Why Cash Flow Is Key for Captive Insurers

Understanding Cash Flow in Captive Insurance 

Maintaining the financial health of a captive insurer hinges on thoroughly understanding its financial statements, with the cash flow statement being particularly critical. Astute financial professionals dedicate significant attention to this statement, which is often the most overlooked financial report during routine board meetings. Why is this so important? Captive insurers and risk retention groups primarily use accrual accounting for reporting. Under this method, income shown on the statement of revenue and expenses may not have been collected, and expenses may not have been paid. The adage "cash is king" is especially true in the insurance industry—you can only pay claims with cash. This highlights why cash flow is vital for captive insurers. 

A Deeper Dive into Cash Flow Statements 

A thorough understanding of the cash flow statement is crucial for board members, particularly those without a financial background, as it provides key insights into the true performance of a captive insurer. It's important to focus on the distinctions between accrual and cash accounting methods, especially since most captive insurers use the accrual method. Entrepreneur.com defines accrual accounting as an "accounting method that records revenue and expenses when they are incurred, regardless of when cash is exchanged." 

This can pose challenges for board members without financial training. A captive may appear to be profitable on paper but could be facing a cash shortfall. Ultimately, what matters is whether there is enough cash on hand when it is needed.  

Key Areas of Focus for Captive Board Members 

Premiums 

One of the primary areas to focus on is premiums, which serve as the main source of revenue for most captives. Under the accrual accounting framework, premium revenue is generally recognized evenly over the policy's active period, usually a year. However, several factors, such as installment billing, multi-year contracts, or retro contracts, can influence the timing of cash collection. Furthermore, premiums are typically billed before the policy goes into effect, with minimal lag between billing and collection. Board members should closely monitor the premiums receivable account, especially if it's growing without a corresponding increase in written premiums, as this may indicate potential cash flow issues. 

Investments 

Investment income is another area where timing differences can lead to discrepancies between reported revenue and actual cash collected. Bonds, which dominate most captive insurer investment portfolios, usually pay semi-annually, while stocks pay dividends quarterly. This means revenue may be reported before cash is collected, a discrepancy that, though often minor, should be monitored. 

Board members should also understand the difference between total return and book yield. Book yield includes interest and dividend payments, while total return also factors in unrealized gains or losses. However, these gains only become cash when the security is sold and cannot be used to pay claims or expenses. Additionally, realized gains are typically reduced by taxes unless the captive is tax-exempt. 

Liquidity within the investment portfolio is another concern. If a captive needs to raise cash quickly, how easily can securities be converted to liquid cash? Board members should be aware of potential liquidity challenges. 

Reinsurance 

Cash flow problems can also arise from reinsurance arrangements, making it crucial for reinsurance contracts to include interim payment clauses. For example, in the event of a large property loss, policyholders expect prompt payment as soon as they submit a notice of loss and provide reasonable documentation. However, some reinsurance contracts may require the insurer to pay the entire loss amount upfront before seeking reimbursement from the reinsurer, who may have up to 90 days to fulfill their payment obligations. If a captive is required to pay a substantial loss, such as $10 million or $20 million, and must wait several months for reimbursement, it could face significant liquidity challenges. These challenges are compounded if the captive's investment portfolio lacks sufficient liquidity, potentially leading to further financial strain due to the need for quick asset liquidation, often at less favorable prices. 

Claims 

Warren Buffett is known to favor the insurance industry largely because of the concept of float—the gap between collecting premiums and paying claims. This float gives insurers the opportunity to invest the cash from premiums and generate additional revenue. However, cash flow challenges can emerge from claims due to several factors. For instance, does your captive typically produce an underwriting profit, or does it rely on investment income to cover losses? Relying heavily on investment income can pave the way for a cash flow crisis, which can be triggered by scenarios like larger-than-expected losses (severity), a rise in the number of claims (frequency), shifts in the legal environment, higher-than-expected claims inflation, or adverse loss development. Moreover, reinsurance dynamics can exacerbate these challenges, particularly when reinsurance agreements require the captive to pay out claims before receiving reimbursement. 

Due to their smaller size, captives are more vulnerable to liquidity events, where insufficient cash on hand could lead to significant risks. To mitigate these risks, it is essential for captive management to prepare monthly cash flow estimates, outlining available cash, expected inflows, and necessary outflows for claims and expenses. Furthermore, adopting a conservative investment policy is key to ensuring that enough liquid short-term investments are available to cover any anticipated or unexpected cash flow gaps. This proactive strategy helps avoid delays in claim settlements, thereby preserving policyholder trust and preventing potential financial distress. 

Conclusion 

Captive board members should consider requesting their auditor to present on cash flow, with a focus on issues specific to insurance companies that the auditor has encountered. This proactive measure can be a valuable component of a risk management program, helping to identify and address potential problems before they escalate.