Supply chain risk management using a captive insurer poses challenges

Car manufacturers were confronted with supply chain issues after the earthquake and tsunami in Japan earlier this year. Some companies are considering using captives to cover the risks, but the short-/ REUTERS

Some risk managers and organizations seeking to address their supply chain risks, highlighted by the disaster in Japan, have weighed covering their suppliers through their captive insurer, but few, if any, have taken that approach, experts say.

Competitive pricing for business interruption coverage and a general caution about adding external supplier risks to the company-owned captive have limited the approach's appeal among buyers, they say.

Companies often require outside suppliers to obtain a certificate of insurance with specific limits per the negotiated contract. If the supplier cannot put up the amount of insurance the company wants, the company often buys an excess layer covering the supplier and passes the costs on to the outside provider, observers say.

The recent earthquake and tsunami in Japan and other natural disasters have highlighted this specific exposure that companies face. One way to handle the exposure is placing it in a captive, which brokers say could carry tax advantages as a third-party risk and assist a company's risk management efforts.

“We do bring it up,” said Gary Osborne, president of USA Risk Group Inc. in Montpelier, Vt., when company boards inquire about innovative ways to cover suppliers.

“We haven't seen many people using the captive (approach). We've actually had three or four clients buy a policy,” said Mr. Osborne, who works mostly with Fortune 2000 to 5000 companies with $1 billion in sales and premiums of $5 million to $8 million.

When the issue is brought up to clients, “quite a few of them have found that the coverages are priced where they didn't want it or they aren't willing to take the risk in the captive,” he said.

Many captive managers are finding competitive pricing in the commercial insurance markets for business interruption and supply chain risks, Mr. Osborne said. “They're finding the products (in the commercial market), and they're not particularly comfortable writing it in the captive,” he said.

Les Boughner, executive vp and managing director of Willis Group Holdings P.L.C.'s North American captive practice in Burlington, Vt., said companies with captives are more focused on protecting their internal risks.

“The discussions we've had with our clients are much more directed on "how do we use a captive to protect us from the exposure' than it has been to "how do we build a business out of it,'” Mr. Boughner said. “If we had an entrepreneurial captive that was really interested in starting to sell this coverage, they'd probably find the rates are so low they weren't interested in it.”

Nancy Gray, regional managing director-Americas at Aon Insurance Managers Ltd. in Burlington, said some captives cover a company's internal supply chain risks, but so far there has been mainly discussion of expanding to cover outside suppliers, among other third-party risks such as customer risk and employee benefit programs.

Amid a soft-market insurance cycle, companies during the past five years have been forced to cut captive expenses as much as possible, Ms. Gray said. “Utilizing the captive to become a profit center becomes another source of revenue to companies while also keeping their costs down,” she said.

Since the early 1980s, many captive owners have “moved away from writing third-party exposure and focus just on writing their own exposure,” Ms. Gray said.

But if captive owners have a good understanding of the exposures related to their suppliers and are confident in underwriting those risks through the captive, they can look “at their captive as a profit center instead of just a cost center,” she said.

If a company writes enough third-party business, it qualifies as an insurance company for federal income tax purposes and receives the tax benefits of deducting loss reserves, Ms. Gray said.

“If you're not an insurance company, you only get the tax deduction when the losses are actually paid. So this is an accelerated tax deduction if you can write enough third-party risk in your captive,” Ms. Gray said.

Companies also can team with standard insurers to underwrite supply chain risks through their captive, said Steven R. Bauman, senior vp and head of captive services at Zurich Global Corporate, North America, in New York.

The captive would underwrite the risk using Zurich's form and take a retention in their captive or quota share risk with Zurich, or they can take the underlying deductible amount in their captive and Zurich would take the excess layer, Mr. Bauman said.

The customized coverage can cover suppliers several links down the chain, Mr. Bauman said. “We are talking to several people now on the possibilities.”

“It gives the assurance to the client that the coverages that are provided to those suppliers or those contractors are to the standards that the client dictates through their captive,” Mr. Bauman said.

Risk management strategies often prevail as the preferred approach in dealing with outside suppliers, experts say.

“I'm not sure captives will be a large solution for, in terms of numbers, captives that will be used for the supply chain risk of the suppliers,” Aon's Ms. Gray said. “I think there are more opportunities for captives looking at a company's own risk profile. They need to understand the risk themselves.”

Supply chain risks are short-tail exposures, said USA Risk Group's Mr. Osborne.

A company affected by the March earthquake and tsunami in Japan likely already has worked its way around the blockage and knows its ultimate loss, Mr. Osborne said. “It's not going to take you six years to figure out what was my actual loss from that supply chain incident. There's not a whole lot of sitting on money for a tax deduction.”

Instead, companies are looking at ways to deal with supply chain problems, such as rerouting the supply chain, diversifying their suppliers and moving away from the tight margins that come with just-in-time strategies, Mr. Osborne said.

“I've seen much more standard risk management techniques rather than financing it,” Mr. Osborne said. “This is one of those (situations) where, even with my love of captives, I'm not sure the captive brings much to the table,” he said.