transfer, where virtual captives can be used as a stepping stone to more advanced captive structures.
“They usually start with traditional insurance coverage,” he says. “From there, they may move to multi-year, multi-line transactions, which are a bit more sophisticated.
“Next, they might transition to what we would consider a virtual captive—something more complex that allows them to better retain risk and smooth out volatility.
“The final step in this journey could be setting up their own captive.”
If a company wants to form a traditional captive, capital must be allocated. If losses exceed expectations, that’s where the capital comes in to cover the excess.
However, with a virtual captive, there is no upfront capital because no legal entity has been formed.
Keist says in this instance virtual captives can introduce an additional premium feature to cover the excess.
“The key point is that there is no capital to cover the loss burden in excess of the expected,” he adds. “Instead, the additional premium finances that risk.”
The advantage for the client is that they do not need to put any money upfront because the additional premium is only paid when actual losses exceed expectations.
“In addition, it’s like the captive buying a stop-loss coverage to protect its capital, since from that point on, the carrier assumes the risk of any further negative loss experience,” Keist explains.
He says this stop-loss mechanism is built into the virtual captive concept.
“The virtual captive has as a primary element a premium component reflecting the expected loss, but they have the additional premium if the loss experience exceeds expectations, and it’s capped at a maximum.
“Once that cap is reached, the ongoing risk is transferred to the carrier, just as if there was a stop-loss in place.”
Challenges
Maxwell says people often do not see virtual captives as a well-defined term, which makes them more ambiguous compared to something like a cell captive, which is clearly defined.
“A virtual captive is a much broader concept,” he explains. “There may be concerns, especially in jurisdictions where captives are not allowed, that if a client starts talking about a virtual captive, people might assume it’s not permitted or subject to the same regulations as a traditional captive.
“In reality, a virtual captive is simply a brand name for an insurance contract, without the same regulatory framework.”
Dobrinsky says that a virtual captive, in some ways, is a similar concept to a cell.
“A legal contract that outlines where things are going is important, but if there is not actually a legal entity in place to accept risks and structure things accordingly, there’s a level of liability and exposure there.”
Dobrinsky says that for smaller captives, especially when the product is more simplified, virtual captives are a useful tool.
“However, when dealing with more complex products and structures, and a larger flow of funds, it usually makes more sense to set up a fully structured entity,” he adds.
“Virtual captives are heavily reliant on the fronting carrier’s appetite and underwriting, present less control to the “owner”, and ultimately can be inflexible in certain ways.”
Keist says that with more traditional captive structures, firms can adjust their programme as often as every quarter.
“For example, if they decide they no longer want to underwrite marine risks in the captive but prefer to focus more on property, they can make that change at your discretion through a board meeting,” he says.
“With a virtual captive they are typically locked into the agreement for a set period, often three years, and any changes to the programme would require mutual agreement with the carrier.”
Pozzo believes a virtual captive is a good tool, especially for organisations with specific targets or constraints.
“However, albeit I still think that either a cell captive or a pure captive offers a higher degree of flexibility compared to a virtual captive,” he says.