ESG and captive insurance: setting captives free

Environmental, social and governance (ESG) has gathered steam in recent years as a vehicle for grouping together a range of corporate responsibilities that are increasingly in demand by boards, regulators, investors, employees and customers alike.

As ESG-related risks have intensified, so has interest in captives. Many dynamics fuel this interest – the social, economic and political shocks that came with the Covid-19 pandemic, the increasing cost of natural disasters and geopolitical tensions.

“We are living in a decade of cascading global risks, which can greatly impact coverage capacity and increase insurance rates in the traditional risk transfer market,” says Adriana Scherzinger, head of captives sales & execution for Zurich North America. “Given those cascading risks and the harder market for many types of risks, we are seeing more risk managers adding or expanding the use of captives.”

Captives have historically been a go-to risk transfer vehicle for companies seeking to self-insure high frequency but low severity risks, usually backed up by reinsurance protection and boxed in by other traditionally bought insurance policies for those risks that did not fit captive risk appetite.

Attitudes as to which risks ought to find their way into a captive have been changing in recent years, including to meet the range of ESG priorities, amid shifts in (re)insurance market pricing, from governance risks, such as directors and officers liability (D&O), to environmental exposures, such as climate-exposed natural catastrophe risks.

“A captive can be used to insure almost any of its parent’s insurable exposures, from traditional property and casualty coverages to employee benefit programmes,” says Sherzinger. “I’m seeing property, product liability and international employee benefits being put into single-parent captives. And lately, there’s increased interest in putting cyber, medical stop loss, D&O and several other coverages into captives.”

Climate and extreme weather

Boards have been energised most notably by the ‘E’ in ESG and by political activism, as well as increased regulator pressure to address the climate emergency in particular.

“On the property and casualty side, climate change risks and environmental factors are driving interest in captives. Historically uncommon losses are becoming everyday events with extravagant price tags,” says Sherzinger.

Nowhere has this been more evident than for extreme weather-exposed US businesses, which were exposed to some of the hardest rate rises at recent (re)insurance market renewals. This follows recent loss experience. The US experienced 20 separate billion-dollar weather and climate disasters in 2021, according to National Oceanic and Atmospheric Administration data, and in 2020, there was a record 22 billion-dollar events.

“This trend is not going to reverse any time soon, and with inflation driving up replacement costs, losses are only going to climb higher,” says Sherzinger. “That’s one reason companies are using captives to fund that risk upfront, providing coverage for local businesses that may not be covered by traditional insurance policies or when the coverage provided is inadequate.”

“Captives can be used to provide coverage for these risks or to supplement the coverage provided by traditional insurers. While many companies turned to captives simply for efficiency in years past, now it’s increasingly for foundational business resilience,” she adds.

P&C rationale

Reasons for creating a captive differ. Hard market insurance pricing in recent years has encouraged some firms towards captive structures, for example, as well as aiming to benefit the bottom line more generally through a mature approach towards managing and transferring ESG risks.

“Captives can provide an alternative to traditional insurance when capacity in the market is limited. It can provide more control over premiums by smoothing market volatility caused by the poor loss experience of others,” says Emma Sansom, group head of captives, Zurich Insurance.

Captives can also be used to provide cover for emerging risks with limited loss experience and for which there is limited appetite among traditional (re)insurance markets.

Sansom adds: “Initially, loss experiences can be poor for new technologies, for example, with fire risks for solar panels and lithium batteries, but over time as understanding of those technologies evolves, leading for example to improved manufacturing methods and risk management approaches, then in theory claims experience will also improve. In addition, the captive can collect data on these risks, which can then be taken to the traditional markets to supplement the captive’s capacity.”

S stands for HR

Captives tend to be well understood by risk managers and insurance professionals, but less so by human resources (HR) professionals. However, HR is at the forefront of many ESG-minded captive projects, particularly with its focus on employee benefits, many of which require health, liability or other insurance policies.

“Many companies are also considering putting employee benefits in captives to have greater control over their global employee offerings,” Sherzinger says.

For a multinational firm, this can enable a consistent employee benefits programme, despite the differences involved in operating in many jurisdictions with different legal and regulatory systems and insurance markets.

“A captive can enable companies to expand employee benefits for social equity reasons, such as covering things like pre-existing conditions and gender transition treatments – in essence, difference-in-conditions coverage,” says Sherzinger. “A large multinational company wants to be able to say this is what they provide all their employees, not just their US employees.”

Data benefits can also emerge, like the previous example of building better data for emerging technologies, although these would be put to very different uses by HR professionals.

“An added benefit of this approach is that the company has access to the aggregated anonymised employee data, which can be mined to help refine and enhance employee benefits. Unlocking that data can help employers drive well-being benefits and policies, and that’s what we’re seeing in many current captive programmes,” Sherzinger says.

Governance focus

There is nothing new about focusing on governance, but combining it with ESG and captives is more modern. Captives give leaders greater control and transparency for their risk programme, reaping governance benefits.

“By adding ESG and sustainability to the organisation’s risk register, captives can be used to establish a framework of identifying ESG topics,” says Sansom. “ESG can be incorporated into the due diligence associated with the underwriting of risks, so that when combined with an assessment of more traditional risk management techniques, a more positive view of the risk might be possible. Where there are no insurance solutions available, a captive can provide capacity and apply underwriting principles to the risk.”

ESG strategies are evolving, and many companies are still not ready to use captives for ESG.

“ESG risks and opportunities will be a long-term dialogue with no instant answers, but instead, a quest for longer-term, deeper commitment, meaningful discussions and thoughtful valid ways to enact reasonable action and accountability,” says Renea Louie, chief operating officer, Pro Group Captive Management Services.

Those companies that do not seriously embrace ESG discussions may lose competitive advantages as their investors and their customers evaluate their citizenship in this regard among others and choose to do business with them, she warns.

“No matter what phase a company is in within its ESG evolution, ongoing reassessment of goals, benchmarks and corporate action are all in the equation,” Louie adds. “As exposures grow, captives can manage that on an increasing basis. Some of the first steps a captive board can take are not only to look at its climate and environmental risks, but also to look at its investments and ensure that the portfolio represents its ESG strategies and values.”