Performance drag: proactive strategies for managing capital

As market conditions and risk profiles evolve, companies continue to adjust their risk management strategies. It is why captive formations are on the rise and why alternative risk transfers continue to grow in popularity. However, new and existing captive owners need to take an “active management” approach to their captive operations by revisiting the business plan created at inception, as needed. This includes reviewing the capital required to fund the captive.

Loss events can be irregular and their severity variable, so it is crucial for captives to hold an adequate amount of capital to protect against underwriting and operational risks. The minimum required capital is determined by a jurisdiction’s regulator and can vary from one jurisdiction to another. The amount can vary depending on the premium written, the lines of business covered, and the level of reinsurance purchased. Captive owners can use current actuarial methods and reasonable assumptions to determine appropriate capital levels each year and consider the operational costs of running a captive day-to-day when determining capital needs.

Of particular importance to both new and growing captives is the concept of “stacked capital”. Stacked capital is where the captive needs to add capital each year until it reaches a “steady state”. Steady state is achieved when the number of years of premium equals the length of the claim payout pattern.

Here is an example for two situations: 1) the captive writes only workers’ compensation coverages; and 2) auto liability is the only coverage. In both cases, the annual premium for each coverage is $4.5 million. The capital requirement is typically higher for workers’ compensation (20 percent of reserves) relative to auto liability (15 percent of reserves) due to the longer payout pattern and the potential impact of medical inflation, for example.

Table 1 shows for each year of premium, the claim payments and remaining reserves until all claims are closed.

Table 1: Claim payments and remaining reserves until all claims are closed, by year

Figures 1 and 2 show how the capital stacks as each additional year of premium adds a new capital charge and steady state is achieved. For workers’ compensation, the steady state capital is $1,790,000; for auto liability it is $1,005,000.

Figure 1: Workers’ comp—time taken to achieve steady state

Figure 2: Auto liability—time taken to achieve steady state

Historically, captive owners have had limited options for capital release. Most commonly, the captive would continue to operate until the last claim has closed, and then the captive could be legally dissolved, with the remaining capital returned to the owner. However, there is currently an active group of specialist companies interested in acquiring all or parts of claim liabilities from captives. Captives could strategically utilise reinsurance mechanisms such as a loss portfolio transfer (LPT) to reduce the steady state capital needed while maintaining the level of premium written.

To illustrate this, look at the previous example for workers’ compensation. If an LPT was completed at the end of Year 3 for each year of premium, the captive has effectively shortened the tail of the line of business and reduced the steady state capital. In our example, this would be $1,320,000 rather than the $1,790,000 before the LPT (Table 2).

Of course, there are costs associated with completing an LPT. Still, in a well-run captive with conservative reserves, these costs are much lower than the benefit of releasing capital to be deployed elsewhere.

Table 2: Claim payments and remaining reserves after LPT transaction at end of Year 3

When does a capital release solution make sense?

Before making a decision, there are several factors an owner should consider in assessing current capital efficiency, including:

• Long-term capital commitment: When a captive is formed, it requires the dedication of risk-bearing capital depending on the solvency requirements as dictated by the regulatory body of the domicile. Once a captive assumes the risk, risk-bearing capital must remain in place until all liabilities are extinguished. Therefore, the more premium written, the higher the capital needed and the longer it takes for capital levels to reach a steady state.
• Type of business underwritten: Another factor to consider is the line of business underwritten by the captive. For example, a workers’ comp claim behaves very differently from an auto liability, which behaves differently from a construction defect claim. In addition, payout patterns, average severity, and frequency will vary depending on the line. These factors can create uncertainty that makes a capital release solution worth considering.
• Alternative use for capital held within the captive: The captive may have significant capital that the owner could redeploy. An opportunity cost is associated with not being able to access that money. Over time, this cost adds up if the owner needs to borrow capital from other sources. Released capital could be used for underwriting new business, issuing dividends to shareholders, supplying loans back to the parent company, and more aggressive investment income strategies.

The bottom line

When captive owners review their business plans and evaluate how efficiently the operation utilises capital, there are multiple factors to consider, such as capital commitment and alternative uses for capital. Therefore, an LPT could be a successful strategy to release and redeploy capital more efficiently while maintaining the efficient operation of the captive.