2013 Vermont Captive Insurance Association (VCIA) Special Section

A captives' influence on a firm's risk profile

VCIA panel will explore the captive's role within ERM initiative

By Michael J. Moody, MBA, ARM

Over the past few years, many captive owners have been exploring new opportunities to further utilize their captives. While there have been several new ideas discussed recently, one idea that continues to receive significant attention is determining the role captives should play in an organization's enterprise risk management (ERM) program.

The upcoming Vermont Captive Insurance Association (VCIA) conference will include a session titled "ERM: Impact on Captive Organizations and Risk Management Tools." Several captive experts will serve on the panel, which will be moderated by Christopher Mandel, CPCU, ARM. Mandel is a senior vice president, strategic solutions for Sedgwick. Previously he was assistant vice president, enterprise risk management for USAA from 2001 to 2010, where he designed, implemented and managed USAA's ERM program. Additionally, he was named Risk Manager of the Year in 2004 and served as president of the Risk and Insurance Management Society (RIMS) in 2002-2003. He also has designed, implemented, managed and participated in governance of multiple captives and risk retention groups in multiple domiciles.

Captives: are they a good fit?

"Initially, I never thought of captives as requiring a distinct application for ERM purposes," says Mandel. "But on further consideration," he says, "I realized that captives, being insurance entities, do have, or should have, a unique take on ERM as distinct from a non-insurance parent owner. After all, insurance organizations really led to the widespread use of ERM due to the obligations of rating agencies to ensure they are properly capitalized and run." The fact is "ERM got considerable mojo in the insurance world and has probably been most robustly applied in that sector." Today, many of the more successful applications of ERM are occurring in the insurance sector. Much of the focus centers on capital and capital adequacy goals, and a concern with maintaining sufficient surplus to honor financial obligations.

"Let's face it—it was in the insurance space that ERM has flourished the most," he says. "If you look at the original S&P model, from its rudimentary view when it was introduced as part of their overall review process in 2006, until they began taking a more detailed and rigorous approach in their Level 2 process in early 2009," it changed how ERM was viewed and the importance it received. Further, now that S&P has designed and launched its Level 3 process, it is heavily focused on economic capital strategies.

Given that view of an insurance operation, any insurance company, including captives, will need to implement an ERM program that would typically originate as an "enterprise level strategy that then cascades down through the business units." So having a captive supports the argument that ERM as a whole "actually deserves more attention and perhaps with some specificity related to the unique and often unfamiliar exposures captives bring to their owners."

From a purely financial standpoint, he says, "in most large Fortune 500-sized companies, the captive may be financially insignificant." As such, in the bigger picture, "the captive may be way down on the list of concerns before it gets anyone's attention. When you have a division (i.e., the captive) that is a $50 million facility in a corporation that has $100 billion in assets, it likely represents a rounding error." But it's not just "the financial concern that should be the focus of a captive ERM strategy; it is broader." Central to ERM success is "the rigor and specificity with which it addresses the exposures it brings to its owners."

An appropriate ERM strategy "is designed at the enterprise level." From that standpoint, "ERM should be as common to a captive as it is to any other part of the company's operations," Mandel says. But it is really deeper than this, he points out. "When you get down into the governance of the captive itself, management and governance need to be concerned about the more capital-focused regulatory concerns that will to some degree define its success. At one of my prior employments, for example, I had a risk governance representative in the form of a risk officer in every major subsidiary entity and function. As a result, I played that role in the captive management/governance structure. Collectively we recognized the unique and often very poorly understood exposures that captives bring to companies whose main business is typically something quite different from insurance or underwriting exposure."

Any captive, despite its obvious potential financial impact on its parent's performance, should be providing a robust enterprise-wide risk assessment process to its strategy and tactics. Part of this process should include a determination of the risks assumed and whether or not they are within its appetite. Thus, having a captive should necessitate the development of a risk appetite framework or at least contribute to the framework used at the parent or holding company level.

Point in fact, "many companies start with this risk framework, rather than try to deploy a comprehensive ERM strategy from the start." Mandel points out that for some organizations this issue of risk appetite comes to the management's attention as a result of new subsidiary formation of which a captive is but one variation. "So even if the captive represents a 'rounding error' from a financial standpoint, it's the protection of the parent's reputation that can often be the bigger pay-off."

There is value in this view, "especially if it bubbles up as a result of a simple, captive-focused risk identification and assessment process. You will at least know what the risks are as well as have some concept of their magnitude." In effect, Mandel says, "It can become a catalyst for the assessment effort in the first place."

Mandel believes that over time, people will begin to see the need for a risk-focused approach to all aspects of a firm's operations, similar to how his current employer, Sedgwick, addresses its clients' interests. "Currently, we provide services to captives, and for the most part we don't necessarily label our efforts with ERM or Strategic Risk Management monikers." He says for Sedgwick, it's really just risk management as it always should have been—addressing all significant risks to an entity in the light of its short- and long-term objectives.

"At Sedgwick our focus is to help our clients manage the risks they care about most, as effectively as possible. While most of our captive business revolves around group and specialty captives, we are considering whether to broaden our service offerings to 'pure captive channels.'

"One thing that I've begun to realize is the commonalities between ERM and IDM or integrated disability management. Our emphasis is to help clients find ways to address related or overlapping exposures (e.g., occupational and non-occupational risks) and get them more effectively and efficiently addressed." Fundamentally, this is the essence of ERM with the distinction being only which and how many of the exposures are being addressed. "Unfortunately, in some cases both ERM and IDM have not achieved what they could for those with this mindset for managing risks. As a result, stakeholder expectations have often not been met," says Mandel.

"We are always looking for ways to deliver strategic solutions, which will not only meet clients' expectations, but exceed them as well.  ERM, like IDM, has that potential to add value if applied correctly."

Conclusion

Having a captive can affect the risk profile of its owner, sometimes significantly. "Because it's addressing exposures, involved with things with which management might not normally be familiar, they frequently have a limited understanding of and ability to deal effectively with its risks." So whether or not the captive should serve as the focal point of an ERM program will depend on the culture and risk attitude of the organization affected. However, Mandel says, "It could serve as the catalyst for the board's engagement in ERM." At the very least, the captive should trigger some level of risk assessment that can assure its owners of the degree to which it has any significant impact on the owner's risk profile.

"Many organizations do not have a lot of commitment to a broader approach to managing risk," notes Mandel. Captive ownership can provide the impetus for driving a more comprehensive and disciplined approach, such as through the development of a risk appetite framework.