The upcoming audit season

30-11-2012

Geoff Johnson

The upcoming audit season

A thoughtful and attentive audit can cast a telling spotlight on the finances of any captive. Following a troubled few years in the financial markets, such scrutiny is all the more pressing, says Geoff Johnson at BDO.

The reputation of Cayman as a domicile of choice for the captive industry is a result of the work done by many parties on the Island. The Cayman Insurance Managers Association (CIMA) provides a robust, business-focused regulatory environment, and the Insurance Managers Association of Cayman fosters the protection and promotion of the Island’s reputation. It is, of course, the job of the auditors to opine annually on the financial statements of these captives, prior to their submission to CIMA and in advance of the six-month deadline.

Where captive owners are remote from the day-to-day running of their captives, an audit can offer a high level of comfort to the financial statements and the historical information that they are reading and using to plan for the captive’s future. On the other hand, where the captive is under the close supervision and control of the owners, the additional benefit that an audit can provide might be seen as limited—merely a function of regulation, with management’s only consideration being to minimise interruption and expense.After all, a captive’s survival and profitability are measured by its ability to minimise its expenses.

As we are now well into the final quarter of 2012 and the main auditing season is looming large in front of us, auditors will be busy planning their approach, and the questions will no doubt have started. So, what types of questions should you be prepared to address?

Change

If you have seen the face of any auditor when you mention change then you will have noticed that they will often seize this idea and not let it go. This is entirely down to the auditor’s responsibility to identify areas of possible audit risk. The change may ultimately have absolutely no impact on the audit or the business model of the captive, but there could well be a number of questions which need to be asked in order for us to arrive comfortably at that conclusion.

Big changes

Examples here will include loss portfolio transfers, novations, and commutations. These can represent significant changes in the lines of coverage offered by the captive, or strategic business manoeuvres designed to realign or streamline the captive. These types of transactions have proved to be particularly popular in recent years (from my own experience) as the captive industry has adapted and changed following the financial downturn and the challenges that this posed. Captives have used these methods to consolidate or divest in efforts to exploit potential pricing opportunities or just to survive, and also to optimise their structures—either to weather a current storm, or to expand the coverage offered to maximise return.

Unexpected results

Where the results of the captive as a whole are unexpected, or if surprising outcomes are limited to a particular line of business, this will no doubt be explored in detail by the auditor in order to understand fully the underlying reasons for these outcomes and to gather support for the resulting numbers.

During the 2008–2010 audit years, a number of captives were booking reserves for premium deficiencies. These additional liabilities are set up on the face of the balance sheet when the anticipated unearned premium on a policy in place at the year-end is expected to be insufficient to meet the corresponding period’s expenses and losses that are predicted based on current loss experience. These reserves can be a function of unexpectedly high losses in a particular year, due to one-off incurred losses, or due to an increase in claims, or the unfavourable loss development of existing claims. They appeared on the books of captives in increasing numbers as financial markets continued to decline. Fortunately, these have decreased markedly in the last couple of audit years, as captives have adapted their lines of coverage accordingly.

Fraud

One of the largest misconceptions around an audit is the auditor’s responsibility to detect fraud. Many incorrectly believe that the purpose of an audit is to identify fraud, investigate it, and to root out any and all errors. Auditors are required to opine on the financial statements and indicate that they are free from material misstatement. The misstatement in question could arise from fraud or error, and it is the responsibility of the auditor to design their audit approach accordingly. Fraud is an area that is inherently difficult to audit for as, by nature, any fraudulent transactions are likely to be well disguised to protect the perpetrator(s).

That said, it is important for the auditor to have a sound understanding of the business plan and structure of the captive so that they can then more easily identify any items that are outside the scope of its legitimate operations, and pursue these further to be able to understand their nature comprehensively.

Other-than-temporary impairment

Another outcome from the declining financial markets of recent yearswas the necessity of assessing more closely the investments held by the captive for other-than-temporary impairment (OTTI) testing. As a large number of the investments that were held for trading were at a year-end valuation which was significantly below cost, the auditor had to take additional steps to satisfy himself that the impairment in the valuation was only temporary, that the investment had the possibility of regaining its losses in market value and that the captive’s management had both the ability and the intent to hold the investment until such time as it improves. Should the impairments manifest themselves as long-term, then the unrealised loss will have to be reclassified from other comprehensive income and booked as a realised loss in income, decreasing the captive’s net income. We will have to see how the markets perform to the end of this current reporting year before we will know what role OTTI testing will play in the audits.

Claims testing

This can sometimes be a contentious issue for a captive, as the auditor seeks to review a sample of the paid claims for the year and closing loss reserves at year-end in detail. Claims testing can be considered unnecessary should the captive ask a professional third party administrator (TPA) to process the claims—provided, of course, that the auditor can gain the necessary comfort from the processes and procedures that the TPA has in place to protect the integrity of the losses paid and claims reserves data, and be convinced of the independence of the TPA. When a captive (or its parent company) processes its own claims in-house then the claims testing is usually a necessary part of the audit of the losses paid and the loss reserves established at the year-end.

Cayman’s auditors sit in an enviable position in a world-class captive jurisdiction. They are able to see the intricate workings of a wide range of captive insurance clients, alongside the captive industry as a whole. The intrinsic knowledge that Cayman’s audit populace has honed over the years, related to the captive sector, gives us a unique perspective of the Cayman captive industry and the wide variety of coverage it offers.

The timely conclusion of the annual audit process is touted as key to maintaining good auditor–client relationships, as most clients will agree. In addition to the tight deadlines, it is the professional rigour and knowledge of the auditing standards that allow the audit process to be such an intrinsic part of promoting, and upholding, the reputation of the Cayman Islands within the financial world at large.

Geoff Johnson is audit manager at BDO in Cayman. He can be contacted at: gjohnson@bdo.ky

Cayman, BDO, audit, captive, insurance

Captive International