Understanding captive feasibility studies

What is a captive feasibility study? Some think feasibility studies provide rudimentary answers to the question “Should I form a captive?”. Others think it entails a detailed actuarial analysis of the risk exposures faced. In our view, a feasibility study should be a comprehensive, qualitative and quantitative assessment. It should highlight the expected benefits of the preferred structure and how it is best suited to the client’s particular needs.

The quantitative portion of the analysis should include the projected gross and net premiums, expected and adverse loss projections, operating expenses, investment income, statutory capital and contributed surplus requirements, net revenue and tax ramifications.

However, the qualitative assessment is just as important. It should compare the captive to other risk financing strategies, address captive coverage issues and contrast the various forms of captives. Since captives types can include large, direct-issue, single-parent (pure) companies, fronted reinsurers, segregated cells, group captives, risk retention groups, and even more esoteric structures such as reciprocals, differences in captive structures can result in significant operational efficiencies that should not be overlooked.

In addition, the study should include an in-depth domicile analysis, and address key regulatory and tax matters. In-depth regulatory, tax and legal matters typically require input from suitably qualified professional advisors.

In that light, a truly comprehensive feasibility study should include the following.

Goals and objectives setting

This can be the most important step in the process, since every company has different objectives they are trying to fulfil. Some organisations will be focused on driving down long-term costs, others trying to solve coverage issues, and some will want to offer third party solutions.

Hurdles to financing risk in the captive must also be identified so that the recommended solution can be structured to ultimately achieve the stated objectives. There may be numerous ways a captive can meet the client’s contractual, statutory or regulatory needs, but there is likely only one that will do so most efficiently.

Key stakeholder interests should likewise be ascertained, as they can directly affect the captive’s structure and funding, since a wide array of internal and external interests may have to be aligned to get the necessary approvals to launch the captive.

Data collection and analysis

This involves compiling historic premium, exposure and loss data for all lines that will be analysed for the purposes of actuarial analysis. The recommendations should include loss projections across a range of confidence levels and identify the methodologies and assumptions used in calculations.

Those projections will be critical to developing the captive’s pro forma financial statements, business plan and licence application.

Programme structural recommendations

At this point, developing the structural recommendations becomes the next logical step. Those recommendations should identify all reasonable options and rank them according to the pros and cons of their relative merits.

Captive domicile analysis and recommendations

Discussions about captive domiciles tend to spur visions of Caribbean beaches, ski vacations and far-flung board of directors meetings. In the end, however, the decision about whether to domicile a captive should be made based on the consistency and professionalism of the regulators, quality of supporting infrastructure (such as professional advisors in the domicile), and accessibility for the captive owner.

A captive feasibility study should impartially compare the pros and cons of the relevant domiciles rather than simply defaulting to a given domicile.

Financial assumptions

Captive financial analysis depends on key assumptions such as funding levels, investment returns, exposure growth, variances in loss costs and operational expenses. Therefore, it is important that the assumptions be scrupulously reviewed, and pro forma financials illustrate the results over at least a five-year timeframe.

In addition, adverse loss scenarios should be included. Finally, the inclusion of advanced analytics, such as Captive Quantified, can interactively stress test a wide range of customised captive strategies.

Implementation plan

The report should also provide an implementation plan for the captive, including costs and relevant timelines. These in turn will help the client decide when the key decisions need to be made.

Last factors

Finally, a few other items and issues should be noted, as they are integral to feasibility studies.

Executive summary

Even though the executive summary is the last step in preparing the report, it is placed at the beginning to deliver the “key takeaways” up front while referencing the conclusions, assumptions and calculations contained throughout the report.

Appendices

The feasibility study will likely refer to the actuarial study and supporting documentation (claim trends, key coverages and sample reinsurance documents, etc). Those documents should be included in the report for the sake of ease of access and completeness.

Peer review

Feasibility studies should undergo scrupulous peer review. Laws, taxes, regulatory interpretations and industry solutions change over time, and a second (or third) set of eyes can help ensure the study’s recommendations are comprehensive and accurate.

Executive presentations

Even consultants who avoid using insurance jargon in reports will commonly have to explain their recommendations to senior management who are unfamiliar with the nuances of insurance and risk financing.

Costs

Feasibility study costs can vary significantly depending on the magnitude of the premiums involved, the availability and quality of data, lines of coverage analysed, complexity of the required structure, need for supporting reinsurance, and other concerns.

However, including the actuarial, consulting, tax and legal opinions that are generally required to generate a comprehensive study, fees between $25,000 and $75,000 are relatively common. While that may seem a significant up-front investment, there are many factors to consider when setting up a captive.

The financial and operational efficiencies generated by implementing the right form of captive, and in the best domicile, tailored to the client’s needs, will far outweigh the initial cost of a comprehensive feasibility study.

Bruce Whitmore is a director and senior consultant in the global captive and national healthcare practices at Willis Towers Watson. He can be contacted at: bruce.whitmore@willistowerswatson.com