Captives Should Challenge the Status Quo To Optimize Capital

Optimizing a captive insurance company's capital structure is critical in supporting the captive's long-term success, but there are a number of factors to consider in seeking capital optimization.

Speaking at a recent Strategic Risks Solutions (SRS) webinar titled "Optimizing Captive Capital—The Benefits of Diversification," Michael O'Malley, managing director at SRS, outlined several factors that can shape a captive's capital structure.

One is the captive's underlying risk profile, the risks it's taking, coverage lines, and correlations between coverage lines, he said. Another factor is regulatory or rating agency requirements.

"When you approach a regulator with a business plan, they're oftentimes going to want the captive to be funded to a certain confidence level," Mr. O'Malley said. Rating agencies will have their own requirements associated with certain rating levels, he said.

"Another item to consider is the investment portfolio," Mr. O'Malley said. "Insurance companies are unique in that there is risk on both sides of the balance sheet."

Fronting partner collateral requirements can also affect captives' capital requirements. Fronting insurers will typically require collateral to eliminate or reduce credit risk, Mr. O'Malley said.

A traditional approach to captive insurance company capital is to think in terms of different silos, Mr. O'Malley said. Many captive insurance companies take this approach in which capital structures are developed to address each different coverage line in the captive, without considering correlations between the lines.

A better approach, however, might be to consider capital across the entire collection of risks written by the captive insurance company. "One of the things we talk about is understanding diversification, understanding correlation among the lines to determine if there is a more efficient way to allocate capital in this situation," Mr. O'Malley said.

"As you're developing a capital strategy for your captive, think about the underlying coverage lines, think about how they are correlated or not correlated, and use that in developing the amount of capital that you would approach the regulator for to get approval for the captive," he said.

There could also be benefits to merging different types of risk within the captive structure that might help optimize capital.

In considering investment assets, some prospective captive parents express interest in an aggressive investment approach in the early stages of the captive's development, Mr. O'Malley said. "Our recommendation in all instances is to start with a conservative, high-quality, fixed-income approach, build the balance sheet before you consider other options," he said. Too aggressive an investment approach can increase the chances of a captive's insolvency.

Ultimately, the captive's asset approach should be matched with its liabilities to determine the optimum amount of capital needed to support the risk, Mr. O'Malley said.

Regulatory requirements typically factor significantly in captives' capital decisions, particularly risk-based capital (RBC) standards in many jurisdictions.

"In recent years, we have seen an increased application of risk-based capital," said Derek Bridgeman, managing director at Strategic Risk Solutions (Europe) Ltd.

The European Union's Solvency II is perhaps the most widely known RBC regime, but other jurisdictions such as Switzerland, Singapore, Guernsey, Bermuda, the Cayman Islands, and others have taken their own approaches to RBC, according to Mr. Bridgeman.

Regulators in the United States also are effectively applying a risk-based capital approach, primarily toward reserves, Mr. Bridgeman said.

"Solvency II was a great burden on a lot of captives. I think once captive owners have gotten through the pain of that in terms of the initial capitalization and the reporting requirements, they're now starting to see that it could provide some benefits in terms of rewards for diversification," Mr. Bridgeman said.

"The overall concept of the risk-based capital approach is to establish a minimum capital requirement based on the types of risks to which the company is exposed," he said.

"Traditionally, compared to commercial insurers, captives have not written well-diversified risk profiles, I think in part due to the fact that there was little benefit from a capitalization perspective," Mr. Bridgeman said. While captive insurance companies' solvency capital requirements were previously determined only by premium and reserve levels, RBC considers both the asset and liability sides of the balance sheet, he said.

RBC actually rewards captives by imposing lower capital demands if captive insurance companies diversify their risk portfolios and consequently reduce total portfolio volatility, Mr. Bridgeman said. That, together with the hardening commercial insurance market, is resulting in the expansion of captive insurance programs. "A lot of the captive owners don't realize that, that oftentimes an additional line of business would not require an additional capital requirement," he said.

"Although the risk-based capital approach and Solvency II have resulted in additional capital requirements, I think the subsequent benefit has been the ability to optimize the captive capital through increased diversification of risks, of the reinsurance panel, and of the investments," Mr. Bridgeman said.

He outlined a number of capital optimization considerations.

General

• Determine whether the captive domicile is still appropriate.
• Understand risks through risk quantification analysis.
• Drill down to understand what is driving RBC requirements. "Quite often, there can be tweaks in structure that reduce the risk-based capital requirements," Mr. Bridgeman said.
• Undertake scenario testing to understand the capital impact of different captive structures.

Investments and Capital

• Evaluate opportunities to diversify assets and reinsurance across a greater number of counterparties.
• Evaluate opportunities to place investments or reinsurance with counterparties with higher credit quality.
• Consider opportunities for alternative forms of capital.

Underwriting

• Evaluate opportunities to diversify the captive structure with the inclusion of additional uncorrelated risks, potentially with lower volatility.
• Conduct actuarial analysis of probable/estimated maximum loss to optimize catastrophe risk capital charges.
• Evaluate opportunities to capture inherent diversification within the existing captive program, such as structured reinsurance.
• Determine the optimum retention level, including tailored cross-class aggregates.

"The advice is to challenge the status quo because quite often there can be a number of tweaks that can be made to optimize the overall captive placement and the capital and potentially free up capital which perhaps can be repatriated or loaned back," Mr. Bridgeman said.

Structured reinsurance, once known as "finite risk," is a tool that can help optimize captive insurance company capital, according to Neil Campbell, a consultant at Strategic Risk Solutions (Europe) Ltd. Structured reinsurance "is making a bit of a resurgence right now, probably not unexpected given the shrinking capacity and coverage, the price hikes we're seeing across pretty much every line of commercial insurance," he said.

The risk financing tool has been around for about 30 years, Mr. Campbell said, but largely fell into disuse during the lengthy soft market.

"The best way to describe structured reinsurance is it is a blend of risk transfer, contingent capital, and pre-loss funding, combined in a single insurance or reinsurance contract," Mr. Campbell said.

Structured reinsurance of a captive can expand a captive's underwriting capability and allow captive parents to put their captive at the heart of their risk financing strategy, "to think about moving away from being buyers of insurance towards sellers of risk," he said.

The programs are typically arranged on a 3- to 5-year basis, with pre-agreed terms and cost, according to Mr. Campbell. A key feature is the agreement's profit commission element, which rewards good risk management.

Using structured reinsurance could allow a captive to participate more fully in its parent's insurance program through the ability to take higher retentions on existing programs. It also could make it possible to participate in a broader range of programs and allow the captive to serve as an incubator for new risks where commercial market appetite is limited.

The mechanism allows captive parents to leverage corporate buying power, reduce the total cost of risk, capture the inherent value of risk diversification, and manage volatility to an acceptable level.