Actuarial Projections and the Captive
November 2002
Actuaries are crucial to the formation and
success of captives. Michael Mead discusses the role of the actuary in understanding
claims, establishing premiums, and projecting profits.
by Michael
R. Mead
M.R. Mead &
Company, LLC
In the process of evaluating whether or not to form a captive, an early part
of the process is working with an actuary to determine the probability of future
losses. In this article we will examine this process, and how to use it to the
best advantage for achieving maximum efficiency in risk financing.
Some of this material will be seen as basic by experienced captive owners
and operators. To many considering formation of a captive, however, this may
be vital, new news. I encourage you to contact me with your views, whether you
agree or disagree.
Understanding Claims
Recalling the basic idea of forming a captive as using the owner’s better
risk profile to achieve maximum efficiency, it is imperative to understand the
claims, their history, and origin. A primary advantage of a captive over traditional
forms of risk financing is the ability to choose claims managers, risk managers,
and other vendors. Central to all of the process is an actuarial feasibility
study. Central to the feasibility study is the projection of future loss payments.
When a claim occurs, it has a value. If it is not immediately settled, which
is usually the case with liability claims, the time value enters the equation.
Projecting that value to the ultimate payout is one of the chief roles of the
actuary.
The Actuary's Role
An actuary is a professional not often encountered by most business people,
including many insurance people, even though their work is highly regarded and
widely quoted. However, their work is also widely misunderstood and misused.
The point of the actuarial review and forecast is to analyze the past loss
record of the client, compare this to the industry, and develop trends and project
the probability of the timing and amount of future claim payments. Actuaries
are trained in, and use, very sophisticated mathematical probability and forecasting
formulas, and patterns of logic based on experience with statistics and actual
claims results. Few, if any, captives will be formed or approved, or find a
risk sharing partner without an actuarial feasibility study.
The actuary is a highly skilled and trained professional whose work can be
used like the Bible, to prove a variety of points, some of them in opposition
to each other. For this reason most actuaries today require that their work
is closely controlled as to distribution, and they prefer to explain the results
in person.
It is worth noting that not all actuaries are trained in all lines of coverage,
or are familiar with captives. Additionally, in many cases it is individual
actuaries who are recognized by regulators, so that time and investigation in
choosing an actuary can save money.
Working with the Actuary
Considering that a captive is usually formed to insure the risks of its owner(s),
it is wise to carefully study and analyze the probability of future loss. At
this stage in captive formation, many owners become confused and uncertain.
Owners very well may not agree with the conclusions and recommendations of the
actuary, but it behooves them to understand them. If the mathematical part is
not easily understood, perhaps the logic can be followed. The owner may not
accept either part, but others will give them great credence.
When a traditional insurer uses an actuary to project future losses, it will
often do so based on the statistics for the entire industry class. It is then
up to the underwriter, and/or the agent, to determine the specific characteristics
of the individual client that make it a better (hopefully) risk than the class.
Such matters as specific client claims history, risk management programs, and
claims practices can cause the underwriter to favorably modify the rate projections
of the actuary.
For the captive owner, this process takes on a more personal perspective
as the owner often does not share the perspective of the class, or the wider
view of the underwriter or actuary. The belief that one is better than the class
is not enough to persuade a risk sharing partner, or a regulator. Nonetheless,
history has demonstrated that the actuary’s projections should be heeded, if
not adhered to absolutely.
IBNR Losses
The history of captives is replete with meetings in which IBNR is explained
to the novice captive owner. IBNR, which stands for “incurred but not reported,”
is the industry phrase for losses that statistically will occur, but practically
have not yet been reported. Most people will agree that the concept is sound.
Disagreement comes at the point of determining the amount and timing of the
loss, and the form of security required to meet the obligation. Captive owners
must pay their own losses, excepting layers of coverage that are transferred
elsewhere. Most would agree with that point also. Getting agreement on amounts
and form can be quite confusing, frustrating, and painful.
In order for the captive owner to achieve the desired goals of maximum risk
financing efficiency, the actuary and the owner must effectively communicate
their positions. The captive owner should understand the actuarial projections,
as the actuary should understand the reasons why the owner believes that his
company will outperform the class, and utilize that view in his projections
if he believes them to be valid.
