21 August 2013Actuarial & underwriting

US captives outperform commercial peers, but underwriting drops sharply

A recent report by AM Best has found that in spite of US captive insurers having faced significant losses in 2012, the captive industry continues to outperform the US commercial casualty market.

Captives achieved a five-year combined ratio of 92.3 percent, compared with 103.3 among commercial casualty carriers in 2012, as the captive sector outshines its commercial peers. Return on equity (ROE) rose from 7.2 percent in 2011 to 8.4 percent in 2012 within the captive sector—with an 8.4 percent five-year ROE being achieved by the sector—comparing favourably to the 6.7 percent ROE achieved in the commercial market over the past five years.

Investment yield in the captive sector did however decline in 2012, but return on investment was held up by realised capital gains, with captives averaging a 4.7 percent total return on investment in 2012, a 1.4 percent increase on the previous year. Operating and underwriting expenses both rose however, to 83.2 percent and 20.3 respectively for 2012, but captive operating and underwriting expenses continued to outperform their commercial peers.

Underwriting under fire

Captives surplus grew by $1.39 billion during 2012, but net income fell precipitously, the sector earning $539 million less than the previous year, or a 26 percent fall in net income. Net income was hit by a 71 percent drop in underwriting income, which together with a troubled investment environment are serving to buffet the industry. Underwriting income was hit by increases in loss-adjustment and underwriting expenses, likely linked to the active catastrophe season experienced in 2012.

The report also found that captives were being pressured by their parents to practice greater capital efficiency in an “environment of low growth and self-destructive pricing behaviour”. This has encouraged many captives to return capital to their parents, in the form of dividends and premium rate credits. Nevertheless, the level of premium being written by US captives continues to rise—although only marginally—with figures now approaching pre-financial crisis levels—$8.3 billion.

Captive International spoke with Steven M. Chirico assistant vice president and Fred Eslami senior financial analyst at AM Best about the squeeze faced by captive insurers.

How significant is parental pressure to return funds and streamline the use of capital?

There is significant pressure on most captives as well as any other company within a group to operate as efficiently as possible from a capital use perspective since this is what drives ROI, ROE, which the senior management of any organization is driven (and paid) to maximise. So yes, this pressure will continue as long as stock analysts put buy and sell recommendations on public companies. The decision that needs to be made internally is the balance between a well capitalised risk bearing captive and corporate capital efficiency. Single parent captives tend to make significant net income in most years that will accumulate over time.  At some point, the capital can become excessive for the risks being borne and if the captive doesn't/can't take additional risk then it can be appropriate to return some of the excess capital to the parent to use as working capital.  If the captive is rated by AM Best, then the risk manager knows how much capital is required according to AM Best's stringent analysis and capital in excess of this amount can be returned while maintaining a particular rating level.

Is there a danger that driving down operating expenditure will undermine captives underwriting and risk control capabilities?

The practice observed from rated captives is that expenses are being minimised within certain quality standards. Generally, expenses at the captive level are more administrative in nature and are managed carefully. There is a danger that cutting expenses without contemplation of the effects can be dangerous. For instance as a thought experiment take a captive who had an attorney on staff to supervise the claim handling performed by a third party administrator (TPA). They decided to cut this position and rely on the TPA's internal controls and compliance with client handling instructions. The TPA's adjustor quit and was replaced by a new hire that didn't comply with the client handling instructions. A bad faith claim and a double digit reserve development later, the importance of the TPA oversight function was discovered. Expenses need to be managed...but carefully and thoughtfully.

Should the current economic climate persist, do you expect this pressure to continue or even increase?

There is some correlation to the relationship between capital, expense pressure and the economy.  So for instance in the tables of our recent captive report you can notice that stockholder dividends and contributed capital show heavy contributed capital in 2009, which anecdotally occurred at the beginning of the year and a heavy stockholder dividend amount, which anecdotally occurred at the end of the year. This activity can represent net capital provided to shore up capital during the crisis as well as the recovery later in 2009 and a subsequent return of that capital.