AN OVERLOOKED ADVANTAGE

Rough Notes, Apr 2005 by Moody, Michael J

Investment income can play a significant role in captive finances

When any organization starts to consider the feasibility of a captive insurance company formation, they typically will review the advantages that can be obtained from the movement. Among the key advantages that are frequently noted are the following:

* Control one's destiny

* Cost savings available from reduced traditional insurer charges

* Lower costs for protection due to purchasing coverage wholesale (reinsurance)

* Obtain investment income from holding reserves

* Flexibility in designing coverages

And while all of these advantages have significant potential, for many captive owners, investment income all too frequently is shuffled to the back burner once the captive is operational. This is only natural since the primary focus of the captive is managing risks. However, this typically results in few captives utilizing the investment income opportunity to the maximum.

The importance of investment income

Investment income has always been a cornerstone in the insurance industry. To see just how important it is, one has only to look at how commercial insurers report their financial results. Traditional insurers provide summary financial data in two broad categories: underwriting results and investment income. Unfortunately, over the years, many insurers have had to depend on investment income to support less than stellar underwriting results. This went to extremes when interest rates were in double digits some years ago and carriers adopted a "cash flow underwriting" mentality. Many accounts were written purely for the investment income. Overall, however, investment income is a huge strategic component to any insurer's operational plans.

Without question, traditional insurance companies depend on investment income to support their underwriting decisions. The same should be true for captives. However, for many captives, portfolio management has not been a high priority. And to some extent, this has not always been the fault of the captive. Until recently, the investment community has not viewed the captive market an attractive one. Today things are changing and investment advisors have now realized the potential the captive market represents and are moving aggressively into this arena.

New-found respect

Originally, many of the captives that were formed were single-parent companies that utilized thinly capitalized structures and offered little, if any, opportunity to generate meaningful investment income. Over the years, however, large group captives and risk retention groups, as well as rent-a-captives, have begun to accumulate significant amounts of capital and surplus which the investment community is taking note of. Additionally, single-parent captives are now beginning to add a variety of other coverages to their original selections, thus bringing in additional capital as well.

One additional factor that is certain to have an impact for captive customers is the movement by investment managers to gain transparency. The investment community had felt the need to gain transparency even before the insurance industry was beset with its contingent commission problems. The investment industry has been experiencing a number of embarrassing revelations recently, including such things as late trading by some mutual funds, client favoritism with regards to high-flying IPO shares, and allegations of extra charges associated with the sale of stocks to smaller investors. All of these have caused the industry to embrace the concept of transparency as investment managers take steps to reduce their expenses and establish operational oversight. As a result, captives, despite their relatively small portfolios, should find themselves on a more level playing field with multi-billion-dollar institutional investors.

This should allow captives to receive treatment, terms and conditions that are similar to those enjoyed by many larger investors.

Starting conservative

Many captives adopt similar, conservative investment philosophies when starting out. In fact, some new captives choose to keep all of their assets in cash. Once started, however, captives usually begin a natural maturation process that occurs once the captive has had an opportunity to determine its paid claims and expenses and has established its liquidity requirements. At this point, captives usually change their focus and begin to use money market funds and to allocate more into fixed income securities. Ultimately, the investment strategy that many captives adopt is developed based on the best match of assets and liabilities, which is necessary to assure they are employing their assets efficiently.

For most captives, maturation usually occurs around the third or fourth year of operation. By the fourth year, captive owners are beginning to get a good feel for their cash flow requirements and are gaining confidence in their operations. At this point, some captives start to move towards more diverse asset classes and incremental risk in their investment portfolios. Despite the improvement in investment choices, some experts believe that captives continue to err on the side of liquidity and improvements should be made.