Captive insurance and its prospects in Hungary

A captive insurance undertaking is generally defined as a wholly owned subsidiary created to provide insurance to its non-insurance parent company (or companies). Captives are essentially a form of self-insurance whereby the insurer is owned wholly by the policyholder. Its primary purpose is to insure the risks of its owners, and the insured benefit from the captive insurer's underwriting profits.[2] This definition aligns with the one provided in Article 4, point 118 of Act LXXXVIII of 2014 on the Business of Insurance, commonly known as the Hungarian Insurance Act.[3]

The Hungarian Insurance Act includes only one specific provision related to captive insurers. Notably, Article 269, paragraph (8), point j) states that the captive nature of an insurance undertaking must be considered during supervisory review processes. This means that the regulatory authority must consider whether the submission of data and information would be overly burdensome in relation to the nature, scale and complexity of the risks managed by the captive.

Despite the global rise in captive insurance formations, the popularity of captives in Hungary remains relatively low. Only two of the largest companies, namely OTP Bank and MOL Hungary, have established captives. To understand this phenomenon, it is essential to assess both the advantages and disadvantages of captives.

Advantages and drawbacks of captives

Captive insurance has the following advantages:

1. In the ever-fluctuating world of insurance, businesses are increasingly turning to captives to achieve more stable and lower insurance premiums. The traditional insurance market is notoriously cyclical, with fluctuating costs that can wreak havoc on companies' budgeting and profit forecasting. Captives offer a compelling alternative, allowing businesses to operate with lower premiums due to the absence of marketing expenses, lower wages and reduced risk-taking and operational costs. Unlike traditional insurers, captives are content with minimal profits, enabling them to assume higher loss ratios than traditional insurers would typically accept. Traditional insurance premiums often include up to 40 % in cost components, such as profit, operational costs and acquisition costs. By establishing a captive, these costs can be significantly reduced, allowing the company to retain profits and pay premiums based on its own loss history, thereby sharing in the risk exposure.
2. One of the most significant advantages of captive insurance is the easier access it provides to the reinsurance market, which can further reduce the cost of a company's insurance coverage. Reinsurers are generally more willing to take on the risks of captive insurers because they benefit from the parent company's higher standards of risk management and loss control. Additionally, reinsurers gain a clearer understanding of the captive insurer's risk characteristics. Captives can also earn commissions on reinsurance premiums, which reduces their overall costs.
3. Commercial insurers typically require premiums to be paid at the beginning of the risk period, often at the start of the calendar year. This allows them to earn income from investing these funds. In contrast, premiums paid to a captive are spread evenly throughout the year, enhancing cash flow retention and control. Claims are paid as they arise, and premiums can be retained within the group until claims are settled, allowing the captive to earn investment income on the collected premiums.
4. For certain specialised risks, such as sensitive product liability, environmental pollution, pharmaceutical liability and certain professional liabilities, obtaining insurance coverage in traditional markets can be difficult or even impossible, regardless of the loss history. Even when coverage is available, it often comes at a very high cost or with terms that are unacceptable, even for policyholders with excellent loss histories. In contrast, a well-structured captive can provide the desired coverage for these risks while also accessing the reinsurance market on favourable terms.
5. The insurance industry is often criticised for the poor communication between insurers and policyholders. Since a captive is closely aligned with the policyholder and is typically a part of the same corporate group, this issue does not arise.
6. As insurers may apply rating guides or tariffs to certain industries or activities, even policyholders with good loss ratios are likely to be subject to the minimum premium for their industry, regardless of the amount spent on risk management. Conversely, high loss ratios will lead to premium increases. This results in "good" risks subsidising "bad" risks. Additionally, commercial insurers are often unwilling to develop customised policies or coverage. Conversely, a captive can provide the exact insurance coverage needed by the parent company at an adequate risk premium.
7. One of the key benefits of captives for multinational corporations is the ability to apply greater financial net retention at the group level, which would be difficult to justify at the local subsidiary level. By considering various risks at the group level, subsidiaries can avoid the need to purchase full coverage with low deductibles at high costs in the local market. This approach not only reduces insurance expenses but also centralises claims control within a single group captive. The parent company remains constantly aware of claims, enabling it to track them effectively and use the information to enhance its risk management policies and practices.
8. Another significant advantage of captives is that the capital requirements are typically lower compared to a commercial insurer.

The potential drawbacks are as follows:

