Adapting your captive for a shifting risk landscape

To ensure the long-term financial strength of their captives, owners should welcome the proactive use and understanding of actuarial analytics, especially when dealing with shifting risk profiles, say Michelle Bradley and Enoch Starnes of SIGMA Actuarial Consulting Group.

In recent years, insurance professionals have witnessed numerous reminders that a company’s risk profile can shift dramatically and without any warning. The impact of a global pandemic, a rising tide of shock verdicts, and an increasingly complex cyber landscape have changed insurance needs to a point which few could have predicted. What might have been easier to predict, however, was the resulting influx of companies in need of alternative risk financing solutions, such as captive insurance.

With a wave of new entrants in the captives space, 2024 serves as a fantastic opportunity to reinforce the type of mindset captive owners should adopt to ensure the long-term financial strength of their captive. It’s our opinion that such a mindset includes the proactive use and understanding of actuarial analytics, especially when dealing with shifting risk profiles.

One of the key components of a captive’s actuarial analysis is the loss projection, which generally uses a combination of loss and exposure data to predict a reasonable scenario (or range of scenarios) for loss experience in a future time period. Since the loss projection can have a direct impact on how a captive’s premiums are determined, it’s crucial for captive owners to make sure they’re providing complete and accurate information to their actuary.

For most risks, the process of compiling historical loss data should be relatively straightforward. Gathering exposure data, on the other hand, can sometimes be more difficult. These amounts are typically presented in a numerical format without further context and, while the numbers are certainly useful on their own, we want to emphasise that the underlying shifts and changes impacting those numbers can be just as vital in an actuary’s determination of potential future loss experience.

These changes can take various forms, including:

· Geographic operations

· General business activity, including mergers and acquisitions, or new products, processes, or employee job type

· Economic or legal shifts

· Newly introduced or revised legislation

· Societal attitudes

Why might this be important for the actuary to know? To use an exaggerated example, consider a company which primarily employs office workers which acquires a smaller firm composed almost entirely of roofers. The increase in total payroll, an amount often used by actuaries as a proxy for workers’ compensation exposure, may not stand out as anything other than “normal” growth, but the types of risks faced by that company’s employees are now drastically different than they were pre-acquisition.

Implicit in actuarial loss projection methods is the assumption that future risk profiles are relatively similar to historical indications. In other words, the default assumption in a captive’s loss projection is that the factors which might produce a claim next year aren’t substantially different from those in years past.

While this concept may be fairly straightforward on a theoretical level, the difficulty often comes in recognising what it looks like in practice. With that in mind, let’s take a look at a few more examples and identify potential solutions.

Example 1: Mergers and acquisitions

As a starting point, we’ll focus on the type of activity referenced in our earlier example: mergers and acquisitions (M&A). When companies are merging or going through an acquisition, one of the key questions to be answered from an actuarial perspective is how different or similar the two entities are in terms of their overall risk profile.

Will this transaction lead to shifts in the combined entity’s class code mix or geographic footprint? Does it add new types of risks? Is the historical loss experience for one entity significantly above or below the other’s? All of these are great examples of items which should be addressed prior to the transaction to ensure there are no unintended surprises down the road.

A more specific example of this scenario is when an acquired entity has coastal property exposure where the purchasing entity has historically had none. Alongside the standard information an actuary needs, two additional datapoints an actuary might request in this case would be previous catastrophe models and building construction information for the entity being acquired. If historical claims data is limited, these items can be very useful in helping an actuary decipher the nature and extent of a given property risk.

Example 2: Adding or expanding locations

Companies may be presented with the opportunity to increase their customer base or operations through expansion. If credible data is available, such as through benchmarking sources, it can be used to produce a reasonable analysis of expected future losses. It’s possible that actual experience in the new location will differ from industry benchmarks, but such analyses can still offer a better understanding of the likely range of loss. Furthermore, these benchmarking analyses can be used in the future as a measuring tool when unique loss experience emerges.

Depending on the risk in question, it may be difficult to find credible data prior to expansion, but that doesn’t mean the resulting impact shouldn’t be closely monitored going forward. Analytically-minded captive owners, for example, might request that their loss and exposure data be segregated geographically to highlight the impact of certain expansions or identify locations whose loss experience differs from the overall portfolio.

Example 3: Legislative changes

More complex shifts can come through legislative changes. While this type of activity may not be as quickly realised as in the prior examples, it can definitely have as much or more of a direct impact on a company’s risk profile. One recent example can be found in relation to sexual misconduct liability. The Adult Survivors Act, which was passed in 2022, offered victims of sexual misconduct in New York a one-year window to bring forth claims which previously fell beyond the statute of limitations. Because of this, policies for a risk which effectively had a cut-off point on reported claims became exposed to further potential losses.

The legislative scenario can be more difficult to track from an analytical standpoint, but insights can still be captured through the careful monitoring of claims and proactive communication. An actuary tasked with analysing a captive’s risk portfolio which could be affected by legislative changes should be included in qualitative assessments and discussions regarding potential changes in claim parameters, such as extensions on statutes of limitations.

Shifts in a captive’s risk portfolio can easily fall into the realm of “silent evidence”, especially when the cause is unintentional. Whether it’s through consistent reviews of the captive portfolio or conversations with their actuary, giving voice to such evidence should be a key goal of the future-minded captive owner.

It’s impossible to perceive or predict all of the factors impacting a captive’s insured risks, but it might be surprising how effective even a minimally proactive approach to risk-based analytics can be for a captive’s success. Fostering an environment where these changes are monitored, analysed, and communicated provides a strong foundation from which a captive’s capacity as a risk financing solution can be built.

Michelle Bradley is a consulting actuary at SIGMA Actuarial Consulting Group. She can be contacted at: mb@sigmaactuary.com

Enoch Starnes is an captive & complex risk consultant at SIGMA Actuarial Consulting Group. He can be contacted at: enoch@sigmaactuary.com