Captive collateral - Part 1: Initial capitalisation

Greg Lang (pictured), founder of the Reinsurance and Insurance Network (RAIN), unpicks some of the issues that surround captive collateral.

Captive collateral is one of the least understood captive concepts and a source of considerable frustration and pain for potential and current owners.

There is much to consider, which is why this is the first article in a series on this subject. Parties you don’t know get a say in how much collateral you need and when you get it back. It requires a general understanding of statutory accounting. You also need to be familiar with, and have strategies for, collateral stacking and collateral jail. Moreover, while there are several types of acceptable collateral, many however are unacceptable. There are also collateral alternatives.

I just wrapped up a call with an unhappy prospective captive owner. Today’s issue was collateral. No one properly explained how capitalisation worked. The feasibility study only addressed initial capitalisation. Who’s to blame? Prospectives buyers can start by looking in the mirror. In this case, all parties to the feasibility study – the actuary, captive manager and broker – appear to have played a role. Each must have decided it was someone else’s job to explain how captive collateral works.

It is important to consider the motivation of the parties before starting the formation process.  Most brokers and captive managers don’t get paid unless they sell you something. A broker might try to sell you a captive even if it makes little sense. Captives are often presented as bright, shiny objects that will solve all your problems. They won’t. Remember, they need to sell you something to get paid. They might be happy selling a feasibility study. Some actuarial firms have grown too close to the brokers and captive managers that feed them business. They have also lost objectivity.

Want some free advice? Don’t waste money on a full feasibility study until you know: 1) what your developed losses look like and 2) have some idea of what your programme structure might be. The answer to question 1 drives the answer to question 2. Today’s call was about capital.  This article will focus on the first of the three types of financial capital required to run a captive. Initial capitalisation

There are actually four, not three types of capital required to set up and run a captive. The three I will discuss are financial. The fourth is human. Human capital involves committing personal time, an employee, colleague, or renting human capital from someone else. Most successful captives use a combination of all three. In this caller’s case, they chose poorly in selecting their captive support team.

The go/no-go captive decision is a financial one. Does it make sense to allocate capital to keep risk on the balance sheet? Does the frictional cost of setting up and running a captive outweigh the potential for savings. Buyer beware. Most feasibility studies I review do a lousy job of addressing both issues. Expense components are often missing or understated. That was also a problem here. The caller just didn’t know it until we got on the phone. Expenses impact capitalisation. If the expenses are wrong, the capitalisation numbers will also be wrong.

The caller told me the capitalisation conversation got awkward when outside parties started offering different perspectives on the dollar amount required for initial capitalisation. Let’s dig in.

Initial capitalisation

The formation stage is usually the first time insureds recognise multiple parties get a vote in determining what your initial capitalisation will be. The selected domicile, fronting carriers, reinsurers, your actuary and even rating agencies can all have a say.

Most US-based domiciles have a minimum statutory formation capital of $250,000 for single-parent captives. Offshore domiciles generally require a little less. There are extremes.  Seychelles’ minimum is $5,000. Anguilla is $10,000. For specialised captives such as captive reinsurers in Oregon, the minimum capitalisation is $300 million. Yes, million.

The statutory minimum capital to get your captive licensed is rarely the amount recommended in any well thought-out business plan. Although significant, a $250,000 threshold usually only applies to captives writing direct business. Captives requiring front paper and/or reinsurance have thresholds that are often much higher.

The Kenney rule, or Kenney ratio, suggests a 2-to-1 ratio of gross premiums to policyholder surplus. The rule was first applied to insurance companies. It was later adopted for captives. Don’t confuse this Kenney rule with the other "Kenny” rules. The Kenny (no e) rules can refer to two different concepts: a college football rule regarding quarterback slides or a legal principle regarding the exclusion of evidence in Irish courts. But I digress.

Most see the Kenney ratio of 2 to 1 as conservative. This 2 to 1 rule typically applies to short tail lines of coverage such as property. It’s one of the reasons there are so few property captives.  Property captives are capital intensive. Captives writing liability insurance often post 3 to 1.  Programme and group captives can provide a better spread of risk and can be written as high as 5 to 1. The premium to surplus ratio is used to calculate a captive’s financial stability and solvency.

