The captive piggy bank: are companies raiding it too much?

As the global economy took a turn for the worse the Cayman Islands Monetary Authority expressed concerns that the solvency of its captives could come under pressure. Captive International reports.

As the insurance market hardens, many companies are making increased use of their captives, or seeking to create a captive. While captives provide a proven solution to the complex risks faced by companies today and offer an affordable alternative to the increasingly challenging insurance market, they bring other advantages too—notably the ability to address liquidity issues, generating funds and lending to their parent companies.

This is making them increasingly relevant in the face of challenging economic conditions, as a September Marsh captive landscape report “Captives Offer Value in Uncertain Times: Effective tools to address pandemic and other risks”, highlights.

The report outlines multiple ways in which captives help address liquidity issues—from risk financing to intercompany lending.

“Financial flexibility is one of the key advantages of captives, which is of particular interest now as cash flow has come into sharp focus during the pandemic,” the report states. It notes that when businesses face supply chain disruption along with government orders to close their operations, shift how they can continue to serve customers, and/or ask employees to work remotely, cash on hand can dwindle.

During the COVID-19 pandemic, a major impetus for economic stimulus and relief legislation was the financial impact on small and midsize businesses and their employees. Since the start of March 2020, Marsh has helped its clients free $3 billion from their captives.

“In exchange for a payment to a third party, a captive parent can sometimes remove liabilities from its balance sheet.”

Marsh captive landscape report

Liquidity tactics

Key ways in which captives can help their parents respond to cash-flow challenges include short-term liquidity tactics whereby a captive’s investment strategy can be adapted to satisfy the captive’s requirements and provide benefits to the parent organisation.

Intercompany lending is another important tool: a captive’s investments can complement its parent organisation’s investment strategies and build up a significant surplus. This surplus can then be used to provide intercompany loans that are quicker and easier to arrange than bank credit facilities and enable parents to repay funds back into a captive.

In 2019, a quarter of the total investments held by Marsh-managed captives were in intercompany loans, totalling $69 billion.

Captives can also invest in parent company assets, including real estate and trade receivables. Total assets held within captives under management in 2019 amounted to $391.4 billion.

“When a captive purchases these assets for cash, they become part of its balance sheet—providing the parent with more cash to fund its operations,” states the report.

“Capital and surplus Marsh-managed captives have a combined $113 billion in total shareholder funds, which represents the amount by which assets exceed liabilities—an important element for any insurance vehicle.”

While regulators require captives to maintain a certain amount of surplus, excess surplus can be made available for other purposes, including liquidity needs such as dividends, premium financing via discounts/premium holidays, and risk management expenses—whereby a captive, rather than the parent organisation, can pay for appropriate risk consulting projects.

“Making additional surplus available to the parent organisation can help support liquidity needs,” states the report. “Beyond simply accumulating profits, there are medium- to long-term strategies that a captive owner can use to potentially generate more surplus.”

These include offloading older liabilities to a third party.

“In exchange for a payment to a third party, a captive parent can sometimes remove liabilities from its balance sheet and thereby reduce the ongoing expense to run off these claims,” states the report.

“Typically, this is achieved by a novation and loss portfolio transfer agreement with a third-party commercial insurer, or through the sale of the captive in its entirety to a run-off insurance vehicle.

“Typically, achieving this finality has a price—and while there is some potential to unlock value, these long-term strategies can take several months to execute.”

“A captive’s investments can complement its parent organisation’s investment strategies and build up a significant surplus.”

Reinsurance and other options

Another strategy is purchasing reinsurance behind a captive. “This can lower overall surplus requirements, since a captive would retain less exposure as this is one of the primary benefits of owning and operating a captive,” states the report.

Discounting loss reserves is another option: working with a captive actuary and regulator, it may be possible to discount loss reserves, which would result in a lower book value and corresponding increase in surplus.

More surplus can also be generated by adjusting premium-to-surplus ratios. “In some cases, regulators have allowed captives to maintain a higher premium-to-surplus ratio,” states the report.

“For example, moving from a 3:1 ratio to a 5:1 ratio can result in a lower surplus requirement for regulatory purposes and permission from regulators to increase loans and issue dividends.”

Does this add up to an entirely positive picture? As the global economy took a turn for the worse, the Cayman Islands Monetary Authority expressed come concerns that the solvency of its captives could come under pressure as parent companies raided their captive subsidiaries via loans and dividends to bolster their liquidity.

Dara Keogh, managing partner at Grant Thornton, says that in his experience this form of borrowing has been rare.

“Grant Thornton works with around 100 captive and reinsurance clients in the Cayman Islands and we have not seen many captive owners taking money out of their captives; this is something that has happened only in exceptional circumstances,” he says.

Kevin Poole, deputy managing director from Artex Risk Solutions, agrees that there has not been a rush of activity of this type.

“The whole point of a captive’s surplus is that it enables the captive owner to offset the good and bad times, which is what we have seen this year,” Poole says. “Where they have been able to, we have seen captives helping out their parents, but we have not seen a mad rush of activity in this area.

“It depends on what industry the parent is in and how resilient it is to the economic shock experienced as a result of COVID-19.”

However, he adds, at the start of the crisis, potential clients were being very cautious, so he did not see much activity, but the longer this situation has gone on the more people are evaluating their business needs.

While captives have the potential to help businesses address liquidity issues, Poole also expects that organisations will need to bolster their captives’ capital.

“As the market hardens that will also encourage captive owners to write additional coverage through their captives, which could mean captives need additional capital,” he says.

As for the danger that raiding the captive “piggy bank” could weaken captives, Poole insists Cayman’s regulatory system provides protection:

“Any loan or dividend paid out of the captive requires regulatory approval in Cayman. The regulator determines whether the captive has sufficient capital to make the payment and still has sufficient assets to cover its liabilities,” he concludes.


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