2 September 2022ArticleAnalysis

Great captive managers consider the past

“As in prospective reinsurance, the protection can be for all of the reserve, or a part of it.”

Mory Katz, BMS Re

A great captive manager is forward-looking, anticipating trends and reacting to the changing environment. But what about the past? Between 60 and 70 percent of a captive’s assets support past liabilities, and even more is tied up in costly collateral. Because of this, it is increasingly important that captive managers are aware of how legacy transactions can assist their clients.This common tool in the carrier world has been largely overlooked in the captive insurance space, especially among smaller captives, but that is changing. Below is information captive managers and owners should consider to better serve the complete life cycle of the captive

What is a legacy transaction?

A lot of history and even some folklore make this field seem much more difficult than reality. Insurers of all kinds buy reinsurance in case their future estimates of losses prove to be wrong, and their loss costs are higher than expected.Legacy is no different. In a legacy reinsurance transaction, a captive protects its future income statement and balance sheet against the possibility its prior reserve estimates are wrong and turn out higher than expected. As in prospective reinsurance, the protection can be for all of the reserve, or a part of it, and will usually have a limit.Legacy transactions can be thought of roughly as a stop loss or quota share on prior loss estimates. Figure 1 illustrates three versions of this type of transaction. An “in the money” transaction simply means assets are transferred with the liabilities and the coverage attaches below the current carried reserve.Figure 1: Three types of legacy transaction

There are other types of legacy transactions: a closed captive could be sold or its reinsurance novated by a legacy reinsurer and a particular line of business could be put into run-off and the liabilities transferred to a legacy carrier. This type of transaction may also bring significant expense and operational benefits.

What are the benefits of a legacy transaction for a captive?

Table 1 summarises the benefits of legacy to a captive. A while ago it was more common to see legacy transactions used to provide exit solutions or run-off solutions, but today they are increasingly used to free up capital and release collateral.Table 1: The benefits of legacy to a captive

Case studies

Collateral releaseBMS worked with a small captive that wanted to free up collateral. Figure 2 shows $8 million of premiums with liabilities of $6.3 million supported by $11 million of collateral. With a 16-year duration and the collateral released in the fourth year with an assumed 5 percent investment rate, the investment income reclaimed is about $1 million with a present value of over $750,000.This return is about double the cost of the reinsurance. This is a return to the captive and the future reserve development risk has been transferred as well.Figure 2: Example of collateral release

SaleBMS had a client that built a successful business over a lifetime and sold it to a similar company. The buyer had its own captive for workers’ compensation, believed it to be overcapitalised, and the captive was no longer needed. The captive had about $8 million of liabilities reinsured by a carrier.We took the captive to market and received offers to novate the liabilities and to buy the captive outright at a negative price. These structures allowed the captive to eliminate its liabilities and return capital to its owner. Similar benefits can be seen when captives merge through the sale of their parents.

Trends captive managers should be aware of

Smaller deals are now in style. A number of legacy reinsurers are willing to look at captives both small and large, and transactions thought to be too small not that long ago are now common. In some cases a facility can be put behind a captive to transfer losses annually or even in the future, after they reach a certain amount.
Social inflation is a big risk for captives. Trends such as litigation financing, greater tolerance for legal appeals based on emotion, and an increased tendency for jurors to award bigger damages mean reserves set only a few years ago could be significantly light.
Some courts are just recovering from backlogs from the COVID-19 pandemic. The result is that smaller easier-to-settle cases have moved through the courts while larger more difficult cases have lagged behind their usual settlement rate. The result of this could be more cases pending with higher average settlement costs per case. This may result in significant material adverse development.
The benefits above apply to various lines of business including workers’ compensation, commercial and personal auto, general liability and other long tail casualty lines. Lately there is innovation in the property space, as some property lines now take up to three years to settle.

How can legacy improve a captive manager?

Knowledge of legacy allows a captive manager to manage the entire lifecycle of the captive from the beginning. It can answer questions such as “How do I get my capital out if I need it?”, “How do I reduce my collateral if my premium continues to grow?” and “What if I no longer want the captive?”.By answering these questions up front, the captive manager can provide exit options and protect against unknown contingencies for its client. By freeing collateral and capacity, legacy also allows the captive to grow. These are benefits that translate to a more prosperous captive and a happier client.The legacy market as served by its brokers, reinsurers, regulators, and service providers is a valuable resource that can benefit captives and captive managers. Significant benefits and competitive advantages await those who take advantage of it.