Expert Commentary

Searching for the GUT (Grand Unifying Theory) Value of a Captive—A New Perspective (Part 1)

Over the past 100 years or so, physicists have been looking for what is known as the Grand Unifying Theory, also known as the Theory of Everything, which would encompass all of the known laws of physics. It's a very complex issue, of course, but it boils down to reconciling the four forces that comprise the Standard Model of particle physics (the strong and weak nuclear forces, electromagnetism, and gravity) with the very bizarre physical laws that govern the quantum (subatomic) realm.

November 2012

Thankfully, our quest doesn't require a PhD in quantum mechanics or astrophysics, but measuring and expressing the true value of a captive to its shareholder(s) presents a similar conundrum. The problems stem from the inadequacy of our current methods of value definition and measurement, our inability to crystallize the multifarious, bordering on qualitative, benefits provided by a captive to individual company circumstances, and last (but certainly not least), our conceit that a "one-size-fits-all" theory of everything exists and is desirable. (Neither is true, but there is a template we use to identify the appropriate issues.)

Measuring Captive Value

First and foremost, a company's ability to form a captive is dependent on its cash reserves. The company may be perfectly capable of paying self-insured claims as they occur over time and yearn for the independence a captive can provide. But, unless it can devote a significant amount of cash (capital and premiums) in a lump sum to a captive, there is no captive.

What does this fact have to do with measuring a captive's value? It reveals a simple truth—the parent company’s value expectation always precedes and must fall short of the captive's apparent value. Put another way, if the company cannot, for whatever reason, fund a captive, it has no expectation of value, so none can be created (at least by a captive). This is an extreme example and may seem completely self-evident but not when viewed within the context of value creation and measurement.

A captive certainly has the capacity to add value to its parent company, but only commensurate with the company's value expectations. There must be almost perfect symmetry between value desired and value created. If this is not the case, in the final analysis, the ill-conceived captive will fail. Another example will illustrate.

Gap Analysis

In the right conditions, captives can convert a non-insurance company's self-insured expected losses, which it pays over a 5- or 10-year payout period, into tax-deductible insurance premiums. This can result in accelerated tax deductions providing significantly better cash flows than those available in the non-captive scenario.

Now, if this was the one and only financial transaction this company ever made—that is, paying for insured losses—the captive would add tangible value to the company where none existed. But, because this company does a lot more than merely paying self-insured claims, the captive’s apparent value was only made possible by the company's expectation of exactly (or close to it) the same amount of value.

If it did not, the captive would prove either inadequate and incapable of providing apparent value to the company, or its value would be deemed excessive and unnecessary (and of no value to the company). This gives rise to a central fact of human nature—what we value is based on what we have versus what we need (or want).

This has another name—gap analysis—which involves examining the current state of affairs, quantifying what's missing, and filling the gap. Alas, this is far easier said (or written) than done. As I mentioned above, unless the apparent value matches, as closely as possible, the company's apparent need, it will fail.

Captive Benefits

So, that's the philosophy. How do we turn this into something we can use to calculate the value of a captive to its parent? We must begin by identifying the differences between the company's value expectations and the actual value provided by a captive.

I like examples, so let's have a look at the following. Here are three generic "benefits" that we usually expect from a captive:

  1. Create formal risk financing when the commercial insurance markets are unable and/or unwilling to do so for a non-usurious price.
  2. Enhance cash flows through the use of insurance accounting, when appropriate.
  3. Provide a vehicle through which to impose a rigorous cost-of-risk allocation system on subsidiaries, operating units, partnerships, etc.

Consultant Bob is discussing the wonderful benefits of captives with Client Jack. Bob decides to focus on the above three captive benefits, because these are the ones that he identified as having the most potential value for Jack. (Bob has already spent considerable time with Jack in order to identify these issues). Jack is the company's chief financial officer and is never satisfied with any purported "benefit" if it cannot be quantified to his satisfaction.

Obviously, each of the above three benefits requires entirely different ways to measure its value—no single metric can encompass all of them—at least not at first. So Bob's task is to reduce each benefit to a metric, a mathematical value, and then calculate the economic value each benefit confers on the company.

Finally, once the individual economic values are determined, Bob adds them together and selects an appropriate company benchmark (revenues, earnings per share, etc.), against which to calculate a single metric that expresses the aggregate value of all three benefits. I mentioned above that while there is no "one-size-fits-all" über-methodology, there is a template we use to gather the client's value expectations, evaluate them against a captive’s ability to match them (the benefits in the above example are but three), calculate their individual mathematical value to the client, and develop the appropriate metric that encompasses all of the benefits.

In Part 2 of this series, we will discuss this template and how we use it. Stay tuned!

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