9 May 2021ArticleAnalysis

Maintaining a healthy captive

With the COVID-19 pandemic upending the global economy and forcing many businesses to cease trading for months during the first half of 2020, it has been a difficult time to be a company treasurer or finance officer. With cash scarce, an increasing number of businesses have turned to their captive as a source of liquidity.Companies with captives have been increasingly interested in extracting excess surplus from their captives via intercompany loans and dividends, and reassessing reserves, according to Evelyn Kim, associate director of risk finance and captive consulting, global risk consulting at Aon. Captives have conducted capital and collateral reviews, and made revisions to premium payment terms, she adds.“By Marsh’s latest count, captives had paid $2.6 billion out in loans and dividends since the start of the COVID-19 crisis,” says Ellen Charnley, president of Marsh Captive Solutions.“Most of these payments were made by older, well established captives that had strong balance sheets and surplus levels.”Captives owners have recently been exploring ways to accelerate the claims closure process, while reviewing their captives’ collateral structures. They have conducted reserve reviews and considered loss portfolio transfers, all with a view to improving the liquidity within the captive, says Kim.As more businesses lean increasingly heavily on their captives to help them through this period of economic uncertainty, this has raised questions about the impact on the captives themselves. Could these captives be sacrificing their own economic health in the interests of their parent companies?

How adequate?

Each captive is unique, retaining different levels of risk and subject to varying levels of volatility. While some captives will start generating surplus on day one, others may not be in that position for several years.ctuaries will assess a captive’s exposures and calculate what it needs to hold in reserves in a capital adequacy evaluation. Captive managers should have a good idea of how long it will take a captive to build up surplus from the outset.“Undertaking a thorough captive feasibility study can provide insight into the captive’s projected performance in the first few years, and highlight potential areas for concern,” says Kim.“Ensuring the success of the captive in its early years by adequately identifying the appropriate risks and retentions and sufficiently funding the captive for those is essential and cannot be dismissed.” Captives are, by their very nature, flexible and nimble, notes Kim.“For a wholly-owned captive, the concept of control is what sets it apart from traditional insurance carriers, but also from other captive structures,” she says.“However, a captive must ensure that it operates like a true insurance company and does not bring into question the substance of its transactions, such as excessive loan-backs to the parent which may be flagged by the Internal Revenue Service.“Depending on the structure of the captive, the captive may be limited in how much support it can provide to its parent.”Like all insurers, captives must ensure that they retain enough capital on hand to respond to claims as they come due, while also reserving for unexpected losses.“A captive’s finance, treasury and audit committees can help the main board by providing guidance on how best to strike a balance between the needs and responsibilities of the parent and the captive,” says Kim.An annual actuarial review of reserves can ascertain the level required, but the captive must still ensure that it meets the requirements mandated by the local regulatory body.In the short term, a captive may be able to support the liquidity of its parent by reducing total insurance spend as the market hardens, or by returning excess surplus via a dividend or loan. However, a longer-term view is also needed, which warrants a thorough analysis of the captive via a utilisation review, says Kim.“Such a study will outline the ways a captive can support the current and future operations of the parent organisation, and outline the potential financial impact via projected pro-forma financial statements,” says Kim.

“It typically takes around five years to build surplus, and to get a handle on the loss ratio, and to educate the captive’s board.”

Ellen Charnley, Marsh Captive Solutions

He’s not heavy, he’s my parent company

“Inviting your investment manager and actuary to the conversation is key to ensuring that the captive undertakes an investment strategy that matches its assets to liabilities.”