1. Establishing a captive insurer can offer significant benefits, but it also comes with a range of complexities and challenges that must be carefully considered. These challenges can be particularly daunting for smaller companies and those operating in jurisdictions with stringent regulatory environments, such as Hungary.
2. One of the primary hurdles in establishing a captive insurer is the significant initial, one-time capital investment required. This can be a major financial burden, especially for smaller companies. Beyond the initial investment, running a captive insurer involves various ongoing operational costs, including management fees, operational expenses and costs associated with maintaining regulatory compliance. These expenses can add up quickly, making it essential for companies to carefully assess their financial capacity before proceeding with the establishment.
3. Captive insurers must comply with the regulatory requirements of the jurisdiction in which they are established. This can involve complex and time-consuming processes, such as obtaining licences, meeting solvency requirements and fulfilling ongoing reporting obligations. In Hungary, the regulatory landscape is particularly challenging, requiring the expertise of seasoned professionals to navigate effectively.
4. Since the inception of insurance entities, the concept of risk distribution – aggregating risks to reduce the potential volatility of overall loss results – has been a fundamental principle. A captive insurer, however, concentrates risks within the parent company. This concentration of risk can be a disadvantage compared to spreading risks across multiple insurers in the traditional insurance market. It may also lead to increased scrutiny, raising questions about the adequacy of risk distribution for a transaction to qualify as insurance.[4]
5. Captive insurers need to maintain sufficient liquidity to pay claims. Unlike traditional insurers that pool risks from many policyholders, a captive insurer typically covers risks from a single parent company or a small group of related entities. If a captive insurer faces large or unexpected claims, it may struggle to meet its obligations, potentially jeopardising the financial stability of the parent company. The limited risk pooling can result in higher volatility in claims, posing a significant financial risk.
6. The tax treatment of captive insurers can be complex and varies by jurisdiction. In Hungary, the insurance tax regime is particularly specialised and challenging to navigate, even for local tax experts. Captives must ensure compliance with these complex tax regulations to optimise tax benefits and avoid penalties. Additionally, tax authorities may scrutinise captive arrangements to ensure they are not being used primarily for tax avoidance, which has traditionally been a primary reason for establishing captives.
7. Stakeholders, including customers, investors and regulators, may view the use of a captive insurer sceptically. Concerns about the financial stability and ability of the captive to pay claims may impact the parent company's reputation. Exiting a captive insurance arrangement can also be challenging, particularly in Hungary, adding another layer of complexity to the decision-making process.
8. Perhaps the most significant drawback of captive insurers is the risk of underinsurance. Captive insurers, being wholly owned subsidiaries created to insure the risks of their parent company, often operate with limited capital compared to traditional insurers. This underinsurance can result in substantial out-of-pocket expenses for the parent company, potentially jeopardising its financial stability and hindering its ability to recover quickly from significant losses.

In general, it can be concluded that captive insurance serves as an excellent alternative to risk retention groups and even securitisation when it comes to alternative risk transfer. However, it is crucial to stay vigilant regarding potential risks.

Trends

In the commercial landscape, the benefits of captive insurance companies far outweigh the drawbacks, which is why a significant number of Forbes 1000 and Fortune 500 companies have adopted this model. Captive insurance companies offer a strategic advantage, particularly in managing complex and emerging risks that traditional insurers are often reluctant to cover.

One of the most notable trends among these corporations is the use of captives as incubators for difficult or new risks. For instance, in the renewable energy sector, insurers frequently cite the lack of historical data, making them hesitant to provide comprehensive coverage. Similarly, in the realm of cyber insurance, skyrocketing prices have driven companies to seek alternative solutions. Property insurance in nat-cat (natural catastrophe-prone) regions also presents significant challenges. In these scenarios, corporates have increasingly turned to their captives to not only provide insurance but also to serve as central repositories for risk data. This data collection is crucial as it helps underwriters gain a better understanding of these risks, ultimately encouraging their participation.

Another significant trend in the captive insurance sector is the move towards onshore domiciles. Vermont, for example, has emerged as the largest captive domicile globally, surpassing traditional offshore centres like Bermuda and the Cayman Islands, according to Business Insurance rankings. The primary driver behind this shift is the desire to minimise the risk of incurring self-procurement premium taxes. However, it is important to note that while some offshore domiciles report a decline in the number of captives, they are still experiencing substantial premium growth. This growth is particularly evident in sectors like life insurance captives, with Bermuda being a notable example.

Hungary

In Hungary, the landscape for captive insurance companies is fraught with challenges that set it apart from other jurisdictions. 

One of the primary issues is that captives are treated the same as any other insurance undertakings. This classification subjects them to the same extensive administrative burdens and complex legislative requirements, which are difficult to navigate without the presence of seasoned professionals. Most importantly this makes them subject to the same supervision regime of the National Bank of Hungary as any other insurance undertaking in Hungary. Accordingly, this fact contradicts the European Insurance and Occupational Pensions Authority's (EIOPA) Opinion on the supervision of captives as it neglects the special characteristics of captives.[5]

Consequently, unlike other countries that have specific regulations to facilitate the operation of captive insurance companies, Hungary offers no such concessions. There are no special rules or grants to ease the funding and maintenance of captives. This lack of facilitation undermines the inherent advantages of captives, such as cost-effectiveness and flexibility, putting their viability at risk.

Another significant barrier is the general lack of self-organisation and self-care within the Hungarian corporate culture. There is no established tradition of structuring corporate entities in a way that would allow captives to play a pivotal role. This cultural gap further complicates the adoption and success of captive insurance models in the country.

Given that Hungary is not an offshore centre, it is generally not cost-effective for companies to employ their own management for captive insurance operations. Instead, most functions should be outsourced to professionals who are well-versed in local conditions. Fortunately, finding such professionals in Hungary is relatively straightforward, making this a viable option for companies looking to navigate the complex regulatory environment.

Despite these challenges, there are potential pathways for the captive insurance market to grow in Hungary. One promising avenue involves the formation of a small group of entities with similar insurance interests and no conflicting ownership stakes. By pooling their risks, these entities could have a relatively significant own insurance interest. Thus, the ideal Hungarian candidates for captives are (i) municipalities, (ii) public utilities, (iii) companies wholly or majority owned by the state, and (iv) universities.

In conclusion, while Hungary may not currently be the ideal location within the EEA region to establish a captive insurance company, there is a silver lining on the horizon. Unlike Malta[6], which boasts a sound regulatory and legal framework along with a favourable tax system for captives, Hungary faces significant administrative, legislative and cultural challenges. However, these obstacles are not insurmountable. There is increasing awareness and interest among potential candidates who are beginning to reconsider their approach to the idea of opening a captive in Hungary. With ongoing efforts and reforms, Hungary has the potential to evolve into a prominent destination for captives in the long term.

authors: Gábor Pázsitka, Bálint Bodó.