Actuarial involvement in captive formations Brokers considering a captive will have early contact with actuary By Michael J. Moody, MBA, ARM
For nearly every current and future captive owner, it all started with a feasibility study to determine the best risk-financing option. The feasibility study, which typically emanates from a consultant, captive manager, or possibly even a broker, will provide insight into the viability of a captive insurance company or other option. And while there are many variables as to the exact form of the study, a critical aspect to the study is the work provided by the actuary. A feasibility study serves a number of purposes; however, one of the primary purposes according to Charles R. Lenz, ACAS, MAAA, consulting actuary and principal for Perr & Knight, is that “it helps a firm assess the benefits and costs associated with a captive compared to other risk-financing alternatives.” And from an actuarial standpoint, the main purpose of the feasibility study, says Robert J. Walling, III, FCAS, MAAA, principal and consulting actuary from Pinnacle Actuarial Resources, is to determine “the expected losses. Everything turns on the expected losses,” Walling observes. It is also important to remember that there are other uses for the feasibility study. For example, most domiciles require a potential captive owner to include a feasibility study as part of the overall application process. In that regard, the feasibility study should be designed to address the major concern that regulators typically have—that being what assumptions are being used to calculate the captive’s financial projections. All of these issues will need to be considered by the actuary and addressed as part of the feasibility study. Of course, an additional use for the feasibility study is to provide critical information regarding the rationale for establishing the captive in the first place. It can serve to document the process used in determining the feasibility of the proposed venture. In the future, should the question arise from any of the various stakeholders, management can refer to the study for the reasons they chose the captive over other risk-financing approaches. Since the current environment favors transparency, the feasibility study could become a valuable resource in supporting the captive decision. Early involvement The actuary is one of the first service providers to become involved with the captive. Typically, the consultant, captive manager, or broker will begin working with an actuary early on in the feasibility process. And despite the fact that the actuary may become involved via a referral, the potential captive owners should consider the following items when selecting the actuary: Almost any actuary is capable of developing an expected loss picture based on past losses; however, that is not the key to a valid loss projection. The key, according to Lenz, is “dealing with the uniqueness of the account.” It is first important for the actuary to understand and have specific experience with the type of captive, as well as the line of coverage(s) under consideration. Over and above this basic requirement, says Walling, the actuary should be able to utilize the prospective owners’ actual experience (including loss experience, exposure basis, and risk management details) to determine the ultimate loss projection. At the end of the day, he says, “the actuary needs to ascertain how the prospective captive is different from the industry benchmarks and then determine how that plays out in the actuarial analysis.” While it is important for the actuary assigned to the project to have specific industry experience, it is also important for the actuarial firm to have a firm-wide experience in the captive insurance market. There are several reasons why this is important. First, this firm-wide experience is necessary to assure proper peer review of the final work product (i.e., the captive feasibility study). It is also important to have the resources to stay current with the industry developments, and this usually requires more than a single actuary on staff to maintain a commitment to the captive marketplace. The universal language of an actuary is numbers, and periodically this can lead to communications problems. Accordingly, it is important to make certain that the actuary not only is able to provide the results of the study, but also is able to communicate them to non-actuaries. “When you talk to regulators, fronting carriers, or even reinsurers,” Walling notes, “you need to communicate in a manner they understand.” And it goes beyond verbal communication, “It also deals with their writing style in the reports they issue,” he says. And like most of the other service providers, it should be remembered that there is an ongoing involvement by the actuary after the completion of the feasibility study. Whether for regulatory compliance, parental oversight or other reasons, the actuary will need to update their projections from time to time. Most domicile authorities require an annual review and an updated Statement of Actuarial Opinion from the captive’s actuary; however, other stakeholders may require more frequent reviews. An additional ongoing involvement, according to Lenz, can be “the allocation of loss costs.” Having the actuary provide this allocation to either the other policyholders, in the case of a group captive or RRG, or other business units, in the case of single-parent captives, can help to avoid many potential problems, says Lenz. He indicates that captive owners can bypass some of this allocation controversy by using the actuary. The search for perfect data The key component to the feasibility study is the expected losses. And this number is the product of trending past loss experience, future exposure basis and risk management considerations. Ideally an actuary would prefer to have at least five years of detailed loss information, but as Walling points out, “It’s hard to expect perfect data.” Many times an actuary may get only the current year, or three years of aggregate loss data, or only summary data and no detail on large losses; and this will affect the accuracy of the feasibility study. Most of the time, however, there are ways around the data issue. “In cases where perfect data is not available,” says Lenz, “we can supplement it with information from other sources. “Information from industry sources such as rating bureaus can be a good source of supplemental data. Additionally, some actuarial firms have sufficient internal information to develop their own propriety database, which can also provide supplemental information. And while it is important to develop an expected loss level, it is not the only figure that needs to be calculated. In addition, most domicile regulators will want to see a worst case scenario. Accordingly, the feasibility study will need to include the adverse loss development aspects as well as expected loss numbers. Future Over the past several years, captives have continued to grow worldwide, and some have questioned whether or not such growth can continue. For a variety of reasons both Walling and Lenz believe that captives are still a growth industry. For one thing, Lenz points out that “more and more of our existing clients are looking at adding employee benefits to their captives.” Many experts also think that it’s this area that will provide the impetus for future captive movement. Walling also notes that agency captives continue to generate interest. He says that “many mid-level agents and brokers are trying to facilitate captive formations.” This is usually the case when the agents and brokers consider risk-financing alternatives for their larger insureds, Walling points out. And he indicates that there appears to be ample support from insurance carriers with regard to agency captives. Insurance carriers are seeing these types of captives as a way to tie their better brokers to them and, as Walling notes, the agency captives “help the smaller agents to remove many of the barriers to entry that typically are required to access the captive market.” And since captives are now a worldwide risk-financing alternative, Lenz notes that there is an increasing interest in captive formations from foreign parents with U.S. operations. One of the reasons for this interest, according to Lenz, is that “the captive can help stabilize the parents’ overall risk management program and subsequent costs.” * |
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