1 January 1970Analysis

Five questions: unpacking your feasibility study

A quick look at US captive growth figures for 2011 would reveal that interest in captive formations has risen markedly in recent months. More and more US and international firms are considering setting up captive entities—with an emphasis on single-parent captives and the smaller 831b captive entities—whilst those with existing entities are looking again at ways to maximise the potential of their captive vehicles. Speaking with John Lochner, director of consulting services at Towers Watson, it is clear that “in the last year, and increasingly so in recent months, there has been a significant amount of interest in new captives and captive strategy work for existing captives, i.e. we have a captive, does it still makes sense for us, and if it does, can we be doing something bigger and better with our vehicle”, with firms spurred on by improving economic conditions in the US and a desire to “get a jump on the next hard market”. Either way, interest in captives has received something of a lift following the hang-over that came in the wake of the global economic downturn, with feasibility studies and their inherent demands gaining increasing interest among US corporate parents in 2011.

Two challenges...

Feasibility studies are an integral part of the formation process, providing invaluable insights into the scope, challenges and objectives of the captive within the context of the parent’s business plans, but are themselves not without their own specific challenges. Addressing those issues presented by drawing together the feasibility document, Lochner indicated that there were two major challenges to those taking on the study process. The first is in “assembling the right team of internal project members, the right team of external advisors and in ensuring you maximise and co-ordinate the disciplines of all parties”. In bringing to bear the expertise of a suitable pool of people, you not only get a “better end result”, Lochner said, but also secure the “necessary buy-in throughout the process” that will ensure that the captive entity envisaged succeeds.

In terms of company personnel, Lochner stated that you need people representing risk management, finance and legal, as well as a tax representative, and in the case of a captive relating to staff benefits,then “it is critical for someone from human resources to be integrally involved in the captive evaluation”. Externally, a “team of experts that would comprise finance and actuarial capabilities, as well as tax and legal, and also include brokerage and captive management resources to help with the implementation of the captive” would further bolster the mix as the parent approaches its feasibility study.

"Feasibility studies are an integral part of the formation process, providing invaluable insights into the scope, challenges and objectives of the captive within the context of the parent's business plans, but are themselves not without their own specific challenges."

The second concern that Lochner highlighted in the feasibility process was in gathering “appropriate data” in order to conduct an effective analysis of whether, and how, a captive should be considered by the parent. Included among such details should be “financial projections of what the captive’s results might look like”, in order that results and expectations can be aligned. Lochner also highlighted issues inherent in the data-gathering process that could impact the validity of such information. He indicated that a key issue relates to “client data versus industry data, where the challenge is trying to obtain a sufficient quantity of data from the client, such that the data is statistically credible and can be relied upon”. This can be tricky, particularly if the parent has a deficit of pertinent data or “the history of the firm’s development from an insurance perspective” is deficient. Issues such as recent merger and acquisition activity, changes in service providers and any holes in the company’s data set can all serve to complicate the issue, and it is evident that clarity of information is an essential component of an effective study.

Five questions...

Captive feasibility studies are designed to drill down into the motivations and expectations of the parent company. Why do you want to own a captive, what do you hope it will bring to the business? Asked about what are the key questions that one should ask when considering a feasibility study, Lochner outlined five major questions that need to be addressed by those considering a captive, namely:

1. What are my organisation’s objectives for considering the formation of a captive, and will a captive in fact help my organisation achieve those objectives?

2. How much is the captive going to cost—both in money and time— to start up, and to operate going forward?

3. What are the likely financial results of establishing a captive and what adverse scenarios could result, recognising it is a risk-bearing entity?

4. How much capital and surplus is required to support the captive?

5. Where should the captive be domiciled?

By addressing these five questions, and doing so in an honest, enquiring manner, parent firms should be able to paint an accurate picture of exactly why a captive insurance entity is—or is not—an appropriate solution for them.

...and five more

The questions get even more complicated for those considering a group captive. As Lochner made clear, whilst the same five questions apply to those considering group captives, a further five are worth bearing in mind, if not during the feasibility study itself, then during the implementation phase. These are:

1. Who will qualify to participate in the group?

2. How will the group’s risks be underwritten and by whom?

3. Will the programme be assessable? For example, if losses are significant and additional money is needed, will the group captive go back after additional contributions from each of the insureds?

4. How will claims be handled?

5. And importantly, if a member leaves, will they get any of their money back, and if so, when and how is that determined?

However, as Lochner pointed out, sometimes “these issues are not considered at the outset of a group captive”, creating obvious concerns moving forward as the position of the group captive, and that of the parent’s captive entity within it, develop. Close attention, it would seem, needs to be paid to both sets of questions.

An educational document

Addressing the aforementioned questions is key to an effective feasibility study, but such documents also have an invaluable educational role to play within the parent. Bringing onboard the right people can help to “influence some of the assumptions” that go into the study, inform company actors about the potential of the captive entity and—critically—help to encourage the steering of the “ultimate design of the programme”, Lochner said. Furthermore, the study also helps create a “realistic set of expectations as to what a captive can and cannot help an organisation achieve”. As Lochner made clear, not all feasibility studies will point to the creation of a captive entity—captive entities are not after all appropriate for every firm—but by bringing the right people into the process, the potential, scope and challenges presented by captive insurance entities will inevitably be better understood by a wider audience within the parent company.