Supporting the views of the actuary is the fact that many claims, closed
for years, can be reopened and require additional payments. This usually occurs
in the workers compensation class in a jurisdiction where the state has increased
benefits on claims, awarding increased payments to claimants. While a new captive
owner may wish to deny this possibility, the actuary, and his audience, must
consider the probability. If there is a probability, then the security must
reflect that fact. It does happen.
The issue of providing security against future claims can become the turning
point of the decision to proceed with a captive, which is why the role of the
actuary becomes critical. If the security required to assure payment of future
losses exceeds the owners’ ability or need to self finance, then the better
decision may be to stay within the traditional market, and use premiums to finance
the risk. Of course, the traditional underwriter will also have an actuary,
who may see the projections in the same vein and recommend additional security
through increased premiums or a letter of credit to secure an increased self-insured
retention.
Somewhere in this process the captive owner must demonstrate to the actuary,
and the risk sharing partners and regulators, that the insured firm(s) has a
risk management program that will clearly achieve a claims result superior to
the class. This can be demonstrated through showing a thorough analysis of exposures,
alternatives to financing, aggressive claims management, and proactive senior
management.
Establishing Premiums
Another key role of the actuary is to establish the premiums for the captive.
Probably the most difficult part of any insurance transaction is to determine
what to charge for the risk. If the premium is too low, the losses will aggregate
to cause a loss in real dollars, or an increase in security, and possibly a
close regulatory review and meetings with the risk sharing partner. If the premium
is too high, the loss ratio may cause a regulator to inquire as to the true
purpose of the captive in regard to deductibility of premiums for tax purposes.
In the purchase of traditional insurance, the actuary works with the underwriter
and others to provide a premium. In a captive situation, the actuary often works
largely unaided to calculate a premium that will cover the claims, and provide
an underwriting profit. Negotiation becomes important to provide the actuary
with as complete an explanation as possible of the potential risk.
An important point to bear in mind in the ownership and operation of a captive
is that the owner does not necessarily want to reduce his premiums premiums.
The true goal should be seen as controlling and predicting premiums. Actuarially
derived premiums substantiate the owner’s position on security, and on possible
tax deductibility. Reducing premiums to show an improved bottom line in the
parent can have dire consequences for the captive in terms of security for increasing
future claims payouts against declining premiums.
If the premiums are deductible by the parent/insured(s), then reducing them
in the face of contrary actuarial information can raise issues with regulators,
risk sharing partners, and others about the long-term viability of the captive.
It is usually far better to go with the actuarially derived premiums, and generate
funds for other uses by the parent/insured(s).
Profit Projections
Finally, the actuary provides a pro forma estimate of the profitability of
the proposed captive. If the captive is projected to lose money, there will
be questions from many quarters as to the wisdom of proceeding to formation.
Many factors go into the pro forma, including assumptions. The assumptions are
delineated and explained in the notes to the pro forma, and need close scrutiny.
Included in the assumptions are such items as interest rate income derived from
funds on deposit, payout profiles, and expenses.
The assumptions become as important as any other component in the formulas,
and are often overlooked. The assumptions can make or break the profitability.
None of them should be unexamined or taken for granted. There will be funds
available for investment, and there will be independent vendors to expense.
There will be meeting expenses. There will be annual review and certification
of loss reserves by the actuary, and a certified audit. Often, in the haste
to do the deal, managers and actuaries will use “plug” formulated percentages
and numbers. These must be questioned. They may be right. They may be way off.
Timing of these funds, availability for claims payments, liquidity, all these
things are considered by the actuary and the other partners of the captive.
Focused discussions are needed here in the low interest climate of today. There
was a time, and there will be again, when interest from invested funds was a
major component of insurers and captives balance sheets. To project above 4
percent today would require a detailed explanation to gain credibility.
Conclusion
When forecasting the viability and profitability of a proposed or current
captive, if partners of any sort are needed, then it is essential to use qualified
professionals and to understand what they are doing, and how they are doing
it. The actuary is an important element of that forecast. It’s your risk. It’s
your money.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author’s employer or IRMI. This article does not purport
to provide legal, accounting, or other professional advice or opinion. If such advice
is needed, consult with your attorney, accountant, or other qualified adviser.