How many captive owners realise that their actuary, more than many service providers, can spell the difference between survival and ruin in the financial life of the captive?
Captives have a variety of professional service providers supporting their operations. The list can run long, including management firms, lawyers, actuaries, auditors, underwriters, claims managers, investment managers, reinsurance brokers and potentially others.
Yet among these professional advisors, it is the actuary that is better positioned to spot signs of financial distress – an important “early warning” system for the health of your captive. Think about it: actuaries review and comment on the adequacy of an insurance company’s loss reserves. They use their experience to gain insight as to financial health of the company and their findings can influence such critical areas as capital assessments, dividend policy, future premium rates and the entry or exit from entire classes of insurance business.
When the captive’s actuary performs his analysis, he can be seen as holding the beating heart of the captive in his hands. He has enormous responsibility; in short, a good actuary can save a captive, and a poor one can kill one.
Despite this, many captive owners select their actuary almost as an afterthought – often at the recommendation of another service provider, and frequently without a careful vetting as to the qualifications of the actuary or a clear understanding of the services that will be provided.
A common misconception is that, because actuaries all share a professional credential, they are all equally competent and qualified to perform a wide spectrum of assignments that can involve deep technical analyses. But all actuaries are not alike. To be sure, credentialed actuaries are all subject to a professional code of conduct that strictly governs the way their analysis is performed and documented.
However, just as physicians and lawyers do not all share equal training, skill, experience and specialty, credentialed actuaries exhibit a wide variety of capability and experience that must be considered prior to engaging one to review the reserves of an insurance company. Put another way, just as you would not select your doctor by flipping through a telephone directory, you should not select your captive’s actuary without a clear understanding of his or her capabilities, track record, knowledge of the industry (ie healthcare, consumer and industrial products, etc), monitoring of legislative and regulatory changes and intended scope of services.
The scope of actuarial services can vary widely; captive owners should assess their specific needs very carefully prior to retaining an actuary. While a very low professional service fee may seem very alluring, it should not be the final word, considering the actuary’s role in protecting the solvency of your captive.
The level of detail and care contained in the actuary’s report often reflects the cost of the study. Fundamentally, the owner needs to decide how often the actuary’s reports require updating: annually, semi-annually or quarterly. That is, how quickly can business conditions change for the captive, and how long can the captive afford to wait to react to those changes?
There’s also the question of when, during the year, the analysis should be performed. Many captive owners will have the actuarial analysis performed prior to captive’s fiscal year-end.
The actuary’s findings are then “rolled forward” to the year-end, so that management can react and adjust to any unusual developments and/or changes in reserves prior to the fiscal year end, when the books are closed. Performing the analysis prior to year-end may also allow a captive to better estimate the amount of the dividend it will pay to its members prior to a board meeting held in the subsequent year.
Besides the frequency of the actuarial studies themselves, abundant knowledge can be gained from dividing the captive’s reserves into useful segments that allow owners to track loss trends or isolate areas of potential problems. However, the actuary should also balance the owner’s thirst for additional detail with the limits of data availability. Splitting the data too finely by creating too many segments can damage the reliability of the actuary’s report by compromising the credibility of the loss projections for each of the segments.
In addition, an actuary needs to have a reasonable approach for dealing with the captive’s per occurrence retention. In some cases, the actuary will perform an analysis for a primary loss layer in which there is considerable loss frequency (eg first $250,000 per occurrence). Then, the actuary will separately also do an excess layer analysis (eg between $250,000 and the captive’s retention). As an alternative, some other actuaries might perform analysis on the captive’s losses on an unlimited basis, adjusting for claims that exceed the captive’s per occurrence retention.
This approach allows the parent company to estimate an asset for insurance recoveries from a third-party commercial insurer. Understanding which approach is preferred (and why) is important to understanding the captive’s loss reserves.
To boot, the analysis described above can come in very handy in designing the captive’s retention and reinsurance plans, since understanding the volatility of the loss layers retained by the captive can inform decisions about capital and reinsurance budgets.
Next we turn to the sources of information that the actuary may consider in preparing his or her analysis. How does the captive’s actuary keep up with recent developments in the insurance industry or with issues that directly affect your captive? These may include such areas as tort reform for professional or products liability, or changes in workers’ compensation benefit levels in specific states where the captive has insured risks.
Recent statutory limitations on non-economic damages (aka “pain and suffering”) have affected the potential value of liability claims in several US states, but if an actuary looked only at average historical claim severity levels for a given client, he would not have captured that subtle but important change in estimating the value of future claims.
In addition to statutory and macroeconomic trends, the actuary should explain whether and how he uses “industry” information related to loss development, loss trend, exposure trend, or other important factors. The danger in using industry information is that it is not always a reliable proxy for the specific risks being insured by your captive.
The actuary should be able to discuss the appropriateness of using this information for your captive, as well as the role (if any) of your own information. And, the actuary should be able to confirm that the “industry” information being used is current and relevant.
Closer to home, the actuary should be up-to-date in recent developments or changes in the operations of the risks being insured by the captive. Changes in the mix of states where risks are located, implementation of safety initiatives, or legal defence strategies, should be taken into account when estimating reserves or setting future rates. Providing this information to the actuary can help him or her identify favourable or adverse changes.
Also, your actuary should be checking in with other operational functions of the insurance company (eg underwriting, legal, claims management) to understand and account for any changes in the approach to premium rating or claims handling. This is a part of the due diligence process that is frequently overlooked. Many actuarial consulting firms also have consultants who can perform a claims file review to identify potential issues with the third party claims administrator in case reserving practices.
It is not sufficient for your actuary to tell you only what’s happened; a greater value can come from examining what’s happening, so that your captive’s management can take appropriate steps to adjust course as necessary. When estimates of ultimate losses change dramatically from one actuarial study to the next, the actuary has an obligation to work to understand and explain the reasons for that change.
A conscientious actuary should use an assortment of diagnostic tests to identify favourable or unfavourable trends in claims frequency and claims severity.
It is also important to look at the level of care and professionalism shown by the actuary in finalising his or her analysis. Are the actuarial reports peer reviewed by another independent actuary? Are the reports reviewed for technical correctness and mathematical/typographical errors?
And finally, the actuary should be independent of other important service providers to your captive, especially underwriting, brokerage, and audit. Having an independent actuary can allow you to receive important management information about your captive’s operations, unfettered and unfiltered by competing or potentially conflicting concerns.
Clearly the actuary plays an important role in identifying and analyzing issues that can create threats and challenges, as well as setting future direction for the captive. When you treat the preparation of the captive’s actuarial report as an undifferentiated, pro forma “rubber stamp”, you do it at your own risk.