News & Events

It’s Time for a Captive Check-Up

The following article appeared in Captive Review‘s 2019 Tennessee Report.

A lot of work goes into forming a captive. It may take prospective captive owners several years to get all of the internal stakeholders behind the idea of forming a captive. It may then take upwards of a year to execute the final design and implementation of the captive program. One couldn’t blame the company risk manager or CFO if they decide to take a break from getting into the details of their newly formed captive and entrust the ongoing operations to the captive manager or program manager. While there is nothing wrong with letting the captive manager and service providers some time to execute the plan of operation, captive owners should mark their calendar for a comprehensive health check-up two or three years down the road.

By the end of year three, the captive owner can really put to the test many of the assumptions made in the initial feasibility plan. Since captives typically write only a few policies every year, and some policies may not have any claims in any given year, it usually takes a few years to shake out how likely the projections match with real-world losses.

If the feasibility study assumptions weren’t tight enough, meaning the captive is losing more money than was anticipated, most owners or CFOs would readily understand long before the third anniversary that their captive needs some attention. However, if the captive is doing better than expected, the CFO or owner may be tempted to leave ‘good enough’ alone and not get involved. The problem is that an insurance company doing better than projected faces its own set of risks and concerns.  An owner could be missing an opportunity to place additional risk in the captive or a captive could be jeopardizing its own status as an insurance company if it were later determined that premiums were set too high for the risks insured. If three or even five years go by and the captive is greatly exceeding the projections made in the feasibility study, a thorough check-up is in order.

What goes into a check-up?

A good place to start is with the captive’s initial feasibility study and to compare it with real-world data. Work with your captive manager to develop questions for your actuary to see what data can better inform future models. Next, the captive should make sure that its service providers are doing a hard look at the coverages, limits, and rates and see if they meet the captive owner’s needs or if there are new risks that can or should be added to the captive.

A captive’s feasibility study also likely made a number of assumptions about how the captive should be structured to meet the needs of the insured and to maintain regulatory compliance. In a three year span of time: regulations change and ongoing court decisions can alter the captive landscape. This is a good time for a captive to engage its captive manager, attorney, and actuary to review industry changes and trends and make new recommendations going forward.

A good captive check-up also should involve a review of the captive’s service providers. Evaluate the costs, experience level, and quality of service offered by  your actuary, accountant, attorney, captive manager, investment adviser, and others.

This is also a good time for the captive’s governing board to do a self-evaluation. Review the experience and insights that each member brings to the boardroom. Would the captive benefit from an independent board member unaffiliated with the parent company or a service provider? Should the board invest in captive insurance-specific training opportunities for one or more board members? Is there a succession plan in place for current board members from the parent company or elsewhere?

Why do a check-up?

Many of these steps can and should be done with little or no additional cost. These are the types of questions that a captive should be asking its service providers that are already being compensated.  More importantly, these types of questions are ones that any insurance company, captive or traditional, should always be asking itself. The difference with a captive insurance company is that its smaller size means that important trends can take longer to develop.  Captive owners, especially owners that do not have an insurance background, often need to make the extra effort to distinguish between how an insurance company works versus any other typical business operating unit.

Engaging in this type of check-up is a strong indicator to outside spectators, be that state or federal regulators, reinsurers, pool managers, or rating agencies, that the captive has strong and stable corporate governance. Scheduling a check-up in the third year can help a captive become better prepared for its regulatory examination. Identifying and correcting any issues before the examiner starts the examination can make the process go more smoothly and performed at a lower cost.

Most importantly, a thorough check-up can ensure that the captive is most efficiently meeting the insurance and risk management needs of its insured/owner.

Planning ahead for the next check-up

As part of the check-up, a captive should also map out both quantitative projections for the coming five to seven years as well as a long-range plan for any new coverages or modifications to existing coverages to consider in the coming years. These plans can be used to guide the captive board’s strategic planning over the next few years and then ultimately serve as a benchmark for the next captive check-up in roughly five years. By planning to have a check-up a year or two ahead of the captive’s regulatory examination, the captive stays on a regular schedule to spot and correct concerns before they get out of hand.

Planning for a check-out

A dissolution plan is also an attribute of good corporate governance, even if a captive is healthy and growing. There are many reasons why a captive may need to be shut down in the future. The needs of the parent company may change, such as when the parent company is sold. Whatever the reason, there may come a time when it is best to run off and shut down a captive. Some captive owners who decide to shut down a captive are quite surprised that the run off process for a captive can be measured in years, not weeks. Captives with risk pool liabilities, long developing claims, or occurrence policies are especially vulnerable to multi-year runoffs.

One way to avoid exceptionally long run-offs is to make a practice of buying a loss portfolio transfer (LPTs) for liabilities that linger for longer than a set period of time. While one-time LPTs or reinsurance agreements executed on an expedited basis can be quite expensive, the captive manager and reinsurance intermediary can often negotiate much more favorable rates for a series of transactions. Getting old residual liabilities off the captive’s books allow the captive to more accurately and quickly book underwriting profits. Should it be necessary for a captive to go into runoff, the captive then has a finite set of risk exposures that can more efficiently be dealt with.

It is important that the captive board and captive owner have regular discussions with the captive manager and other service providers to understand what the process for a dormancy, run-off or dissolution would be based on the captive’s current operations regardless of the current status of the company. Having a dissolution plan also serves as a check on keeping the captive from growing so complex that an orderly wind-down becomes impossible.

Active involvement of the captive owner and board

Even if a typical captive board meeting consists of a mostly one-way flow of information from the service providers to the board members, the check-up and check-out discussions are ones that all members of the board should actively participate. These discussions are the best times for board members to switch to an active role and exercise their authority and provide strategic direction for the company. By scheduling a regular check-up and keeping an eye on the dissolution process, board members will meet many of their fiduciary responsibilities to the captive and owner, their regulatory responsibilities to their domicile, and their contractual obligations to their business partners.