Key Concepts for New Captive Board Members

Congratulations; you have just been asked to serve as a new board member for a captive insurance company or a risk retention group (RRG). Of course, your new role requires that you exercise your fiduciary responsibility to ensure the captive is financially sound. While you may well be an expert in your chosen profession, serving as a board member for an insurance company, even a captive insurer or RRG, is an entirely different animal. This article, the first in a series, is intended to provide a basic grounding in several key concepts you should be familiar with in your role as a director of a captive insurance company.

Obviously, the financial fundamentals discussed below are only a starting point and, like all good directors, you should seek to continue your education in insurance as you grow into your role. The article also assumes the captive or RRG is in existence and is not just being organized. Future stories in this series will focus on key elements of a feasibility study to which directors should pay attention.

Financial Statements

There are four important financial statements that all captives and RRGs should produce on a routine basis. These are a balance sheet, a statement of revenue and expenses (otherwise known as an income statement), a statement of cash flows, and a statement of members' (stockholders') equity. The first important thing to recognize about all four of these statements is they are historical in nature (i.e., backward looking). They are accurate only for the date or periods of time indicated on the top of the statements. 

However, astute financial professionals will spend the greatest percentage of time reviewing the statement of cash flows, which is often the one financial report that gets overlooked during a normal board meeting. Why spend time on the cash flow statement? Most captive insurers and RRGs use the accrual basis of accounting for reporting. In accrual accounting, income shown on the statement of revenue and expenses may not have been collected, while expenses shown may not have been paid. You may have heard the old phrase "cash is king." Never is this truer than in an insurance company. You can only pay claims (losses) with cash.

A cash flow statement breaks the information down into three distinct sections in the report, as follows.

• Operating activities—where the information on the income statement is converted from the accrual basis to cash
• Investing activities—reports the purchase and sale of long-term investments (typically the securities in the captive insurer's investment portfolio) and any other property and equipment
• Financing activities—any issuance or retirement of the captive insurer's debt or equity and the payment of dividends

Auditors, regulators, and board members will review the operating activities section of the cash flow statement as compared to the reported net income from the income statement. If cash from operating activities is higher than net income, the captive is considered to be "cash flow positive." If this is true on a consistent basis over time, directors should be encouraged. This is because the captive or RRG has the ability to generate, on an ongoing basis, the cash it needs to meet ordinary losses and expenses associated with running the company while also having the ability to build its investment portfolio and equity positions. 

On the other hand, if the insurer is cash flow negative, especially on a consistent basis, directors should be concerned about the ability of the captive to function as a going concern. Captives with negative operating cash flow will quickly generate interest by regulators and will have problems meeting risk-based capital ratios.

Statement of Actuarial Opinion

At least annually, the captive insurer or RRG should have a statement of actuarial opinion prepared by an independent accredited actuary. These reports are typically done in conjunction with the year-end closing of the financial statements in order to properly establish the reserves necessary to be carried on the insurer's balance sheet.  Besides understanding the four financial statements, the ability to read and interpret an actuarial opinion is a basic requirement for a board member. 

An actuarial opinion should, at minimum, contain the following information.

• Discussion on the qualifications of the appointed actuary—the appointed actuary to be a Qualified Actuary as insurance regulations. Therefore, the appointed actuary must be an individual, not a firm. The appointed actuary is permitted to state reliance on other qualified actuaries as appropriate for review of some portions of the reserves. The actuary may be appointed for one or more subsequent year-ends at the same time. New directors should ask how long both the actuary and the actuarial firm have been supplying the opinion for the captive. Rotation of the opining actuary may be required under your state's regulations; however, most domiciles do not require the actuarial firm to be rotated. Frequent changes in the captive's actuarial firm are a definite cause for concern.
• Definition of the scope of the actuarial opinion—the opinion should contain verbiage to the effect, "I have examined the actuarial assumptions and methods used in determining reserves listed in Exhibit A, as shown in the Annual Statement of the Company as prepared for filing with state regulatory officials, as of December 31, 20__." Additionally, the scope should identify who provided the underlying data the actuary is relying on for his or her opinion as well as whether the data has been reconciled to the captive's Schedule P in its Annual Statement, if it produces one. The actuary should also indicate the methodology used to set reserves and whether the actuary conducted an independent analysis of the reserves or relied on the work of others.
• Statement on the range of reserve estimate—individual actuaries using similar methodologies will arrive at different reserve estimates. The estimate will typically contain a central or point estimate of the reserves and then a range around this estimate. Normally, the range is also nonsymmetrical in that the lower end of the range may be closer to the central estimate than the upper end of the range. Inadequate reserves are much more detrimental to captive insurers than excess reserves. Directors should also understand from management how it selects the actual reserves posted in the financial statements from the range provided by the actuary. Again, caution is warranted where management does not have a set policy and varies where in the range it sets reserves.
• Finally, the actuary should provide discussion and analysis of deficient or redundant reserves and assess the risk of material adverse deviation from the range provided. For most captives, there may be no need to discuss the risk of material adverse development; however, whenever the captive starts to write a new line of business, or if there have been significant changes in the external environment due to changes in regulations, establishment of new laws, etc., this paragraph should be included and directors would be wise to read it and ask probing questions.

Well-educated and engaged directors are best positioned to serve the needs of captives and risk retention groups. As a new director, you should take the time to become knowledgeable in all facets of the captive's operations. Read "Basics of Loss Development Triangles," the second article in this "Key Concepts for Captive Board Members" series.