Expert Commentary

Actuarial Projections and the Captive

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.


Captives
November 2002

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. 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.

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