Lori Ussery, Sigma
Lori Ussery of SIGMA lists 10 things to be aware of when a captive is reviewed by its owner.
The financial viability of a captive insurance company is a primary concern for its board, insureds, regulatory authorities, and service providers alike. AM Best and other agencies provide independent rating services to many captive insurers in order to demonstrate to stakeholders that the captive is able to pay claims and other liabilities in a timely manner.
The US National Association of Insurance Commissioners (NAIC) has established Risk-Based Capital requirements to monitor the ability of insurers to fulfil their obligations to their insureds and identify insurers needing certain regulatory attention. Solvency II requires similar assessments for EU insurers.
While some companies do not fall under such regulatory requirements, similar periodic reviews are necessary to ensure to stakeholders that the captive is financially sound. The following 10 ratios provide insight into the overall financial viability of a captive and identify areas which may need focused attention.
These ratios are commonly reviewed in the insurance industry by actuaries, regulatory authorities, rating agencies, and other insurance professionals and are chosen due to the practicality and availability of information used to calculate the ratios.
- Ratio of net written premium to surplus
The ratio of net written premium to surplus measures the adequacy of surplus to absorb adverse experience. This ratio uses written premium, net of reinsurance, as an indicator of exposure. The higher the ratio, the more risk the captive bears in relation to surplus.
For entities with higher ratios, a review of the volume of net written premium for long-tailed lines is important since the payout of losses for these lines is more uncertain. The ratio is calculated from the income statement and balance sheet as:
Net written premium / Total capital and surplus
For many newly formed captives, this ratio may be higher than typical ranges seen for mature captives but often improves over subsequent years as surplus is accumulated. For mature captives with stable year-over-year exposures, the ratio should be low and more stable over time.
- Ratio of reinsurance premium to gross written premium
The ratio of reinsurance premium to gross written premium measures the reliance of the captive on reinsurance. The ratio is calculated from the income statement as:
Reinsurance premium / Gross written premium
Higher ratios may warrant a more thorough review of the reinsurer’s financial position and ability to issue timely payments. Lower ratios may indicate that further review is needed regarding the limits written by the captive and its exposure to catastrophic risk.
- Change in net written premium
The change in net written premium represents the year-over-year growth or decline in exposure. Significant growth often creates additional uncertainty. The ratio is calculated from the income statement as:
Net written premium for the current year / Net written premium for the prior year -1
During periods of significant change, the mix of premium by coverage, class, and geographical location should be reviewed.
- Ratio of maximum per occurrence retention to surplus
The ratio of maximum per occurrence retention to surplus measures the potential impact of an adverse event on surplus. The ratio is calculated as:
Maximum per occurrence retention / Total capital and surplus
A high ratio indicates that a significant portion of surplus could be depleted by a single event. Actuaries typically review this ratio when determining materiality standards for adverse deviation.
- Ratio of losses and LAE to net earned premium
The ratio of losses and loss adjustment expenses (LAE) to net earned premiums (commonly referred to as the loss ratio) represents the portion of each premium dollar used to pay losses and LAE. LAE includes allocated loss adjustment expenses (ALAE) and may include unallocated loss adjustment expenses (ULAE). ALAE are claim-related expenses directly attributed to specific claims, such as legal costs. The ratio is calculated from the income statement as:
Paid losses and LAE + change in reserves / Net earned premium
The ratio is a measure of the impact of losses on the profitability of the captive.
- Other expenses to net written premium
The ratio of other expenses to net written premiums (commonly referred to as the underwriting expense ratio) represents the portion of each premium dollar used to manage and operate the captive. Other expenses often include captive management, audit, actuarial, legal, regulatory, and other miscellaneous fees. The ratio is calculated from the income statement as:
Other expenses / Net written premium
This ratio is a measure of the impact of operational expenses on the profitability of the captive. The ratio uses written premium since many of the expenses are incurred when a policy is issued. It is typically lower for single-parent captives due to low acquisition costs.
- Combined ratio
The combined ratio represents the total cost of operating the captive program before the impact of investments. The ratio is based on the sum of the two prior ratios, calculated as Ratio Five + Ratio 6.
The lower the ratio, the more profitable the captive. A ratio above 100 percent indicates that the captive is paying out more in losses and operational expenses than it is collecting in premium dollars. A captive may still be profitable with a combined ratio above 100 percent due to investment income.
- Overall operating ratio
The overall operating ratio measures the combined profitability of the captive programme including investment income. The ratio is calculated from the income statement as:
Ratio Seven - Investment income / Net earned premium
A ratio above 100 percent means the captive is not profitable overall. One or more years with operational losses could result in depleted surplus and a need for additional capital contributions over time. Each of the four components in the numerators of the calculation should be isolated when reviewing entities with high ratios.
The combined ratio and overall operating ratio may be reviewed for multiple calendar years combined to smooth any variations caused by a single bad underwriting or investment year.
- Change in surplus
The change in surplus measures the improvement or deterioration of the captive’s financial position over the year. The ratio is calculated from the balance sheet as:
Ending total capital & surplus / Beginning total capital & surplus - 1
For years with ratios near or below zero, other ratios should be reviewed to determine factors attributing to slow growth or deterioration in surplus. Higher growth in surplus may not be as concerning, especially for newly formed captives, as the goal for many of these captives is to build surplus over multiple years to absorb adverse losses and create stability within the programme.
- Ratio of liabilities to assets
The ratio of liabilities to assets measures the ability of the captive to pay its liabilities from the assets available. The liquidity of these assets may also be considered alongside this ratio. The ratio is calculated from the balance sheet as:
Total liabilities / Total assets
Many of these ratios are interrelated and should be reviewed both holistically and individually with the intent of identifying specific areas which may require further discussion and review. Conclusions gathered should not replace capital adequacy assessments, risk-based capital, the NAIC Insurance Regulatory Information System (IRIS) ratios, or more sophisticated analyses that may be available. They should be seen as more of a quick pulse instead of a comprehensive review.
Benchmark ranges for these ratios may be found in the NAIC IRIS Ratios Manuals, AM Best’s Market Segment Reports, and other industry sources. Many captive managers, actuaries, and other captive consultants keep internal benchmark ranges based on their experience serving the industry. Some benchmarks are available for specific industries and captive structures.
Captive directors and their reviewing actuaries may also provide insight into reasonable ranges expected in a particular domicile based on their own internal benchmarks and requirements unique to each domicile. The review of financial ratios is particularly important in the captive feasibility phase as part of discussions regarding initial capital and premium funding, as well as the potential effects of adverse events.
Keep in mind that benchmarks are typically based on larger, more consistent captives and may be less reliable for smaller captives or those covering non-standard risks. The latter may require a more qualitative review. In any case, stress testing the results is important. Regardless of the size, age, and structure of the captive, periodic re-evaluation of these ratios provides useful information for decision-makers as they monitor the financial health of their captive.
Lori Ussery is an actuarial consultant at SIGMA Actuarial Consulting Group. She can be contacted at: firstname.lastname@example.org
ratio, premium, captive, written, expenses, calculated