While captives have become commonplace, most remain footnotes buried in financial statements. To senior management and boards of directors, their ultimate function is anything but transparent. They are curiosities, understood by only a small number of the employees. No automaker employees question the need to own a firm that builds transmissions. Everyone understands what transmissions do and how they contribute to the company’s bottom line. But the appropriateness, utility and benefits of captives are often questioned and misunderstood. Due to this, captives can be polarizing entities with internal champions and detractors alike.
As a result, senior management (and to a lesser extent, the board) often trust their CFOs, treasurers or risk managers to make the right decisions regarding their captive’s use. But we do not live in a static environment. Few people remain in their jobs for life, and companies are constantly revising their strategic plans and embarking on reorganizations. Most corporate directors, especially outside directors, take their board positions very seriously and question management’s decisions on everything from hiring to capital expenditures.
The fact that captives are poorly understood generates more negative impressions than positive ones. The relatively small circle of captive consultants, attorneys, auditors, actuaries and managers inhabit an insular environment. There is little opportunity for educating the noncaptive business community, as the seminars and conferences that do exist usually end up preaching to the already-converted.
While many companies embrace their captives as integral to success, many others remain-at best-neutral regarding the captive’s benefits. This red-headed step-child perception leaves captives ripe for criticism from all quarters. If the economic and financial justification for the captive’s formation and continued usage was supplied by a captive service provider (or anyone with a financial interest in the captive’s continued existence, really), a risk manager’s ability to prove that the captive has value may be compromised. Yes, the analysis may be top-notch, but when the result is a glowing endorsement of the captive, it faces credibility problems.
As disconcerting as this may sound, captives defy conventional financial performance metrics. As a risk manager, you have been told that in order to communicate effectively with your CFO, you must be able to “speak finance.” While this is true, you also must be able to clarify the apparent paradox concerning your captive’s return on invested capital (ROIC). Most risk managers instinctively assume that the greater the amount of capital, the better the captive. In terms of financial strength and the ability to pay outlier claims, this is true. By financial performance standards, however, higher amounts of capital create lower ROICs.
If your captive’s net operating profit after taxes is $3 million, for example, and its capital is $20 million, the captive’s ROIC is 15%. But what if your captive generates net operating profit of $2.8 million with capital of only $15 million? Its ROIC becomes 18.6% and you did nothing differently from a business perspective. Your losses and expenses remain the same-you simply contributed less capital. Let’s further assume that the captive’s premium is $30 million. From a solvency standpoint, reducing the capital to $15 million moves the premium-to-capital and surplus ratio from 1.5:1 up to 2:1-an insignificant price to pay to achieve an additional 3.6% of ROIC.
In a healthy, growing captive, the relationship between earnings and invested capital is expressed only in investment income.
Faced with these realities, there are many reasons a risk manager might want to obtain an annual, third party opinion of his captive’s role in the company’s financial life. And these reasons generally fall into two categories: defensive and offensive. The following breakdown will help you proactively prepare.
On the Defensive
Defensive reasons for an independent analysis involve a reaction to circumstances such as management dislocations, board inquiries, shareholder interest and regulatory compliance (think Sarbanes-Oxley).
Management Dislocations: People change jobs with predictable regularity. If the CFO who originally approved the captive leaves the company, her replacement may (1) know nothing about captives, (2) dislike captives or (3) within the scope of a top-down review of the company’s financial obligations, want to provide an independent, quantitative analysis that illustrates the captive’s benefits. The value of a third party evaluation, undertaken before the CFO decides to resign and rent out beach umbrellas for a living, can be an effective defensive tool regardless of the new CFO’s peccadilloes.
Board Inquiries: Board members generally like convention. Doing things the conventional way creates little controversy and provides plenty of precedents. Captives, of course, are anything but conventional, relative to financing insurable risk. Most outside board members, unless they happen to be in the insurance or reinsurance business, assume that if insurance is available for a given risk, it should be purchased.
Anecdotal evidence to the contrary (e.g., suggesting that it makes sense to retain high frequency losses to avoid “trading dollars” with the insurance company) generally is not enough to justify your exotic risk financing scheme. Needless to say, having a recent, third party analysis of your captive’s risk/reward calculus would go a long way towards assuaging board members’ concerns.
Shareholder Interest: Most shareholders, whether public or private, trust that the company is taking all necessary precautions to avoid major risk events. This is one of the ways in which management protects shareholder value. However, most large companies retain, either by choice or necessity, enormous amounts of event risk each year. A savvy shareholder might wonder whether the potential impact of all of this retained risk is reflected in the company’s weighted average cost of capital (WACC), as many other risk factors are reflected as capital charges. A financially astute shareholder would know that the higher the capital charges, the higher the WACC, and therefore, the higher the company’s internal rate of return (IRR). Few bother to calculate the value of this elusive yet potentially significant capital charge. If they did, they could demonstrate the captive’s hidden impact on this capital charge, revealing yet another financial benefit of the captive.
