Provided by AIG
The risk profiles of companies operating today – particularly multinationals, but by no means limited to them – are radically different than they were just a few short years ago. Many factors are driving the change, including several mentioned below. But the underlying reason can be described in two words: growing complexity. Managing this complexity and the concomitant risks that go with it requires a broader conception of insurance and its overall role in the risk management mix than in the past. It also makes the role of risk manager more strategically important to a business’s success than ever before.
High among the many factors driving risk to new levels is the role of increased regulation and regulatory scrutiny, particularly in developed markets. In emerging markets, the regulatory environment is less certain and is often rapidly changing as well, though frequently in less predictable ways. Knowing how regulatory changes at the local, regional and national levels impact your company’s exposure in whatever international markets it operates is a critical and difficult task. But, it is one of the most important to “get right” in your risk management strategy.
The growing problem of cyber threats is also a relatively new and increasingly important component of overall risk for almost every business. In addition to the very real threat of clandestine hackers sneaking past firewalls and stealing vital customer and business data, cyber threats also include more mundane concerns, such as an employee inadvertently releasing proprietary information on the Internet. In the latter case, a bad problem can very quickly be made worse if the information is picked up by social media, where it can spread virally around the world in a matter of days, if not hours. So as always, the benefits of new technologies must be balanced against the new and previously unknown risks that they engender.
One other area of exposure worth mentioning briefly relates to plaintiffs’ awards. At least in some markets, including the U.S., such awards are much higher today than they were even a decade or ago. Therefore, while not a new risk, the possibility of being subject to paying out such awards broadens a company’s potential overall exposure.
Alternative Tools for Managing Risk – Holding Risk Captive
The burgeoning number and levels of risk that companies are seeing, call for thinking about risk management, in new and different ways and considering all of the tools at its disposal. One of these tools is of course insurance, which has traditionally been thought of exclusively as a means of transferring risk. In today’s environment, it may be more useful to take a broader view of the role that insurance can play.
One common example in which insurance is purchased for reasons other than risk transfer is to satisfy regulatory, counterparty, or other requirements for insurance on a risk that a company would prefer to retain. But, there are alternative approaches to achieving that end. One example is the use of captives, one of several risk retention vehicles.
For those unfamiliar with the concept, a captive is an insurance company established and controlled by a parent (usually noninsurance) company to insure some or all of the risks of the parent. Once established, the parent can assume these risks in its captive either directly, or via a fronting program. In a fronting arrangement, a fronting insurance company issues a policy (and hence acts as the insurer of record) in exchange for a fee and then reinsures that risk back to the captive and possibly other reinsurers designated by the parent. Fronting is often used to insure risks located in a country where the fronting company is licensed to issue insurance policies, but the captive is not.
Companies may form captives (or use so-called ‘rent-a-captives’) for a variety of reasons, such as insuring a business risk that is either not covered by traditional insurers, satisfying regulatory requirements for locally admitted insurance policies, or for covering a risk when traditional insurance is viewed as too expensive. The use of captives can also provide cost-effective access to the international reinsurance market, and to higher levels of coverage and capacity than would otherwise be available. However, companies wanting to use captives to retain risk need to have sufficient liquidity to cover the losses they are responsible for.
Properly used, captives and other alternative risk transfer vehicles provide companies with a broad set of tools for addressing a host of business challenges. To make the most of them, risk managers should be made an integral part of a company’s business strategy. This will provide them with the detailed knowledge they need of the company’s long-term objectives and direction, so that they are better positioned to design a risk management solution that makes the best use of both traditional and nontraditional risk transfer mechanisms.