Virtual Captives: The Best of Both Worlds

If a captive is not an option, a virtual captive offers an innovative combination of a classic insurance product with those of risk financing.


In the 1970s and 1980s, the issue was the liability crisis in the U.S. insurance market; today, it is strained capacity in directors and officers (D&O), cyber and business interruption. Many companies are looking at ways to retain risk to reduce their exposure to rate increases and capacity constraints in the insurance market. The silver bullet of retention is a captive: Growth in the number of captives gained momentum in 2020, with 100 new formations, and is continuing at a similar rate in 2021, according to a recent report from Marsh. Those who already operate a captive – around 7,000 are active globally – are expanding their volume or taking on new risks.  

Captives come with challenges

However, not every company can or wants to act as an insurer itself. The company must be able to set aside large amounts of equity/capital as reserves. The risk manager must not only convince the CFO with a business case but also satisfy the requirements of insurance supervision as well as complex criteria for accounting and balance-sheet management. Operational risk management must also meet the highest standards for analyzing and evaluating risks. In addition, there are administrative costs for the captive to take into account. A captive is always a long-term play over various market cycles.

An innovative third way

But what if a captive is not an option for a business? In those cases, a virtual captive offers an innovative solution that combines the advantages of a classic insurance product with those of risk financing.

This solution is essentially a hybrid solution of risk transfer and self-retention. In the current market environment, companies can take on more risk themselves, getting coverage for risks that are difficult to insure or uninsurable.

Other advantages include better planning for corporate finances and full cost transparency. Unlike cell captives, which allow companies to rent a share in a captive operated by a third party, there is no connection to offshore financial centers, which can be subject to critical scrutiny.

Put simply, a virtual captive is a multi-year rolling insurance program that leaves a portion of the risks with the policyholder but reduces the results volatility from major loss events. The company pays an annual premium to provide for the risk of owning claims with a bonus-malus system. The contract is renewed for a further year if the cumulative loss ratio does not exceed an aggregated level; if it does, negotiations between the parties are required to adjust the terms, or the contract is terminated. Both the financial commitment (a single-digit-million amount) and the time commitment (usually up to five years) are kept within manageable limits.

What are the advantages of a virtual captive?

  • No need for equity capital
  • Easy establishment and expansion of self-retention capacities
  • Increased predictability of results due to lower or partially transferred volatility on the income statement
  • Cost transparency and more cost-effective than a fully fledged captive
  • Inclusion of tailor-made cover for difficult or uninsurable risks
  • Suitability for all risks; multi-line solutions also possible

See also: ‘Virtualizing’ Your Customer Service

Solid financial credentials are a must

A virtual captive is a useful option for those businesses that find it difficult to achieve the desired cover and capacities in the current environment. These are likely to be companies in critical, loss-prone sectors that have a very good risk management performance and are therefore confident they can take on more risks themselves. To develop and structure such a solution, and gain backing for it within the company, the risk manager needs solid technical underwriting know-how and financial acumen.

In principle, all risks that are insurable from a legal perspective can be included in a virtual captive, even D&O and cyber risks, for which capacities are scarce in the current market. Multi-line solutions are also possible.

For many insurers, traditional property and casualty (P&C) insurance products on the one hand and alternative risk transfer on the other are complementary and to the benefit of their clients. Virtual captives can offer businesses a tailor-made solution that aligns with their approach to risk management.

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