It’s all about solvency

The purpose of statutory accounting is to measure financial solvency. Regulators want to be certain a captive can meet its obligations to policyholders. We will do a deeper dive into statutory accounting when we cover the second captive collateral, unearned premium reserves. The third article will cover “gap” collateral. The gap is the difference between the funded premium less expenses and the dollar amount the fronting carrier or reinsurers actuary determines they want for solvency purposes.

All captive collateral is interrelated. Insurers, reinsurers and regulators do not care which bucket your captive collateral sits in. They only care that the total amount is available to cover any shortfall. I have a dirty little secret. Fronting carriers not only don’t care which bucket your collateral sits in, they might use your captive collateral to cover someone else’s shortfall. At least on paper.

Schedule F is a complex report insurance companies include in their annual statement detailing their “ceded” (purchased) and “assumed” (sold) reinsurance activities. Reinsurance transactions that are considered material must be disclosed. A common threshold for materiality is 10%. For most insurers, individual captives rarely meet the materiality threshold. A portfolio of captive reinsurance, however, often does. Since this portfolio would be reported on in the aggregate, one captives over collateralisation might help meet another captive collateral shortfall.

This doesn’t mean your captive would have to pay in the event of an actual shortfall. There are laws against that. The fronting carriers’ concern is meeting their overall collateral obligation for financial reporting purposes. We will get into this further when we discuss the other two collaterals.

High initial collateral helps relieve the burden of other collateral demands. An Oregon reinsurance captive with $300 million in initial surplus is going to get a lot less financial scrutiny than one from Anguilla with $10,000. If you were a fronting company or a reinsurer, which one would you want to stand in front of or behind? It is the reason everyone gets a say. The best front and reinsurance partners are picky, meaning they will be conservative with their collateral picks. The same can be said for the best-run domiciles.

What impacts my number?

Initial capitalisation is the easiest of the three capitalisation numbers to understand. Why, then, is it still complicated? We touched upon Schedule F. We also talked about how expenses affect collateral. Loss development and programme structure are biggest drivers of collateral adequacy or inadequacy. It goes back to the free advice I gave earlier.

Loss development is right up there with collateral when it comes to misunderstood captive concepts. Depending on the line of business, loss development can impact collateral for 20 years or more. Coverages such as workers’ compensation, construction defect, products liability, medical malpractice as well as other general liability and financial lines are all considered long tail business. These coverages are also subject to claim severity. Claim severity and long claim development cause uncertainty. Uncertainty drives the need for collateral.

Structure is also important. A captive insuring its parent company’s own exposures does not create significant financial solvency concerns. If a single-parent captive runs out of money, the underfunded exposure reverts to the parent company where it started from in the first place.

An alternative to initial capitalisation is a rent-a-captive. Rent-a-captives and their sponsors charge their client a fee rather than asking for initial capitalisation. The term rent-a-captive was coined because you are renting someone else’s formation capital to start your captive.

Protected cell and segregated cell captives are examples of rent-a-captives. Many sponsors today require $25,000 or more in upfront collateral in addition to their fees. Zero initial capitalisation now means $25,000 plus fees. The cost of rent is going up everywhere.

Group captives offer a spread of risk. Depending on the number of insureds, this can fall under the protection of the “law of large or at least larger numbers”. The law of large numbers guarantees stable long-term results for an average of random events such as losses. An insurance company might lose money on a single insured, or even a line of business, in any given year.  However, its earnings will trend towards a predictable percentage over time. This is why group captives can write at premium to capital ratios higher than single-owner captives can.  They are more predictable.

Regulators like fronted captive business. Fronts transfer captive credit risk to the insurance company. It is one reason front fees are high. It is also why fronts require so much collateral.  Reinsurers are looking for the same financial security. It is much easier to attract reinsurance when your captive is well funded.

Conclusion

Collateral is a complex subject. Many factors go into its calculation. Those factors can change over time. This uncertainty creates the need for capital. It’s often said: “Insurance is the only product I know of where the ‘cost of goods sold’ is not known at the time a policy is issued.” Unfortunately, the author of this sentiment is unknown. Safe to say, they probably understood collateralisation as well as anyone.

The sentiment is well known. Premiums are set up front. The actual cost (future claims) is determined only after the policy expires, sometimes many years later. Hopefully it will help you understand the need for initial collateral a little better.

Greg Lang can be contacted at: glang@rainllc.com

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