Surplus: too much, or too little?
The past year has been challenging. There are stories everywhere about the cause and effect of the recent financial crisis. Captives and their parents were of course not immune from the malaise, and captive boards are now appropriately asking more questions about the financial strength of their captive companies. Like Goldilocks, they want to make the amount of surplus used in the captive is “just right”. This is the story of how one captive and its parent approached some fundamental questions about the captive, balancing its need for surplus, particularly under varying investment mixes, and its parent company’s need for capital and cash.
We will look at the questions that the captive tried to answer for its board, and the information and outcomes that they discovered in the process. We will not attempt to go into the actual underlying analysis and mathematics as they are beyond the scope of this article.
Like numerous organisations, the parent company was facing issues concerning the strength of its balance sheet, the ability to borrow in tight or disappearing credit markets, and its ability to improve its short-term cash position. As part of its review, the captive was put under scrutiny to ensure that it was supporting the parent company in the most efficient way possible. The parent asked the captive to re-examine the size of its surplus and, consequently, its ability to return some cash/surplus to the parent. The money in the captive had to work for the organisation as a whole. Optimal investment return within the parameters of appropriate surplus was key.
By way of background, the captive has a history in excess of 10 years and writes mainly long-tail business.
To address the parent company’s concerns, a team of management personnel and outside consultants was put together to work through the project. Some of the specific questions the team asked included:
• Was the captive financially best serving its parent’s needs, taking into consideration its own surplus requirements?
• What were the captive’s surplus requirements and how could it determine the optimal amount?
• How did different investment philosophies affect the amount of surplus?
• Would the resulting surplus levels allow the captive to deal with volatility under different loss experience scenarios?
The composition of the team was very important. The group was led by members of the risk management staff and drew on treasury personnel as needed. External service providers included the investment consultants, the independent actuary, the captive counsel and the captive manager.
The group’s first step was to identify the parameters of the project. After some discussion, it was agreed to examine the effect of four different investment philosophies. The first philosophy identified was the captive’s current asset mix of an aggressive allocation to equities and alternative investments. This was also considered a baseline for the study as the captive’s board was familiar with this asset mix. The next two asset mixes were progressively more conservative by means of shifting assets away from equities and alternative investments into less volatile fixed income investments.
The fourth asset mix was designed to mirror the fairly conservative portfolio guidelines that would be required to meet the Medicare eligibility requirements established for offshore captive insurance companies. Healthcare owners of offshore captives must meet these investment guidelines in order to be able to include the premiums paid to the captive as an eligible cost under the Medicare reimbursement rules. (Note that this is only one part of the complex Medicare rules and readers should not infer that simply following the investment guidelines implies that the captive owners will be eligible for reimbursement.) Examining the fourth asset mix was considered important by the team to again assess the value of lost investment income due to the more conservative profile of investments versus the value of the lost reimbursement to the captive owners.
It was recognised that each asset mix had contradictory effects on the surplus of the captive. A more aggressive philosophy would add surplus and value to the captive through increased investment income. But more surplus would need to be retained in the captive to cushion the increased volatility inherent in asset mixes with a higher equity component.
"A more aggressive philosophy would add surplus and value to the captive through increased investment income. But more surplus would need to be retained in the captive to cushion the incerased volatility inherent in asset mexies with a higher equity component."
Using the four asset mixes, treasury staff and the investment consultants were asked to run simulation models using various economic assumptions. The outcome was a range of possible investment returns, and the probability of that event occurring. For example, using asset mix three, the range showed a worst-case return of minus 10 percent and a potential high side of almost 20 percent, with the average expected return across the five years in the six percent range. These investment models supplied the team with a graphical range of outcomes, different for each of the four asset mixes, with percentages of each level occurring.
These investment outcomes were then passed on to the independent actuaries for inclusion in their modelling. Once again, the team discussed the next steps, and the parameters and assumptions for the study.
A full-blown dynamic financial analysis (DFA ) would have incorporated the entire range of possible loss experience in the captive with possible investment returns. Considering the constraints of the project and the current professional liability environment, the team concluded that this type of DFA was not appropriate. Accordingly, the actuary incorporated three simple assumptions in his analysis. Under the first scenario, loss experience would be as expected under his current reserving models.
In the second scenario, loss experience would be assumed to improve by a certain amount in year two and again in year three of the analysis. In the third scenario, the loss experience was expected to deteriorate from that expected by a certain amount in year two and again in year three.
Recognising that this process was only a ‘light’ version of the more sophisticated DFA , the team believed that it would still stresstest the captive’s loss assumptions and their effect on surplus.
The actuary then ran models producing a range of surplus outcomes and corresponding probabilities of that outcome occurring. These results were then reviewed and discussed in detail by the team. Several further iterations of the models came out of these discussions.
It also became apparent that the team needed to discuss key parameters—what constituted a ‘negative’ result. For example, under one scenario, the necessity arose for a 20 percent premium increase from one year to the next (as measured by the premium charged to the facilities of the owner) and this necessity occurred in a certain percentage of the outcomes. The team decided that any premium change exceeding an agreed amount was considered unacceptable for the programme. The facilities needed a certain stability in the insurance programme.
Similarly, the models showed that the captive would be ‘bankrupt’ in a certain percentage of the outcomes. The definition of bankrupt generated considerable discussion. The commercial insurance definition did not seem appropriate—in the case of a wholly owned captive, it may have ready and immediate access to capital (capital call, letter of credit, loan, etc.) that would not be available to commercial insurers.
The results were then refined and presented to the captive board. Numerical support was given for any decisions made about the investment philosophy and mix, as well as the level of surplus that the board wanted to maintain in the captive. Financial ratios, such as reserve to surplus, had been providing assistance to the board in monitoring and managing surplus on a regular basis. This work gave the board a more robust analysis to support its decision on investments, surplus levels and appropriate ratio ranges, helping them determine how much surplus is “just right”.
For others considering a similar project, it is highly recommended to establish the project parameters at the start, make sure all the key team members are in place, and define key assumptions and parameters early in the process. You will then have support for any recommendations you are making to the board about the appropriateness of your captive’s surplus and the level of any financial ratios you may use in the future.
Peter Jones is managing director at Captive Management Initiatives. He can be contacted at: peterjones@cmi.ky