1 January 1970

Risk and corporate governance: orewarned is forearmed

In an Organisation for Economic Co-operation and Development (OECD) report titled Risk Management & Corporate Governance, which was prepared after the financial crisis of 2008, the main finding stated that: “The balance between risk-taking (the life blood of the free market) and risk avoidance is no longer functioning. Similarly, the balance between remuneration and ethical behaviours no longer operates appropriately. The oversight of these two principal balancing acts, which should be exercised by the board does not function properly because the assurance functions are not given sufficient weight.” While it is true that the scope of the OECD report was large banks and large financial institutions, the message is clear: the corporate governance, risk assessment and risk management functions in US and UK corporations are broken.

The avowed crisis in corporate governance, risk management and compliance (commonly referred to as GRC in large public companies), coupled with globalisation, captive tax challenges by the IRS in the US and Solvency II in the European Union, have caused captive managers and boards to face an increasing level of awareness and responsibility for GRC.

Captive boards must be prepared to step up their governance and oversight activities in all areas of GRC, but particularly their risk assessment and risk management activities.

GRC should not be viewed as a series of half-executed board-level policies that are initiated to satisfy some checklist or other regulatory requirement. It should not be viewed as a ‘bolt-on’ to the business operations, but rather, as an overriding framework within which the business runs and operates. The main problem, in A.M. Best’s view, is that GRC is one of those pesky investments of resources where the costs are abundantly clear, measurable and timely, but the benefits are fuzzy as to their direct source and how they will manifest themselves at some point in the future. But manifest themselves they do.

A.M. Best has been publishing insurer insolvency statistics since 1969 in the form of an annual insolvency study, which captures rated and non-rated insurer impairment, including captives. Accordingto this study, the leading causes of insurer impairment that pertain particularly to captives are deficient loss reserves and inadequate pricing (38.1 percent), rapid growth (14.4 percent) and overstatement of assets and investment problems (8.9 percent). These three causes of impairment combined account for 61.4 percent of all insurance insolvencies but represent a higher proportion of captive impairments.

All of these primary causes of impairments were related to some form of mismanagement in the opinion of A.M. Best. The implication is that all of these causes of impairment can trace their roots to the failure of management and the board to properly assess and address the risks of the company.

Deficient loss reserves and inadequate pricing

When loss reserves are found to be deficient, the insurer must strengthen its reserves, thereby depleting its capital and surplus—in other words, the margin of safety between solvency and insolvency. Impairments from this generally manifest themselves in casualty insurers either during or shortly after a soft market.

A captive that writes a material amount of casualty business is prone to this area of risk due to the myopic scope of most captives’ actuaries, who generally use industry loss patterns to supplement the captive’s loss experience when setting reserves, particularly incurred but not reported (IBNR) reserves. This makes the captive’s reserves prone to development, either positive or negative, depending on how closely the captive loss experience correlates with the industry figures. Additionally, most captives outsource their claims-handling to a thirdparty administrator (TPA).

The outsourcing, while efficient from an expense perspective, can isolate the day-to-day claims-handling and case-reserving practices from management. The TPA is generally given a set of ‘claims-handling instructions’ that detail procedures and some sort of reserve and/or settlement authority. In addition, management may or may not have access to adjuster notes, which bring additional colour to the day-to- day reserving practices. Management’s diligence, the quality of the TPA and the method of payment for services are important factors to consider when outsourcing the claim and reserving functions.

The board of a captive that outsources the claims-handling and case-reserving functions to a TPA and the actuarial functions to an independent actuary needs to be mindful that the policies, procedures and authority levels of the service providers are optimal in supporting the captive’s goals and objectives. These policies should be reviewed at least once a year, and the service providers should be required to present to the board on a quarterly or more frequent basis.

Rapid growth

Rapid growth, typically, is accompanied by a deterioration in loss reserve accuracy and in a company’s ability to manage its book of business. Group captives are far more susceptible to this issue than single-parent captives that don’t write material third-party business. Also, the growth issue most frequently occurs during soft markets.

