Keeping optimisation in mind

The captive insurance marketplace continues to expand and evolve, with clear indicators that captive owners have benefited from having their captives in place. Over the long term, our clients have seen expanded coverage and better pricing through their captives in comparison to the commercial and reinsurance marketplaces.

As the pandemic continues to cause disruption in the marketplace and the commercial market is seeing pricing and capacity issues, companies are increasingly looking for help from a captive solution.

Simultaneously, captives are increasingly being scrutinised by the Internal Revenue Service (IRS). There are many good actors in the captive marketplace, but it is always important to understand recent court-case rulings and regulatory updates to ensure their captive is compliant.

In addition to being compliant from an IRS perspective, there are other key considerations for the optimisation of your captive. For example:

• Your organisation’s aggregate risk profile has gone through major changes in the last couple of years.
• Corporate and legislative changes are constant and lead to changes in your company’s risk profile.
• You are experiencing higher premiums and tighter terms in the commercial/reinsurance markets. This is evident with many liability lines and umbrella coverage.

In addition to these common issues, COVID-19 may have caused your company supply chain issues, business interruption issues, remote working changes, and cybersecurity problems. The pandemic has also had a direct impact on claims experience and the future pricing of employee benefit programmes.

At Spring, we recommend that any client who is considering adding coverage into its captive should take a hard look at its current captive state and conduct a “refeasibility” (aka “captive risk optimisation”) study. In going through this process, there are several important questions to answer from the outset:

• Are commercial/reinsurance market conditions yielding unreasonable premium levels?
• Can you save more by retaining underwriting and investment income through increased captive retentions and/or insuring additional risks?
• What is your risk tolerance? Has your organisation’s risk profile changed? Are you exposed to COVID-19 or other pandemic risk?
• Have you considered the potential savings and volatility protection for employee benefits such as healthcare, disability, and life insurance?
• Can you add stability to your captive’s annual claims and financial results?
• Has claim experience been better or worse than originally expected?
• Do captive coverages need to be repriced?
• If you started the captive today, would it include the same risks?

Armed with the answers to these questions, we guide clients through a proven five-step process.

First is the Goals stage, where we gauge the extent to which goals have been achieved to date, or what objectives might have changed since the captive’s inception. This is where we define the organisation’s risk appetite and collect underwriting and other data.

In the Strategies stage, we look at the Risk Hierarchy (Figure 1) to determine an appropriate plan of attack based on prioritisation and return on investment.

During the Structural stage, we discuss the different forms of captives available and whether the current model is still optimal. The hard market and effects of COVID-19 come into play here. Then we move to the Impact stage, which lays out the different pieces of the captive puzzle, such as:

• Quantification of benefit/cost over projection period, including cost of capital
• Domicile—consider change if appropriate
• Current reinsurance levels and how to optimise your use of reinsurance
• Governance
• Operational risks
• Risk shifting and risk distribution
• Review captive financial performance against benchmarks and original forecasts
• Stress test the captive with reasonable adverse case outcomes—understand the confidence level or probability of the outcomes being generated

Finally, we move into the Implementation stage, where we develop implementation plans based on findings and make actionable recommendations for achieving the established goals.

A refeasibility report should include the findings of the study, reviews and recommendations, an assessment of risk distribution and pricing adequacy, and a determination of whether risk is being transferred. During the measurement stage, we establish touchstones and benchmarks for ongoing programme success.

Captive feasibility studies come in many forms, and there are no industry-standard report formats. As a result, many captive owners do not know what to expect as a final deliverable, and we see many feasibility reports that are severely lacking.

Here are five key questions that the captive owner and reviewer of the feasibility/refeasibility report should be able to answer.

Administrative expenses related to operating captives generally include: actuarial, captive management, legal and audit; letters of credit (if used for collateral); captive domicile fees and taxes; claims administration (if paid directly by captive and not insurance carrier), etc.

These fees play a large role in determining whether the captive will be profitable at fully insured market rates. Captive owners need to understand how these fees were determined in the captive feasibility study and if they are market competitive.

As part of the captive feasibility study process, captive owners should work closely with their current insurance carriers to gather as much high-quality data as possible. The captive feasibility study should include the following data for all proposed lines of coverage: all plan documents or summary plan descriptions (for benefits lines); current and prior (at least five years) of policy details, including limits and self-insured retention/deductibles; at least five years of prior premiums and exposures, etc.

Over the long term this level of detailed data will be collected and used to develop future loss estimates once the coverage is placed in the captive.

This data should be readily available, and companies should be reviewing it regularly, regardless of whether they are undertaking a captive feasibility study. Organisations should be looking at their insurance reports as closely as they would their credit reports, since the cost of insurance is a large budget item for most.

It is important that an experienced and qualified actuary reviews the data. A captive feasibility study should always include a robust actuarial analysis and report on the data used, including assumptions and actuarial methodology with appropriate narrative and technical support.

A good actuary will ensure that policy/plan changes, rate changes, and overall exposure changes have been properly reflected in the experience.

In our experience, carriers typically overstate reserves (due to conservative assumptions), inflating the loss ratio. A good actuary will independently calculate reserves to compute a more accurate estimate of historical loss ratios and future losses.

Last (but certainly not least), the captive owner needs to be confident that the programme will qualify as insurance if premiums are to be tax deductible. To qualify as insurance, there must be risk transfer and risk distribution.

There are a few industry-accepted risk transfer tests that will demonstrate that the coverage adequately transfers risk from the insured to the captive. The “10:10 Test” is the most common, determining whether there is a 10 percent chance of a 10 percent loss.

Spring recommends looking at the Coefficient of Variation (CV) and other accepted industry tests to better understand the impact of the law of large numbers.

All captive feasibility studies should address whether there will be adequate risk transfer and risk distribution.

A captive feasibility study is one of the most salient parts of placing property and casualty coverages and employee benefits in a captive. Captive owners should aim for feasibility or refeasibility studies that are transparent, objective, highly robust, and consider all aspects of the captive transactions.

Figure 1: Risk hierarchy

Peter Johnson is chief property and casualty actuary at Spring Consulting Group. He can be contacted at: peter.johnson@springgroup.com