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Investment Strategies for Captives

Michael Mead | January 1, 2006

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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.

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.

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