Typically, the line item on a captive’s balance sheet for loss and loss expense reserves represents a provision for the total required reserves relating to both losses and loss adjustment expenses. It is often displayed as a single line item, but occasionally, entries are shown separately for losses and loss adjustment expenses. Case reserves and IBNR may be shown separately as well.
For the purposes of establishing the amount (or amounts) shown on these line items, loss runs are provided to an actuary containing an entry for each claim reported under the captive’s policies as of a certain evaluation date. These entries have a “paid” component, representing payments that have already been made on a claim, and a “case reserve” component, which is set by the claims adjuster and represents an estimate of future payments needed to close or settle the claim. Using these loss runs, an actuary will then determine IBNR reserves, which include a provision for the development on known claims, as well as late reported claims. Adding the case reserves and IBNR reserves together establishes the total required reserves for the unpaid claim liabilities.
In computing the total required reserves, an actuary may include a single point estimate (often denoted as the actuarial central estimate or expected value) or a range of required reserves. If included, the range of required reserves is not intended to provide an absolute maximum or minimum on the required reserves, but rather to provide a range of reasonable outcomes. It is important to remember that the actual results may vary from the estimated results, and in some cases, this
variance may be significant.
When issuing a formal opinion on unpaid claim liabilities, an actuary may identify and disclose potential risks of “material adverse deviations”. These risks are often understood from the earliest stages of underwriting, and some relate to program design, retentions, and historical claim information. As claims begin to emerge, these risks generally become clearer, as they may be related to specific events or claims.
Asset Strategy – Loss Payout Considerations
In addition to the underlying unpaid claims risk, the potential future payout of unpaid claims (in terms of risk associated with both length and timing) is an important consideration for a captive’s asset strategy. This strategy is more involved than evaluating a portfolio return against an index or applicable benchmark, though. In many ways, the “benchmark” for a captive is defined by the expected claims and total required reserves for unpaid claim liabilities, including IBNR and cash reserves. Understanding the different coverages included in the total captive program must also be a component of the asset strategy, as payout durations may differ between coverages. To ensure duration-matching is maintained, asset allocation must shift alongside liability changes, meaning several “benchmarks” should be used when evaluating a proper investment strategy.
The range identified by the total required reserves should be used as a guide when managing assets, but it is important to note that this range is an estimate, and liquidity remains a priority when evaluating the reserve strategy. Before implementing this strategy, the captive investment policy should be reviewed to ensure it is not overly-restrictive or unnecessarily liberal. An investment policy that is too restrictive could limit the bond grade relative to account size, and a policy that allows for illiquid investments may not be appropriate for the captive program.
With a proper investment policy in place, a total reserve strategy can be established using an actuary’s high and low claims estimates. Cash and cash equivalents, including short term bonds and certificates of deposit, should be utilized conservatively in the early years as program history is established. In addition, matching assets to the potential payout of unpaid claims will give confidence in the program specific to a more defined duration. Cash and cash equivalent investments lead to very little, if any, volatility while maintaining liquidity, both of which are important until sufficient surplus has been established.
Asset Strategy – Diversification and Ongoing Considerations
Once the captive is more mature, though, the asset strategy should become more diverse, utilizing the surplus together with the reserve requirements to help match income to expected claims. As mentioned above, this process serves as the primary benchmark for a captive to measure asset performance. Picture, for example, a manufacturer with a captive for workers compensation and multi-peril risks covering expensive machinery and facilities. Assume the captive has built a large surplus relative to a current yearly premium of $3,000,000, and expected yearly claims of $2,000,000. Rather than sitting on $2,000,000 in cash and earning very little, one strategy might be to take a defined amount of surplus to invest with an income target yield of $2,000,000, allowing the full $3,000,000 premium to then be invested diversely.
Over time, the addition of new risks, including non-traditional risks, causes a captive’s portfolio to grow and diversify. Risk-specific characteristics may lead to special considerations in the asset strategy. Imagine the same manufacturer in the example above has the potential for a very large claim through a non-traditional risk (such as loss of key customer) that has been added to the captive. Maintaining liquidity by only investing in marketable securities and avoiding illiquid investments such as real estate would both become important considerations of the overall asset strategy after this risk was added.
As the captive matures, it’s important to understand that capital growth doesn’t need to be limited by the yield targets associated with the risk. Bonds are important to a captive in both the early years as surplus grows and later on to maintain diversity and reduce volatility. As claims history emerges and potential lines of coverage are added with varying durations, bonds can be utilized to match the coverage terms. Warranty programs are a good example of liabilities carrying beyond the first year’s premium; if the warranty covers a five year period, the asset strategy needs to recognize that liability carrying beyond the first year and provide necessary liquidity if required. A portfolio can become too bond-heavy, though, if the asset strategy is too singularly focused on debt. Especially in the prolonged, low-interest rate environment like we see today, a properly managed equity-income strategy should be utilized to enhance the total portfolio yield while also offering account appreciation.
Once realized, the equity-income strategy strikes a solid balance between volatility and income. As a captive matures, claims data will become more credible and the liability picture will begin to shift, thus forcing the asset strategy to evolve alongside it. An asset manager must therefore be able to not only build an appropriate captive portfolio, but also adapt the asset strategy to match the captive’s situation over time. Successful asset management for a captive insurance company means more than simply having the best returns on the street. When liquidity for claims is achieved without sacrificing either income or asset growth, the captive’s asset strategy is almost certainly well placed.