Key Concepts for New Captive Board Members

Congratulations on your appointment as a board member for a captive insurance company or a risk retention group (RRG). Your role entails exercising fiduciary responsibility to ensure the captive insurance company's financial stability. While you might be an expert in your field, being a board member for an insurance company, especially a captive insurer or RRG, presents unique challenges. This article, the first in a series, aims to introduce essential concepts you should grasp as a director of a captive insurance company. 

While the financial basics discussed below provide a foundation, continuous learning is crucial. This article assumes the captive or RRG is operational. Future articles will delve into key aspects of feasibility studies directors should consider. 

Financial Statements

Captives and RRGs should routinely produce four vital financial statements: 

1. Balance Sheet 
2. Income Statement (Statement of Revenue and Expenses) 
3. Statement of Cash Flows 
4. Statement of Members' (Stockholders') Equity 

These statements are historical and reflect specific dates or periods. Notably, board members should prioritize reviewing the statement of cash flows, which is often overlooked during routine board meetings. Reviewing the statement of cash flows is important because captive insurers and RRGs often use accrual accounting, which can misrepresent cash availability. Remember, "cash is king" in insurance—claims are paid with cash. 

The cash flow statement categorizes information into the following areas. 

• Operating activities: converts income statement figures from accrual to cash. 
• Investing activities: details long-term investment transactions and property/equipment purchases. 
• Financing activities: records debt or equity issuance/retirement and dividend payments. 

A review of the cash flow from operating activities against reported net income indicates the captive's cash flow health. Consistent positive cash flow signals financial strength, while consistent negative cash flow raises concerns about the captive's sustainability and will quickly generate interest from regulators. 

Statement of Actuarial Opinion

Annually, an independent accredited actuary should prepare a statement of actuarial opinion for the captive or RRG. This report aids in establishing necessary reserves for the insurer's balance sheet. Board members should be able to interpret this opinion, which should include the following information. 

• Actuary's qualifications: The actuary should be a qualified actuary as per insurance regulations. New directors should inquire about the actuary's tenure with the captive, with frequent changes indicating potential issues. 
• Scope of the opinion: Details on examining actuarial assumptions, underlying data sources, reconciliation methods, and reserve-setting methodologies. The opinion should contain language to the effect, "I have examined the actuarial assumptions and methods used in determining reserves listed in Exhibit A, as shown in the Annual Statement of the Company as prepared for filing with state regulatory officials, as of December 31, 20__." 
• Range of reserve estimate: Actuaries may provide a central estimate and a range around it. Directors should ensure that the selected reserves fall within a reasonable range. Normally, the range is also nonsymmetrical in that the lower end of the range may be closer to the central estimate than the upper end of the range. 
• Discussion on reserve adequacy: The actuary should analyze deficient or redundant reserves and evaluate the risk of material adverse deviation, especially when venturing into new business lines or facing regulatory changes.  Inadequate reserves are much more detrimental to captive insurers than excess reserves.  Directors should also understand from management how it selects the actual reserves posted in the financial statements from the range provided by the actuary. Again, caution is warranted where management does not have a set policy and varies where in the range it sets reserves. 

Informed and proactive directors serve captive insurers and RRGs best. As a new director, invest time in understanding all aspects of the captive's operations. Next read, "Basics of Loss Development Triangles," the second article in this "Key Concepts for Captive Board Members" series.