Captive investment strategies

Reserves from employee benefit coverages could have a significant impact

By Michael J. Moody, MBA, ARM

Akey component in a captive insurance company’s overall success—or any insurance company for that matter—is its investment strategies. By design, all insurance companies have a basic requirement to hold and invest a certain percentage of its revenues in liquid assets. For the most part, this money comes from two sources: the initial capital and surplus; and from premium reserves.

Captives differ from traditional insurers in several ways with reference to invest­ments. For example, captive legislation typically requires less initial capital and surplus; and due in large part to better loss mitigation efforts, captives usually “enjoy” less claims activity. As a result, both of these situations have historically resulted in fewer funds to invest.

Most of the current crop of captives, however, has been established to provide coverages that typically have longer payout periods for their claims. This extended settlement period provides opportunities for longer term investments. Investment committees for the captives are charged with the responsibility of determining the proper mix of investments to meet the captive’s requirements. In addition, domicile regulators have a critical role to play in this process. Bottom line, regulators will want to assure them­selves that sufficient cash is available to pay claims when presented.

Missing in action

The above overview is, in theory, the key concept to the investment portion of an ongoing insurance operation. Then comes the reality of the situation. We have just managed to survive one of the worst economic crises faced by American businesses since the Great Depression. Everything from businesses that were “too big to fail” to bank bailouts brought the economy to the brink of disaster. As a result, investment committees at even the largest insurers are having to go back to the drawing board.

For many captives, the effects of the financial crisis are even more profound because they run much leaner operations and thus have less of a financial cushion to soften the blow. Historically, one of the central concepts of a captive’s investment strategy has been capital preservation. Thus, captives frequently position themselves at the conservative end of the fixed income spectrum with regard to investments. And with interest rates at historic lows, most captive investment programs have taken a major hit, since many are having to hold more liquid assets, such as cash, just to meet their obligations. Industry observers believe that future investment results on a short-term basis look no better than 2009.

Despite this bleak outlook for the investment side of the house, there are several key issues that captive parents should begin to consider. Two of the more important issues are the effects of loan backs to the parent, and the inclusion of employee benefits within the captive.

An open question

One investment option that has long been considered by captives, primarily single-parent captives, is loan backs to the captive’s parent. This loan back option has been a major issue with regard to the Internal Revenue Service (IRS) because it deals with the specific circumstances under which a bona fide captive insurance company arrangement would be affected. This concern centers on the fact that the loan back to the parent would involve amounts the parent paid as insurance premiums.

Heretofore, the IRS has not taken a formal position with regard to the loan back issue. The Service has not issued any formal guidance or provided information that would assist in establishing a “safe harbor” for captive parents that would like to avail themselves of this option. However, in 2005, the IRS did issue Notice 2005-49 which asked the general public to comment on several issues of concern to the IRS. The IRS raised four issues, one of which related to “circumstances under which the qualification of an arrangement between related parties as insurance may be affected by a loan back of amounts paid as premiums.”

Several of the questions posed in Notice 2005-49 were ultimately addressed by the IRS. This was particularly true of the question regarding cell captives; however, to date, there has been no definitive resolution to the loan back issue from the IRS.

Several interested parties did respond to the questions asked by the IRS. One of those parties was the Captive Insurance Companies Association (CICA) which sent a comprehensive reply.

CICA’s September 27, 2005, letter to the IRS’s “Request for Comments” provides some valuable insight into the loan back issue. In essence, CICA stated that in order to consider any loan back arrangement as insurance, the following four factors need to be addressed:

• Whether the loans represent bona fide indebtedness, which is enforceable by their terms and which contain commercially reasonable terms

• Whether the loans are permitted by the statutes or regulatory authori­ties of the insurance company’s domicile

• Whether the timely repayment of the indebtedness, together with the insurance company’s other resources, permits the insurance company to meet its anticipated liquidity needs

• Whether, taking into account the solvency of, and security (if any) provided by, the debtor, it is commercially reasonable to expect the loans to be repaid in accordance with their terms.

Additionally, CICA notes that in determining if an arrangement qualifies as insurance, the key is that it must have the required risk shifting and risk distribution. Further, they state that if these elements are present, insurance has been established. And they go on to point out that the investment decisions are independent of these two elements.

The IRS has not issued any further clarification regarding the loan back provisions. Many captive parents have noted that their insurance subsidiaries have accumulated significant amounts of reserves and, in these times of financial difficulties, the captive may offer hope as a source for badly needed funds. However, the parent should research CICA’s rationale in detail before moving forward with a loan from the captive.

The wild card

For the most part, many captive owners will continue to maintain a conservative position with regard to their investment strategies. Much of their portfolios will remain in liquid assets (i.e., cash or near cash assets) for short-term situations, and conservative investments for more long-term strategies. However, there are significant potential issues ahead that will greatly affect captives and will require major changes in their investment strategies.

One issue is the emergence of employee benefits-related coverage. Initial involvement in the employee benefit-related area has been limited to term life insurance coverage and long-term disability coverage—both of which will result in large amounts of additional reserve dollars that the captive will be able to invest in longer term investment vehicles. Generally, even the addition of just these two coverages has resulted in reserves that dwarf the amount of reserves held for property and casualty-related coverages.

However, it’s the potential addition of the remaining employee benefit plans that will really trans­form the captive and its investment strategies. Recent U.S. Department of Labor approval of Coca-Cola’s innovative approach to funding their retiree health benefits is just one example of the size and scope of these changes.

Another trend that appears to be gaining traction is to include pension programs in the captive. These types of captive expansions will require significant changes in the operational aspects of the captive, but the investment aspects will certainly take on new importance as well.

Conclusion

For years, the investment aspects of captives have been a minor concern for captive owners. In many instances, it was even difficult to get the attention it deserved from the professional investment community. But slowly, as some group captives and risk retention groups began to accumulate significant amounts of reserves related to long tail coverages, such as medical malpractice or other professional liability coverages, the investment community began to realize the potential of the captive industry.

While falling interest rates and a lack of viable alternatives continue to hammer many captives’ overall financial results, owners must remain forward looking in regard to their investments. Loan backs are one area that typically causes red flags for the IRS, but they may hold a key to parental survival and should be considered in these trying times. And while the IRS has not provided any specific guidance for the use of loan backs, the CICA suggestions do offer some help.

Additionally, now with the potential for significant amounts of dollars moving into captives from various employee benefit programs, captive owners must begin to think of all the ramifications of these changes. Nowhere will these changes be more meaningful than in the investment area. Proactive involvement should begin with both the captive’s owners and the captive’s investment commit­tee. Planning for these types of changes is just good risk management.