Risk financing
Risk financing: 3 technical terms explained – definition, synonyms and legal basis.
Captive
Synonyms: Captive insurance company
A captive is a group-owned insurance or reinsurance company that primarily underwrites risks of its own corporate group, thereby financing a structured retention.
Purpose and benefits
Captives make retentions fundable and predictable: premiums stay within the group, loss experience is smoothed over the years, and good risk quality translates directly into results. They also provide access to the reinsurance market and negotiating power towards primary insurers.
Forms
Common structures are direct captives (writing business directly), reinsurance captives (behind a fronting insurer) and, for smaller companies, cell structures in protected cell companies or rent-a-captive solutions.
Prerequisites
A captive pays off with sufficient premium volume, stable loss experience and professional risk management. Substance requirements, governance and tax matters (place of effective management) must be structured carefully.
Retention
Synonyms: Net retention, Self-insured retention
Retention is the share of risk that a primary insurer or a company deliberately keeps for its own account instead of insuring or reinsuring it.
Distinction from the deductible
While a deductible governs the insured’s participation in a covered loss, retention describes the strategic decision about which share of risk an organisation does not transfer to the insurance or reinsurance market at all.
Role in reinsurance
In reinsurance, the retention is the share the cedent keeps per risk or per event – for example the priority under an excess of loss treaty or the retained share of a quota share treaty. Its level depends on capital strength, underwriting policy and portfolio diversification.
A steering instrument
A deliberately set retention lowers transfer costs and keeps underwriting profit within the company. Vehicles such as captives allow retentions to be financed in a structured way and smoothed over several years.
Fronting
Synonyms: Fronting insurer
Fronting is an arrangement in which a licensed insurer issues a policy and passes the risk entirely or predominantly to another risk carrier – often a captive – via reinsurance.
Why fronting?
Captives often do not hold licences for every country in which the group needs policies. A fronting insurer with local admissions issues the legally valid policies, fulfils local regulatory and tax obligations and cedes the risk to the captive via reinsurance.
Costs and security
The fronter bears the captive’s counterparty risk and charges fronting fees plus security (letters of credit, trust accounts, premium withholdings). The scope and cost of collateralisation are key negotiation points.
Legal position
Towards the policyholder, only the fronter is liable under the policy; the transfer to the captive is pure reinsurance in the internal relationship.