Diminished capital strength becomes a greater probability for insurers that embark on long-term aggressive growth strategies, particularly when new lines of business or geographic expansion and a lack of related underwriting experience are involved. In some cases, unusual rates of growth are evident in the last full year before impairment, usually indicating that the insurer was aggressively writing new business through periods of inadequate pricing.

Captives seem to be particularly susceptible to the lure of excessive growth due primarily to their generally higher net retention to surplus ratio or generally high reliance on reinsurance.

Captives usually grow counter-cyclically during a hard market, when rates are tightening in the commercial market and a captive solution seems relatively more cost-efficient and enticing. Before a captive plans to generically grow by more than about 10 percent per year, the board working in conjunction with management should ensure that expansion resources are secured beforehand.

"Captive boards must be prepared to step up their governance and oversight activities in all areas of GRC, but particularly their risk assessment and risk management activities."

Some questions should be asked and answered, such as: are our claims and underwriting systems sufficient at the sustained growth levels, and does the captive or outsource partner have sufficient staff and resources to handle the additional activity generated by the underwriting and claim functions? Additionally, management and the board should ensure that oversight functions are reviewed on a more regular basis to try to solve problems that manifest themselves before they cause too much damage to the surplus.

The board should consider the source of the growth. Is the captive growing by adding a new line of business? If so, where is the expertise to handle the new line? Is the captive growing by expanding business to new jurisdictions? If so, does it know the pitfalls of doing business in those new jurisdictions? Finally, the board should be cognisant of the fact that an expansion of business requires securing additional capital in the form of hard equity that will be available to absorb the additional risks presented by the new business opportunities.

Overstatement of assets and investment problems

Impairments from this issue tend to occur when assets are reduced by an amount greater than the company’s capital and surplus. This is enhanced when the market value of invested assets declines, as happened during the crisis that started in 2008, or an audit reveals misstatements of reported asset values.

During the recent turbulent investment markets of 2008, 2009 and the first half of 2010, quickly declining asset values from traditional investments, such as highly rated fixed income securities and bluebluechip equities, introduced a level of volatility to the asset side of the balance sheet that has not been experienced since 2000-2001. This asset volatility has manifested itself at a time when the commercial insurance industry is in the middle of a soft market, adding strain to cash flow and earnings. Finally, companies generally have been neglecting proper asset liability matching, bringing their investment portfolios in short so as not to be stuck with declining fixed income values when interest rates increase. The problem is that these shortened portfolios return minuscule short-term rates, which lessen the cushion for underwriting results that have been anaemic due to the soft market.

Many captives outsource their investment management. The boards of these companies should be particularly in tune with the investment philosophy and implementation policies. Gone are the days of the board rubber-stamping a generic two-page investment policy that was sent to a large investment manager and then receiving an annual update.

The board needs to be intimately involved in the investment process and conduct regular scenario testing that incorporates current trends, to assess whether the investment policies in place are still sufficient in this fast-changing environment. The board can be caught between a rock and a hard place when it comes to deciding how to implement an investment policy. Usually, a captive’s staff is too small to have all the investment expertise in-house. Alternatively, a captive usually represents a small fish in a big pond if it outsources its investment management to a large investment firm. The large investment firm has the resources needed to effectively implement a comprehensive investment strategy, but because there are typically much larger clients being serviced, a captive may not receive the attention it requires.

The evaluation that A.M. Best performs on all rated insurers and reinsurers, including captives, includes a comprehensive analysis of GRC. A captive that chooses to engage in the rating process has the opportunity to benchmark its GRC evaluation against a representative composite. Material deficiencies in GRC have a negative influence on the credit rating assigned to any rated captive due to the adverse financial consequences that are expected to manifest themselves in a competitive environment.

Steven Chirico is the assistant vice president, captive ratings, at A.M. Best. He can be contacted at: