Identifying collateral concerns for captives
Alternative risk financing solutions have become increasingly alluring to companies whose insurance pricing has been impacted by the hardening market. Captives allow companies greater degrees of control and customisation over their risk financing and present an opportunity for companies to benefit from high quality risk management performance.
Those who are researching or pursuing a captive formation may not be aware of the associated collateral burden that may be assumed after their captive is operational. This is a vital piece in determining whether a captive is a good fit, so it’s important that those interested in a captive identify potential collateral concerns and understand what information is needed during this process.
While this article does not focus on specific collateral instruments or the philosophy behind why collateral is necessary, it is worth noting that innovative strategies and instruments for collateral continue to emerge. Conducting research into a collateral strategy could have a significant impact on a captive’s long-term success.
How it works
Those unfamiliar with collateral concepts will want to have an idea of how a collateral formula generally works. Consider the items below for a high-level overview of the way collateral might be calculated:
- First, estimated ultimate losses are calculated for each policy period in which losses were retained by the captive. These ultimate loss estimates represent the total expected cost of all claims attributed to each historical policy period.
- Once ultimate loss estimates are produced, payments already made on the claims in those policy periods are deducted to arrive at an outstanding reserve amount. This may be known in actuarial terms as an “estimate of required reserves”.
- The projected ultimate losses for the upcoming period are then calculated and added. When possible, this projection is based on an entity’s unique historical loss experience.
- A credit is given based on estimated payments over the next policy period. In some cases, this is provided only for estimated payments made on claims in the projected period.
- A risk margin is calculated and added to the collateral amount which normally considers both the retention levels and underlying risks for the captive’s retained losses.
- Credit charges may also play into this formula. These contemplate the financial stability of the company. For captives, such reviews might involve an examination of financial statements and stress testing.
The list above covers the typical items included in an insurance carrier’s collateral formula, but the specifics of each item may vary from carrier to carrier. Having preliminary discussions with carriers on how their formula works and how each component is determined will lead to a more informed decision. If collateral is provided to multiple carriers in a specific programme, then separate calculations will be necessary. Doing so should help isolate differences between each carrier.
These components might vary depending on the underlying risk or risks included in the captive. Specifically, the characteristics of the actual claims stemming from each risk, such as their anticipated frequency and severity, might impact various parts of the collateral formula. The captive’s programme structure may play a role in the calculation. An important caveat to the general guideline provided above is that each component of any formula may be based on various sub-formulas, assumptions, or parameters that flow into the component itself.
Discussing this information with a carrier and understanding the various components might seem like an overwhelming task, but it may be necessary to ensure the longevity of the captive’s usage.
Working with an actuary during collateral discussions can also help clarify the collateral formula. Many of the most impactful components are standard items produced by an actuarial analysis, and by having such an analysis produced by an independent, third-party actuary, you will be able to make direct comparisons to the components used by the carrier. When engaging in this process with an actuary, make sure that the loss data provided to your actuary is as close to the evaluation date as possible to the loss data used by the carrier. Failing to do so will hinder the comparative ability of the third-party analysis.
“If collateral is provided to multiple carriers in a specific programme, then separate calculations will be necessary.”
Transparency
A common obstacle companies face during collateral negotiations is the transparency of the carrier with regard to their specific collateral formula. The degree to which a carrier is willing to provide their underlying workpapers varies significantly throughout the industry.
A few items are particularly important in the current climate which should be appropriate for discussion or comparison purposes regardless of transparency. These are shown in the checklist below:
- Make sure that your actuary and the carrier both use the same exposures in their analyses.
- This is important for the most recent historical period, as the exposure provided for this period in prior analyses might have been a projected amount, whereas an “actual” amount may now be available.
- Consistency in exposures for the projected period is also crucial, as it can have a significant impact on the loss projection for that period.
- Ensuring this consistency has especially become necessary in recent years, as pre-pandemic estimates may be significantly different than actual exposures.
- Growth assumptions could differ as well, and again, these assumptions might have changed over the course of the pandemic.
- Hopefully, this comparison will have a minimal impact on older historical periods, but verifying this information provides another useful check on any data differences.
- The last two years have been unique in that some companies’ exposures, payment lags, and similar data have shifted because of the pandemic. The hard market has led to increased carrier loss projections for the current year for some coverages. If your captive includes coverages that were directly impacted by the hardening market, you should ask specifically about relevant trends and loss rate increases. You may want to discuss whether such growth reflects industry-wide increases, or if there are reasons why it may be different for your market segment. Below are a few of the coverages that we have seen be most impacted by such changes.
- Directors & officers
- Automobile liability
- Medical professional liability
- Companies that have struggled financially during the pandemic may receive adjustments to the formula for the credit charge. If this is part of the formula, you may want to ask specifically about the criteria that went into the calculation of the charge.
Even in light of the pandemic, many companies with retained losses are indicating that the collateral process has remained fairly consistent to prior years. Our recent assessment of high-level trends suggests that about 15 percent of companies are seeing increases in collateral directly related to the pandemic. That is likely positive news for those already involved in the captive insurance industry, as it means captive structures have probably remained insulated from market-wide changes and trends.
Collateral can be a challenging topic to deal with, especially for those without prior experience in its usage. Fortunately, there are many ways to prepare for such challenges, including the suggestions outlined above. By approaching these issues with research and understanding, you stand a much better chance of coming out of collateral discussions and negotiations in a positive manner.
The captive landscape offers many potential benefits for those interested in alternative risk solutions. Using the widespread educational opportunities available allows potential captive owners to ensure their involvement is firmly understood and lacking unnecessary surprises.
Enoch Starnes is an actuarial consultant at SIGMA Actuarial Consulting Group. He can be contacted at: enoch@sigmaactuary.com
Michelle Bradley is a consulting actuary at SIGMA Actuarial Consulting Group. She can be contacted at: mb@sigmaactuary.com