Regulatory Compliance: Domicile-based captive managers generally provide adequate oversight relative to the domicile’s solvency and its filing requirements. Non-domicile-related compliance can involve the IRS, the SEC (group equity captives), FASB and the requirements imposed under Sarbanes-Oxley. Annual captive reviews should examine the captive’s obligations to each for their impact on the captive’s continued viability relative to accounting and risk assumption.
On the Offensive
Offensive reasons for an independent analysis of a captive include proactive efforts to improve capital management, reduce variable costs, find alternative sources of collateral and improve the captive’s utilization relative to insured risks and their retentions.
Capital Management: A captive’s capital performance is not optimal at excessive levels. Too much capital is otherwise known as under-employed capital. We know that reducing the captive’s capital and surplus increases ROIC. However, do we know how to optimize a captive’s level of invested capital so that it creates an economic profit for the parent company? Any comprehensive captive review should answer this question. Moreover, if the results reveal that the captive is producing no economic profit, the review should recommend strategies that could turn an economic loss into a profit.
Service Provider Cost Reductions: Consultants usually provide the majority of captive services. These include captive feasibility and formation, claims handling, loss prevention, asset management, legal, actuarial and audit work, and captive management services.
While the intrinsic value of long-term relationships can be very beneficial, bidding out these services periodically provides a benchmark for what the current levels of service and costs should be. You may end up renewing your existing contracts, potentially at a lower cost than the expiring contract. Sometimes a captive review reveals that one or more service providers’ costs have risen beyond normal expectations over the years, and through renegotiation or replacing the service provider, the captive realizes significant savings.
Collateral Alternatives: Collateral is an important risk financing tool utilized by captives. Acceptable collateral vehicles are few in number, but must dovetail with the company’s capital structure (primarily the debt component) and cost of capital. A New York 114 trust or various “funds withheld” arrangements can, depending on the company’s cash flow and other variables, prove superior to letters of credit. Any respectable captive review will analyze the various ways in which each of the alternative forms of collateral might affect the company.
Utilization and Retention Levels: We form captives to manage risk and hopefully reduce the firm’s long-term cost of risk. A captive review should evaluate its coverages, fronting arrangements, retentions and excess insurance, as they pertain to the company’s current and future risk management requirements. Does your captive insure risks that do not require a fronting insurer but have one anyway? Captives employ fronting to satisfy either regulatory requirements or contractual requirements. Fronting can cost between 4% and 10% or more of written premiums. If it is unnecessary it should be dropped.
Captives are mainly high-frequency, low severity loss management tools. Risks that do not conform to these basic criteria may not belong in a captive. Consider the old risk management truism, “don’t risk a lot for a little.” For example, your captive may insure your accounts receivables. You have never had an accounts receivables loss and paying a commercial insurance premium year after year made little sense. Without a catastrophic loss potential this argument is fine. However, the slightest possibility of a catastrophic loss event exposes the captive’s capital unnecessarily, and since commercial premiums for accounts receivables coverage (except perhaps for financial institutions) are relatively inexpensive and limits capacity is usually available, the safer route is to transfer the risk.
Another interesting focus of a comprehensive captive review is retention levels. Often, little creative thought goes into determining the retentions. Companies that move to a captive from self-insurance or a large deductible plan tend to use the same retentions in the captive. While this might make sense from an actuarial perspective, it can foreclose on a creative alternative-using stochastic modeling to determine the likelihood of losses in a layer, perhaps $250,000 or $500,000, immediately above the captive’s per occurrence retention, where actuarial loss projections have little credibility.
If the analysis proves that the likelihood of loss is acceptably low, it might make sense to increase the retention, thus increasing the reinsurance attachment point and lowering the reinsurance premium.
The Life Cycle Myth
Captives are formed to address a specific problem or set of problems. Over time, those problems may no longer exist. Because of this, some captive practitioners suggest that every captive has a “life cycle” within which it grows, levels off, and eventually declines, for a variety of financial, organizational and cultural reasons. While this may be true for some captives, not every captive needs to conform to a pre-determined lifespan.
The most successful captives are those that continue to evolve to meet the ever-changing demands of their parents. Because contrary to what the “life cycle” proponents suggest, sometimes risks do not go away-they intensify. Moreover, new and challenging risks may emerge that few within the company think are insurable. These include a variety of operational and financial risks dismissed as “business risks.” Today, captives routinely insure a wide variety of so-called business risks.
When this is the case, captives truly become integrated into their company’s capital management strategies, and add measurable, significant value in risk management and financial performance. And, through annual, comprehensive captive reviews, you can ensure that your captive continues to work for you and never succumbs to the self-fulfilling life cycle prophecy.