Navigating the storm

“The pessimist complains about the wind, the optimist expects it to change, the realist adjusts the sails”—William Arthur Ward.

A captive insurance company can be viewed as a ship going out to sea. The owners of the captive design their ship based on their overall business objectives and strategies, and assemble the best crew of service providers before setting sail. Once under full sail, the owners of the captive continuously assess and reassess risk from the bridge to ensure that the voyage is a successful and enjoyable one.

Very few could have predicted the spectacular collapse of the global financial markets and its aftermath. We examine below the elements that made up the perfect storm of 2008 relative to captive insurance, and discuss how the sails of your vessel can be adjusted, if necessary, to ensure that the voyage continues safely.

The perfect storm

The events of the past year have been unprecedented and have put risk management into prominent focus. Captive insurance companies are set up as alternative risk management vehicles designed to provide insurance in an affordable manner that allows for flexibility, comprehensive coverage, and control over costs and processes.

Over the past year, the perfect storm has stirred up the financial markets and has had ripple effects across all sectors, including captive insurers. Internally, various organisations have refocused and re-evaluated their risk management strategies to be better prepared for future shocks. Some of the effects of the current financial markets on captive insurers and the risks to which they exposed are:

• Asset risk: This is the risk that financial assets supporting the insurance programme may depreciate or decline in value. The bubble that burst with the collapse of the US housing market had an effect on the prices of almost all financial assets as the mass sell-off and flight to quality took effect. The decline in asset values could have threatened the claims-paying ability of insurance captives.

• Pricing risk: This is the risk that actual losses and expenses may be greater than those anticipated by initial funding requirements. It would have been extremely difficult to forecast the effects of the global recession, but the pricing risk would have been amplified by the increased asset risk and potential increase in claim frequency for programmes that are sensitive to economic downturns.

• Credit risk: For captive insurers, this is the risk that the reinsurance payments and assessments from members will not be collected. Reinsurers exist in the same economic space as the rest of the parties to an insurance programme and were exposed to the same challenges that the rest of the global economy was facing. Inasmuch as most claim payments would have been honoured, any significant delay could have had serious cashflow implications for the captive. Well-intentioned members could also have found themselves in a situation where they had limited cash resources to fund operating expenses as a result of the credit market conditions—again, with cashflow implications for the captive.

• Reserve risk: The risk that the loss payments ultimately required would be greater than the established reserves. Thisrisk is the most pervasive risk in a captive insurance company. The events of the past year would have increased the reserving risk if anticipated investment income was contemplated in setting the reserve and the anticipated rate of return was significantly higher than the realised return. The impact of the economic environment on historical claim payment patterns would also have had an impact on the timing risk inherent in reserve estimation.

• Regulatory risk: The risk that changes to laws, regulations or judicial decisions will give rise to unanticipated exposure to loss or unexpected loss outcomes. As with all historical crises, a narrative is written on what went wrong and policy solutions are suggested shortly thereafter in the form of new regulations. Some regulatory changes such as Solvency II are already underway, but these are by no means complete. In a changing regulatory environment, regulatory risk is increased as the impact of new regulations may be unknown.

"Captive insurance companies are set up as alternative risk management vehicles designed to provide insurance in an affordable manner that allows for flexibility, comprehensive coverage, and control over costs and processes."

All of the risks a captive would ordinarily face have been amplified and could have triggered a chain reaction that could ultimately have led to failure to meet management objectives. For instance, increased claim frequency or severity not originally contemplated (pricing/reserving risk) would have led to the disposal of assets at depressed market prices to settle claims (asset risk) and the further sale of more assets to fund operations should an insurance or financial counterparty fail to meet their obligations (credit risk). For reasons described above, this scenario would have been very real for many captives; the question is, how to adjust the sails of your vessel to manage the increased risk.

Adjusting your sails

With the winds blowing harder and the ship swaying, it is important for adjustments to be made to ensure that the ship rides the storm. From a business perspective, it is important to be conscious of the increased risk. At times of increased risk, the first step is to bring in the crew and brace for the storm. At times like these, it is important to have a knowledgeable crew who understands the objective and has the experience to ensure that the objective is met.

• Adjusting for increased asset risk: All investments are subject to market risk as the market swings up and down. It is vital to understand the asset portfolio’s sensitivity to market swings, which can be done by:

• Obtaining a better understanding of the investments held by the captive and the sensitivity of their values and returns to market swings

• Evaluating the impact of market swings on the captive and how the negative operational effects can be minimised, and

• Closer matching of assets and liabilities, emphasising the risk as well as return.

• Adjusting for increased funding risk: In the current environment, the two main questions with respect to funding are, put simply, are we putting in too much or are we not putting in enough? Neither scenario is favourable; putting too much cash into the captive will reduce the resources available to fund onshore operations, which would not be ideal in the current market conditions, while underfunding could result in the captive being unable to fund losses if bad experience evolves. It is important to find a balance and minimise pricing risk to ensure that the captive can continue to operate successfully and management objectives are met.

• Adjusting for the increased credit risk: In the current environment, it is important for those charged with the management of a captive insurer to have a good understanding of their insurance and financial counterparties in order to minimise credit risk. Good practice is to deal with rated counterparties and monitoring any changes in credit ratings.

• Adjusting for increased reserving risk: Management should take time to understand the sensitivity of the reserves to market conditions and contemplate this in the reserve-setting process. For instance, by discounting, credit is taken for future investment income in setting reserves; the projected return contemplated might not be achieved; and this would result in an understatement of the reserve estimate. If discounting is chosen, an explicit margin can be added to reserves by setting reserves at an increased confidence level that will reduce the sensitivity of the reserve estimate to projected investment returns.

• Adjusting for increased regulatory risk: Once the waves settle, the regulation that will follow will be designed to ensure that when future storms occur, their intensity and damage will not be as extreme. It is important for management to understand how new regulations will affect the captive; for this, all hands will be required on deck to appropriately position the captive for future prosperity:

• Legal advisor: This crew member interprets the effects of new legislation on your captive

• Insurance administrator: This crew member can update you on developments in the regulatory area, given their regular interaction with the regulators, and

• Auditors/accountants: These crew members will be able to update you on any changes in the accounting rules (issued and pending) and how they might affect your captive.

Adjustments also can be made at the board level and from a corporate governance perspective in order to better manage risk. Some of these adjustments may include:

• Increased interaction with service providers and obtaining their input at board or committee level

• Selection of board or committee members with specialist skills that add value to the captive operation, such as finance, audit and underwriting, and

• Increased understanding of financial and insurance processes.

Conclusion

“We must free ourselves of the hope that the sea will ever rest. We must learn to sail in high winds”—Aristotle Onassis.

In summary, the events of the past year have forced an internal review of systems and strategies, and produced new worst-case scenarios. Surviving the storm will require critical analysis of all systems and processes, as well as a coming together of the different members of your crew to ensure that the vessel stays on course and arrives safely at all ports of call as its voyage continues.

Edward Gwekwete is a manager in the financial risk management group of KPM G in the Cayman Islands. He can be contacted at: egwekwete@kpmg.ky

Alan Morris is a director and financial risk management practice leader with KPM G in the Cayman Islands. He can be contacted at: alanmorris@kpmg.ky