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Captive feasibility studies
Tony Bibbings considers the various elements of
a successful feasibility study for a new captive.
April 2006
There are many issues, across many disciplines, to consider when deciding how to prudently address the risks your company faces. If a captive is one of the tools that are being considered, it is worth seeking the help of captive experts who can simplify some of the issues on a company-specific basis.
There is no shortage of experts willing and able to help you decide whether a captive will address your immediate needs. However, you need to satisfy yourself that the captive is the most efficient way to accomplish your objectives. Once you have conducted an initial assessment and concluded that a captive is the right answer, a detailed study will provide the foundation for the structure and a road map to successfully navigate the captive to completion.
There are a number of components to a good feasibility study. The importance of each will vary depending on the risk profile of the entity that will own and participate in the captive. As a minimum, the following elements should be considered:
• the amount of risk the captive will retain, both per occurrence and in the aggregate;
• the structure of the programme;
• the domicile that suits the programme objectives best; and
• which parties will fill all of the roles needed for a complete captive.
The amount of risk the captive will retain.
This is the most important element and should be the starting point.
Ideally, it begins with an actuarial assessment of the probability of loss at various retentions and various confidence levels and should be specific for the entity considering the captive. For instance, estimating the probability of the total losses if the captive covers the first $100,000 of workers’ compensation claims should be compared to other suitable retentions to see how sensitive the captive would be to different retentions. Similarly, the estimates should be determined using various confidence bands to see how volatile the results are when trying to increase the probability of the estimates containing the actual results. The chart below illustrates this point.
The chart above and its related graph show that individual losses under $100,000 are expected to accumulate to $975,000. If you need greater confidence that the loss estimate will cover your losses, they also show that there is a 95 percent probability that claims under $100,000 will total $1,836,000 or less. With a market premium of $1,800,000 for that layer and a reasonable expectation that losses will actually be $975,000, that layer is a good candidate for a captive. On the other hand, while losses over $1 million are expected to be $27,000, there is a 5 percent probability (i.e. the inverse of the 95th percentile) that losses will exceed $3,500,000. With a market premium of $500,000 indicated, the decision is not so straightforward.
The next aspect to consider in the amount of risk to retain is the entity’s financial condition and cost of capital. The analysis that addresses probability of loss should be put in the context of a company’s ability to comfortably sustain losses. A weaker financial condition will often affect a company’s risk appetite.
The outcome of the retention analysis will determine what the entity will need to pay as premium into the captive. It is critical that the commercial marketplace be approached to compare the cost of transferring the risk. We have all experienced times when the competitive pressure in commercial insurance has caused low pricing. Also, not everyone’s assessment of the risk will be the same. However, the expense ratio of many of the commercial insurers is above 20 percent, so it is not uncommon to find risks that are cheaper to retain.
A simple decision tree will usually lead you through a suitable process to decide what the optimal structure will be. For instance, does the line of cover require an admitted carrier? A “yes” answer will lead to the requirement for a fronting carrier on one side of the tree and a “no” will lead to direct or self-procured policies on the other side of the tree.
Other branches on the tree include:
• is tax deductibility of premiums important?
• is tax deductibility of reserves in the captive useful?
• is there more cover required than the captive will provide? If so, should the captive buy reinsurance or can the owner buy extra cover elsewhere? and
• are succession planning opportunities available?
There are a number of other decisions to be made regarding ownership, tax status and risk transfer. They need to be considered before the captive is started, because some of them are not easy to reverse. Some will be dictated by regulators and some will merely be elected by the owner to effect better outcomes.
Many jurisdictions have passed enabling legislation over the last few years that are testament to the fact that captives make attractive business partners. It is a clean industry that provides challenging jobs and the possibility to establish a new tax base. It is becoming more difficult each day to differentiate between the many alternates available. However, there are a number of issues to consider.
For instance: location, taxes on premiums and profits, infrastructure, capital requirements, flexibility in regulation, etc. Each of these options will carry different weight for the owner, depending on what is to be accomplished. Taxes on premiums, for example, may be significant to an entity that plans on generating a lot of premiums and losses, while minimum capital requirements will be more important to an entity that does not want to commit a lot of money (e.g. an MGA).
Finally, the panel of participants needs to be rounded out. This is part of a complete business plan that both you and regulators will be looking for, as well as prudent business management, before you commit to a captive. Depending on the structure, this will likely include third party administrators, auditors, the front company, one or more reinsurers, investment manager, a bank, lawyers and finally the captive manager. In our experience, the fronting company can be the most difficult to identify, with the reinsurers being second.
This is an opportunity to leverage other business relationships and create a team of professionals that will work together to make the captive a success. It all starts with the risk assessment, but a proper feasibility study will point the way to a success in every regard.
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