Reinsurance and asset management: a delicate balance for captives

Jack Meskunas of Oppenheimer & Co  (pictured left) and Michael Woodroffe (pictured right) of Kirkway International provide their insights into reinsurance risk management for captives.

The goal of a captive owner is, of course, risk transfer from the parent to the captive. But what of the goals of the captive—taken as an individual entity—from the viewpoint of the captive as a standalone insurance company? We feel a more holistic approach would be to look at complementary areas within the captive, and try to divine how to maximise each area not individually, but jointly. 

Captive insurance companies, owners, and managers frequently look at each aspect of the captive on an individual standalone basis. This makes sense, given the complexities of risk transfer in general, and captives specifically. It may be difficult for a captive insurance account executive, management company, or owner to be everything, everywhere, all at once while deep in the weeds of all the moving parts of the captive. 

“Reinsurers can create more efficient and creative ways to transfer risk than a regular insurer.”

Between regulations, changing insurance and reinsurance markets, actuaries, accountants, domicile-specific issues, claims, new business, renewals, etc, it may be too much to consider stock and bond market performance/outlook through the lens of reinsurance, or vice versa. But if you think about it, the two are hand-in-hand and are in many ways the primary and most significant sources of value and uses for a captive.

Powerful attributes in reinsurance and investments

One of the most powerful attributes of a captive insurance company is the ability to access the reinsurance market. This allows captive owners to limit losses, select certain layers of risk they are willing to retain (thereby increasing the certainty of their exposure limits) and to lay off excess liabilities and perhaps insulate themselves for black swan events and thermonuclear verdicts. 

Reinsurers can create more efficient and creative ways to transfer risk than a regular insurer. Multi-year and loss-sensitive plans can take the bumps out and combined with an intelligent investment plan can help maximise investment returns.

Another powerful attribute of a captive is to take retained premiums and invest them in ways that would specifically respect and reflect the personality and risk tolerance of the owners, but reflect the markets in real time as well. The level of retained risk needs to be carefully monitored. Just like an investor, the captive and captive owner need to codify their level of risk tolerance. 

As market conditions change, the risk level in the portfolio may rise or fall. Careful and consistent monitoring can allow real-time changes to maximise returns for a given level of acceptable risks.

Choose wisely, and handle with care

When choosing your reinsurer—or your financial advisor—just as one would not put an entire investment portfolio into a single or asset class, the selection of a reinsurance company should not be based solely on cost. The cheapest low-rated reinsurer is not a good and secure choice when the going gets tough. Having a panel of highly-rated reinsurers maximises the likelihood that when your reinsurance is needed, it is there to pay the claims in full and on time.

If one looks at the commercial insurance market, it is an age-old truth that risks that can be covered more cheaply, should be covered there. But although purchasing commercial coverage transfers the risk from the parent company (insurance buyer) to the commercial insurer, it does not take into account the opportunity cost of those premium dollars that flow from parent to commercial insurance company, and the forever lost opportunity to invest those premium dollars and reap the rewards of long-term investment returns.

“A certain amount of a captive’s investments need to be in cash or liquid investments.”

Reinsurance companies typically have lower expense ratios than large commercial insurers. As such, more of the contributed dollars go to paying claims and not paying expensive internal costs. Proper placement and use of reinsurance can act as a substitute for capital, and enable larger risks to be insured—potentially increasing the profitability of the captive.

There are high-cost ways to invest, eg, investment advisors “wrapping” mutual funds and charging fees to manage a portfolio of funds—all of which have internal fees. Captives using this strategy are paying management fees on top of management fees. It is generally not the best—or most efficient—way to invest.

Control and long-term planning 

Reinsurance experts will tell you that one primary benefit of having a captive is the ability to maintain control of your cash. Another is access to the reinsurance market and the subsequent ability to retain only the risks that the captive is capable of bearing, and limiting the exposures that could pass to the captive owner or parent company.

Many risks in captives are long-tail risks. Claims filed in year one may develop over time, be discussed, investigated, and negotiated and eventually be paid in some cases five or more years later. In a captive, premiums are deposited yearly and invested immediately. During the five+ year wait to pay on some claims, those funds can remain invested and grow, resulting in effectively lessening the net cost of the claim to the captive.

High cost, low cost

The relatively high expense ratios of commercial insurance companies may be a problem for them, but they are an opportunity to a captive—typically a leaner organisation with lower expenses—that usually results in higher profits and subsequently more money to be invested.

Investment opportunities—and ‘higher for longer’

Captive insurance companies are almost always long-term investors, and while “higher for longer” was a quote from Federal Reserve chair Jerome Powell (and he was talking about rates, not portfolios) I use it to point out that portfolios generally go higher the longer they are invested. In the investment business we say that “time in the market is more important than timing the market”. The longer your time horizon to invest, the more likely your strategy will have positive returns.

Captives intuitively know this, and while every effort should be made to duration-match maturities and liquidity events with known pending claims payments, it is not always possible to do. That means a certain amount of a captive’s investments need to be in cash or liquid investments (investments that can quickly turned into cash). Every bit as important is having as much invested for the long term to maximise the potential total return of the captive portfolio—if the captive can focus on claims management, and exercise some control over claims payments, it can probably get higher returns on its investments.

An effective and creative reinsurance programme, coupled with an asset management strategy utilising a mix of short, intermediate, and longer-term opportunities can help the captive manage risks, maximise returns, and smooth cash flows in and outside the captive. The long-term benefits of considering synergies by looking at both programmes together can be substantial.

Past performance is not indicative of future results. All investments involve risk. An investment in this strategy involves a significant degree of risk, including, without limitation, the risk of loss and/or volatile performance. All opinions expressed are current as of the date of this letter and are subject to change. Forward-looking statements: Any projections, forecasts and estimates (including, without limitation, any target rates of return) contained in this overview are necessarily speculative in nature and are based on certain assumptions. It can be expected that some or all of such assumptions will not materialise or will vary significantly from actual results. Accordingly, these projections are only an estimate. Actual results will differ and may vary substantially from the results shown. The risks associated with investing in fixed income include risks related to interest rate movements as the price of these securities will decrease as interest rates rise (interest rate risk and reinvestment risk); the risk of credit quality deterioration which is an issuer will not be able to make principal and interest payments on time (credit or default risk); and liquidity risk (the risk of not being able to buy or sell investments quickly for a price that is close to the true underlying value of the asset). This article is not and is under no circumstances to be construed as an offer to sell or buy any securities. The information set forth herein has been derived from sources believed to be reliable and does not purport to be a complete analysis of market segments discussed. Opinions expressed herein are subject to change without notice. Additional information is available upon request. Oppenheimer & Co nor any of its employees or affiliates does not provide legal or tax advice. 

Jack Meskunas is an executive director of investments and a captive insurance asset management advisor at Oppenheimer & Co. He can be contacted at: jack.meskunas@opco.com 

Michael Woodroffe is president of Kirkway international. He can be contacted at: mw@kirkwayintl.com 

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