Evelyn Kim, Aon

Charnley is sanguine about the impact that supporting parents is having on captives.“The majority of captives—though of course not all—are single parent captives,” she notes.“That means that if there was no liquidity in the captive and it could not pay claims, the parent could pay the claims itself from its own balance sheet. It is a fundamentally different situation from that of a commercial insurer not having the capital to pay claims.“After all a captive is, typically, a pre-funding arrangement for companies that want to self-insure their risk.”Regulators are responsible for ensuring captives have sufficient capital on hand to manage any situations that arise among those they insure.“Where a captive provides insurance for a third party, for example for the parent’s customers, tenants or contractors, the captive does have to be more careful,” says Charnley.“That is why regulators may have stricter rules and capital requirements.”The rules imposed on captives are specifically designed to reflect the various different risk profiles to which they are exposed, and ensure they are sufficiently capitalised under stress. Captives that insure long tail risks have higher capital requirements, as do those insuring high severity, low frequency—and therefore less predictable—risks.Generally speaking, US captive domiciles follow a rule of thumb of between 3:1 and 5:1 premium:capital ratio, notes Kim.“However, the local regulator may dictate differently depending on the nature of the risk and other variables,” she adds.Charnley insists that while captives are overseen by a number of different regulators across the US, the reserves the regulators require captives to hold against their risks is relatively consistent.“Most regulators take the same view when it comes to setting capital requirements,” she says.“A state that decided to take a very different approach might attract some extra captives, although in practice most captives hold more capital than the minimum requirement anyway. In fact, the minimum capital requirement is a bit of a red herring in that sense.”Well-established domiciles also require regulatory approval for changes in investment plans and issuance of dividends or loans to the parent organisation.“This ensures that a captive can respond to claims and adverse scenarios as they arise,” says Kim.“A distribution must not impinge on the captive’s ability to meet liquidity and solvency ratios, which will ultimately ensure the captive’s viability going forward.”

More than the minimum

Regulators set minimum capital requirements, but captives are usually advised to keep an extra buffer on hand to protect them against the risk of an adverse loss. This ensures the captive remains financially strong, compliant with its regulations and agreed business plan, and avoids additional capital infusion by the captive’s owner, Kim explains.Charnley agrees. “We would typically advise a new captive not to take money out via loans and dividends,” she says.“A captive is, after all, a place to accumulate surplus. It typically takes around five years to build surplus, and to get a handle on the loss ratio, and to educate the captive’s board, although this varies depending on the captive and the risks being insured.”Charnley says she often uses the analogy of a savings account or a 401(k) retirement savings plan when explaining this to company executives.“You don’t tend to start a savings account with the intention of making a large withdrawal,” she notes.The evidence suggests this message is being heard—there is little indication that captives are running into trouble due to running down their capital to help their parents. In the most extreme cases, companies might close their captives to access capital that was needed to meet capital requirements, but Aon has not observed any increase in closures of captives for such reasons.This may be because closing a captive looks like a bad solution to the problem of poor corporate liquidity. “Closing a captive is a lengthy and complex process and doing so would not allow for immediate capital release,” notes Kim.On the other hand, as the market hardens, the role of the captive has become increasingly important. “It can provide some relief from rising premium rates and tightening capacity,” says Kim. “Closure must be weighed against the benefits that may be gained by using the captive as the market transitions before moving forward.“Overall, a captive is a long-term commitment and will typically build surplus over many years as the captive experiences positive underwriting and investment results.”A review of the captive should be performed every three or five years, she says, to ensure the captive is fully optimised and any excess capital is either reinvested in the captive or returned to the parent organisation. Kim argues it is essential that companies understand their captive’s current performance and the organisation’s current and future needs, to ensure a well-balanced approach.“Inviting your investment manager and actuary to the conversation is key to ensuring that the captive undertakes an investment strategy that matches its assets to liabilities, thus optimising the captive’s capital position,” she says.“Such an approach will allow for the captive to be self-sustaining and require little to no additional capital injections from the parent organisation, but rather over time build surplus to respond to such requests when needed.”Kim predicts that captives owners will continue looking to find new and innovative ways to use their captives in coming months. That could involve adding new lines of cover and retaining more risk, exploring reinsurance and insurance-linked securities capacity, or using fronting solutions.“Over the long term, exploring future pandemic risk in a captive may be an option to fund for uninsured exposures or fund for coverage gaps/higher limits,” she says.“I do not spend my nights worrying about captives paying out too much in loans and dividends, and eating away at their capital reserves,” Charnley concludes.“If anything keeps me awake at night it is the high demand for new captive launches. There are only 24 hours in a day.”