Investment Strategies for Captives
January 2006
Once your captive is up and running, it will
likely begin to accumulate cash balances. Into the third year and beyond, barring
unforeseen claims, these balances may become significant. How these funds are
held and invested is one of the chief features of a captive which we will explore
a bit today.
by Michael
R. Mead
M.R. Mead &
Company, LLC
The source of the cash held in the captive is two-fold: one is the initial
capital and surplus, and the other is premiums. If the original goal of the
captive is to use one's risk dollars more effectively, then it is likely that
the premiums paid in will exceed the paid losses for some time to come.
A commonly held misconception is that the purpose of a captive is to lower
one's premiums. This is usually a hazardous course unless you can simultaneously
reduce the number and severity of claims. Further, to gain regulatory approval
and cooperation from risk sharing partners such as fronts, an actuarial projection
is required. This actuarial projection will forecast premium levels, and convincing
other parties to accept less than the actuary's projections can be difficult.
So, as the premiums are paid in, balances in banks grow. Reserves for future
losses are also held within the captive, usually, and are available for investment.
These two "pools," if you will, can become a healthy number in short order.
For this reason, we always recommend that the board of the captive establish
an investment committee which meets regularly to review the performance of the
chosen investments. This can be one of the more time consuming committees of
the captive.
Initially, the regulators and risk sharing partners will have the last word
on the amounts and constitution of the funds held. Conservatism will rule, and
the funds will be invested in short-term liquid instruments, usually bond funds.
As the captive and its management team gain more experience and therefore
credibility, usually the regulators and risk-sharing partners will loosen up
on the liquidity requirements. This will allow investigation of potential investments
that may carry either substantially greater returns or have strategic value
to the captive and its owner(s).
By loosening up, I mean that when it becomes clear that cash for the immediate
payment of claims is in excess of needs, it becomes reasonable to invest the
funds in a less liquid investment, or a loan. When the captive's investment
committee has the ability to consider some less liquid investments comes the
moment to begin the analytical phase. It is critical that illiquid investments
match the predicted payout patterns of the actuary as reviewed and agreed by
the regulators and the risk sharing partners.
As the actuary develops a feasibility study, it will contain his/her estimates
of the dates on which claims will need to be paid. Since this is the actual
point of insurance in general, and captives in particular, regulators and risk-sharing
partners demand and expect to see sufficient cash available to pay claims that
are due to be paid. This is another point or assumption that needs to be discussed
with the actuary before the report is tendered. These payout patterns will drive
your investment profile, and either make you money or cost you money.
There are many well-qualified professional money advisers who are ready,
willing, and able to assist the captive owner in evaluating investments which
will coordinate with actuarial projections of when cash must be available. Often,
when regulators see that professional advisers are assisting in the timing of
investments with the cash needs of claims, and that the captive owner/manager
has developed a real expertise in managing the investment profile they are then
willing to allow investments in less liquid classes.
The one investment that remains a red flag is the loan-back to the parent
or affiliate. In fact the Internal Revenue Service (IRS) has asked for public
comment on this very subject. Loans are a perfectly legitimate investment, and
done everyday. When a loan is made under egregiously favorable terms to the
parent, questions arise as to the legitimacy of the transaction. There are no
hard and fast rules, but to loan-back 100 percent of the premium on the first
day of coverage would seem overly aggressive to some.
This subject is a legitimate option for a captive and its parent, however.
As long as there is disclosure and repayment and market rate provisions, in
principle, there would seem to be room to support the view of a legitimate transaction.
Investments in the common stock of the parent likewise cause raised eyebrows.
If it can be documented that the parent's stock is the best investment around,
then it is defensible. If not, then it will be deemed less likely.
Traditional insurers have many more restrictions placed on them by the regulators
and spend a good deal of time justifying the purchase of various state municipal
funds. The captive does not have similar restrictions as long as it can be demonstrated
that there is sufficient capital to pay claims.
All in all, the investments of the captive can be tailored to satisfy both
the regulatory needs of claims payments and the owner's needs for profit if
timed well.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author's employer or IRMI. Expert Commentary articles
and other IRMI Online content do 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.