Captive collateral - Part 2: Unearned premium reserve

Greg Lang (pictured), founder of the Reinsurance and Insurance Network (RAIN), dives deep into the issues concerning unearned premium reserve.

In 1982, author Andrew Tobias wrote a book called ‘The invisible bankers: everything the insurance industry never wanted you to know’. It was the first book I ever read about insurance.  It was 1985 and I just graduated from college. I didn’t know anyone wrote books about insurance, never mind one I enjoyed reading.

Mr. Tobias is a financial journalist whose most famous book is about investing. However ‘The invisible bankers’ is about the money and investment side of insurance. It’s one of the many reasons I became interested in captives. It’s also why I write about them. In the past 40 years, I have found few books that discuss, or even mention, captives. The International Center of Captive Continuing Education (ICCIE) was created 21 years ago to help fill that education void.  Fully 21 years later, several voids remain. Collateral is one of them.

This is the second in a series of articles on collateralisation. This focuses on a second type of collateral: unearned premium reserve, which is a statutory accounting issue.

Statutory accounting principles (SAP)

“There are only two things more complicated than statutory accounting. I have no idea what they are.” This is how Tobias started his chapter on statutory accounting. The quote makes many smile. I use it when I teach. I smiled for a second reason the first time I read it. I was an accounting/finance major and, as is the case today, my degree allowed me to select several electives. One possiblity was statutory accounting. I did not take it. I had no idea what I wanted to do when I graduated, but I knew it wasn’t insurance. I have smiled a few times over 40 years.

Seeing a bright future in captives, I decided I had better learn something about statutory accounting. Fortunately for me, and for you, The Institutes has a course for that. I completed my associate’s in insurance accounting and finance (AIAF) in 1989.

The purpose of statutory accounting is to measure the financial solvency and the ability of an organisation, particularly an insurance company, to meet its obligations to policyholders. It offers a conservative ‘liquidation-value’ of a company. This is different from Generally Accepted Accounting Principles (GAAP), used by most businesses to assess a company’s financial viability as a ‘going concern’.

Going concern is the value of a business expected to continue in business. There are two types of liquidation: in orderly liquidation, assets are sold piecemeal over a reasonable period to maximise proceeds. Forced liquidation assumes assets are sold quickly. The liquidation value of a company is a more conservative estimate than its value as a going concern. That is the nature of statutory accounting. Understanding liquidation value will also help you better understand why the list of acceptable assets for captive collateral is limited. The focus is liquidity. But we’ll address acceptable collaterals in my next article.

Unearned premium reserve

SAP takes a conservative approach to how premiums are earned. SAP says premiums must be earned evenly over a policy period which would be OK except for the expenses associated with that premium needing to be expensed immediately. This lack of matching asset recognition with expense puts a drain on an insurer’s surplus.

An insurer collecting a $100,000 premium can recognise $8,333 per month as earned. If that policy has 20% expenses the insurer would recognise $20,000 in expenses during the first month.  $8,333 of revenue versus $20,000 in expense. If that same insurer wrote ten $100,000 policies, ($1m in premium), they would see $83,333 in revenue versus $200,000 in expenses. With expenses growing 50% faster than revenues, an insurer could go bankrupt from a statutory accounting standpoint just by growing too fast.

There is the second time a captive owner feels an invisible hand meddling in its captive business. Ceded premiums you expected to be deposited into that brand-new captive bank or trust account are not immediately deposited. The insurance company says it needs those funds to offset the reduction to its own capital account resulting from the mismatch of premium to expense recognition. One solution to help alleviate this shortfall is a ceding commission.

Ceding commission is a fee paid by a reinsurer to the ceding company used to offset or reimburse the insurer for its costs associated with writing a policy. This ceding commission helps cover expenses such as underwriting, acquisition and administrative costs. Ceding commissions are negotiated as part of a reinsurance agreement. A portion of the premium paid to the reinsurer is held as commission. Ceding commission helps insurers close a gap SAP created from the mismatch of premium and expense. Unfortunately, SAP accounting creates a second collateral hole if your captive is not considered admitted reinsurance.

Admitted vs. alien reinsurance

SAP stipulates insurance companies receive no offset/collateral credit for transferring risk to an alien reinsurer. If the reinsurance company is admitted, they can. This is the reason most captives need to post an unearned premium reserve when acting as reinsurers. It’s important to point out that this additional collateral is not actually additional money a captive may need to post. It’s rather a loss of use of the unearned premium that would have been deposited immediately, less a ceding commission, if the captive was an admitted reinsurer.

The distinction between admitted and alien reinsurance is in the reinsurers’ licensing and regulatory status. An admitted reinsurer is licensed or approved to transact business in the state or country where the primary insurer (ceding company) is domiciled or where the risk is located.  Ceding insurers can generally take credit for reinsurance ceded to admitted reinsurers on their financials, eliminating any need for additional collateral. A captive writing direct business is an admitted insurer in the state of domicile. It is not permitted to write direct policies in any other state unless they are appropriately licensed.

Alien reinsurers are either not licensed or approved in the insurer’s domicile or where the risk is located. Is your reinsurance captive licensed in the same state as the risk it is covering? You might qualify for admitted status. Ask the captive professionals you hired for help.

As an alien reinsurer, the portion of premium that would have been ceded to your captive as ceded reinsurance is usually held by the insurance company in a bank or trust account as collateral. The fronting carrier should pay you some type of interest on those funds. This is usually a nominal amount, but it is better than nothing. One carrier I know pays above market interest on funds held. A smart marketing and practical move. Insureds squabble less about held collateral when they make a market return on those funds.

Conclusion

Ceding commissions and retention of unearned premium are two tools that insurers use to counter the impact SAP on their financials. We will talk more about the impact of SAP in my next article and the third financial collateral, GAP collateral. GAP collateral is where the real frustration begins and often appears like it will never end.

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

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