Captive Basics: Understanding Liquidity

Last year, we did a series of stories on key concepts with which captive insurance company board members should be familiar. The articles were produced to provide a basic grounding in areas that were important to the fiduciary obligations captive board members assume. Two of those articles focused on the concept of cash flow and can be found here. However, with several recent news reports concerning the bond market, we thought we should also produce an article on liquidity.

Liquidity plays a major role in the success of any captive and is usually supported via positive cash flow generated from the captive's operations. But before we get ahead of ourselves, let's first define what we mean by liquidity. Our definition of liquidity is the amount of cash and cash equivalents (assets that can be readily converted to cash with no loss of principal) available to pay claims and general operating expenses expressed as a percentage. The National Association of Insurance Commissioners (NAIC) as part of its Insurance Regulatory Information Systems (IRIS) Ratios Manual defines two liquidity ratios that can be calculated for insurance companies.¹

• Adjusted liabilities to liquid assets ratio is a measure of the insurer's ability to meet short-term obligations. It also provides a rough indication of the possible implications for policyholders if liquidation becomes necessary. The usual range for the ratio includes results below 100 percent. Analysis has shown that many insurers that become insolvent report increasing adjusted liabilities to liquid assets in their final years. Therefore, in interpreting the result of this ratio, it is important to consider its trend, as well as the current-year result.
• Gross agents balances in the process of collection to policyholder surplus is a measure of premiums receivable as a percent of policyholders' surplus.The ratio looks at how quickly cash due for premiums is being collected and whether accounts more than 90 days old are really collectible or should be written off. For captive insurers, this ratio is less of a concern, since, for single-parent captives, there should be no collection issues at all, and, for group captives, if members are not paying their premium, the captive can cancel or deny coverage.

For our purposes, we suggest captive board members should use our definition and the first definition as supplied by the NAIC to measure liquidity. However, measuring liquidity is not enough. Captive board members should understand the various sources of liquidity available to their captive. Additionally, they should ensure that policies and contracts used to govern the captive contain references to liquidity and periodically look to make sure these are working as intended.

Remember, we started this article by referencing our prior stories on cash flow. Positive cash flow is an immediate source of liquidity. Cash generated from operations and from investments is the first source of funds available to pay for normal claims expenses and the costs associated with operating the captive.

From a policy standpoint, the following policies can and should contain some reference to liquidity and liquidity needs.

• Liquidity policy: Not all captives will choose to have a stand-alone policy on liquidity; however, from a governance standpoint, a single policy makes sense. By having a liquidity policy, the board has a single reference document incorporating all aspects of the captive's liquidity needs and how those needs are being met.
• Investment policy: Absent an overarching liquidity policy, the first place to insert a section on liquidity would be in the investment policy. At a minimum, the policy should contain a statement outlining how much cash the captive intends to hold as a percentage of its overall investment portfolio.The policy should also define what constitutes "cash equivalents," both in terms of the maturity date for these short-term investments as well as their ability to be converted quickly to cash with little or no loss of principal. The policy may reference other sources of liquidity, including lines of credit the captive has set up. Lastly, it should make some statement concerning the marketability of the captive's entire investment portfolio and the maximum percentage of investment assets the captive is willing and able to hold that cannot be easily liquidated quickly without the risk of a significant loss of principal.
• Claims policy: The captive's claims policy should reference the sources of liquidity available to the captive to meet its claims obligations.The policy may also note other sources of liquidity, which may be available to the insurer in the event of large or catastrophic losses.
• Reinsurance policy: Like the liquidity policy, not all captives will have a reinsurance policy. If your captive decides to include a reinsurance policy, it should contain reference to the following—the minimum rating of reinsurers with which the captive will do business (i.e., a quasi measure of the reinsurer's ability to meet its obligations), the expected timing between receipt of a fully documented uncontested claim and the payment made to the captive, and the possibility of interim payments on large and/or catastrophic claims.

We bring up the last point because we are a big believer in negotiating interim claims payment clauses in reinsurance contracts. For new or smaller captives, these clauses can be the difference between runoff and survival. Basically, the clause calls for the reinsurer to make interim payments to the captive in the event the captive has a very large claim or a catastrophe claim. These payments help negate the need for the captive to raise a large amount of liquidity, typically by selling investment assets or tapping a line of credit to pay for large losses.

Liquidity, for us, is a key component with which any board member should be familiar. Hopefully, this primer provides for some basic understanding of the concept. In a future article, we'll take a closer look at how changes in the bond market are impacting captive insurers' liquidity calculations.

Footnote

1. NAIC, IRIS Manual (2017). https://www.naic.org/documents/prod_serv_fin_receivership_uir_zb.pdf