We routinely use the terms capital and surplus interchangeably. While they are technically the same thing, they serve different purposes.
Insurance company (and captive) capital exists to support the company's loss reserves; if reserves prove to be inadequate to meet the company's liabilities, capital is used to do so. While capital doesn't replace loss reserves per se, it's part of the formula that determines asset adequacy. Surplus, on the other hand, is not part of this formula. Surplus is funds in excess of that which is required to meet the company's liabilities. Herein lies the problem for the captive owner.
How much surplus is enough? How much is too much? It depends on whom you ask. From the captive's perspective there's no such thing as too much surplus. The more surplus a captive has, the more likely it would be to sustain one or more catastrophic losses in a single policy year. That's a good thing, right? The problem with this position is that it ignores two important things; (1) excess surplus is almost always underemployed capital, meaning that it's not working as hard for the company as it could elsewhere, and (2) the probability of a surplus-draining catastrophic loss (or losses) is almost always negligible.
Unemployed Capital Issues
Let's talk about the underemployed capital issues first. Many captives are overcapitalized because the risk manager (or perhaps the CFO) would rather err on the side of too much than not enough. But excess surplus creates low returns on invested capital (ROICs). A low ROIC potentially drains economic profit from its parent company. Here's how this works. A company's use of capital (captives and otherwise) determines whether it makes an economic profit or realizes a loss. This is called capital management. An economic profit is defined as that amount of investment return excess of the company's cost of capital. In simple terms, a company's ROIC cannot (or should not) be lower than the cost of that capital. When I say investments, I'm talking about everything the company invests in (acquisitions, etc.), not just financial market investments.
Of course, captives usually do not invest in anything more exotic than the equities market, so right away we can see that their ROICs might be lower than that earned by their parent companies. That's okay unless its ROIC is lower than its parent's cost of capital. If this is the case, the argument can be made that the captive is a bad investment and should be discontinued.
Catastrophic Loss Issues
The second problem inherent in the excess surplus question is the argument that it's necessary to fund for the highly improbable (yet not impossible) catastrophic loss scenario. Companies are constantly assuming calculated risks in the normal course of business. Some of those risks are deemed to be too volatile to assume passively, so they're managed internally or transferred to another balance sheet. This makes sense, and it's part of what defines a successful company.
In light of this reality, what sense does it make for a captive to hold surpluses designed to pay for a 1,000-year event? The rest of the company successfully manages its business volatility (insurable and uninsurable) through calculated risk-taking while the captive hoards funds in the event of Armageddon—and the captive is part and parcel of the company's risk management!
Nowhere is it written that a captive is not allowed to earn an economic profit. Likewise, a company's calculated risk assumption should not exclude the question of excess surpluses. It's perfectly fine to fund loss reserves at a conservatively high actuarial confidence level, say 75 or 80 percent; but it's not fine to accumulate excess surpluses year after year with no recognition of the probability of actually using the funds to pay for losses.
How Much Is Too Much Surplus?
Okay, you might say, this makes sense, but what about volatile industries such as pharmaceutical companies: shouldn't their captives hold as much surplus as they can? The answer is no—the financial contingent for outsized losses should not be the captive's surplus; it should be woven into the captive's risk assumption parameters. This means that the company should know how much money, on an aggregate basis, it is willing to lose annually, and plan retentions and reinsurance placements accordingly. Remember, reinsurance is often used in place of capital; it permits the captive to write more business while relieving the capital burden on the parent. The question shouldn't be "how much can we possibly lose?" it should be, "how much are we comfortable losing?"
No captive or its parent benefits from excess surpluses. They drive down the captive's ROIC and distort the captive's real value to the company. For example, let's assume that a captive's ROIC is 5 percent, while its parent company's cost of capital is 6 percent—it's a loser. However, the captive may be serving a critical purpose; perhaps it's providing insurance capacity unavailable (or overpriced) in the commercial markets, but that value is diminished by the fact that the captive represents a poor use of capital.
So, what is the first thing you must do? Calculate your captive's ROIC, and take it from there.
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