Keeping Your Captive Competitive
Membership Accounting at HARRG and HAPI
John Salisbury, Chief Executive Officer
of Housing Authority Risk Retention Group, Inc., and of Housing Authority
Property Insurance, Inc., wrote is a long description of how his financial
models demonstrate to members of his group captives the advantage of staying
in the captive when faced with soft market competition.
(Editor's Note: This article was written
in the mid-'90's. While some of the anecdotal information is no longer
correct, the basis on which the article was written is still valuable.
We have chosen to keep it in our archives for this reason. -- captive.com)
Competition is a word that many group
captive insurance companies have come to understand better in the soft
insurance market. One reason many captives have been able to survive the
return of commercial insurers as competitors is that the captive owner/members
have negative memories about commercial insurers. However, some group
captive boards, managers, and staff have learned the hard way that there
memories fade, especially in difficult economic times when there is pressure
for the immediate savings offered by the traditional insurance market.
They have started to lose members to the commercial competition.
The challenge, for those who govern
and manage captives, is to demonstrate the advantages of the insurance
products and services they provide. This can be accomplished by focusing
on any of the following:
- Cost
- Scope of coverage
- Scope and quality of services
- Overall financial advantage
This article focuses on how to demonstrate
the overall financial advantages of staying in a group captive (or joining
one).
Member accounting system: The
Housing Authority Risk Retention Group, Inc. (HARRG) and Housing Authority
Property Insurance, Inc. (HAPI) have developed a member financial accounting
system that demonstrates how both companies provide the lowest possible
long-term net insurance cost to their members.
The concept behind the member accounting
system is relatively simple. Two types of accounts are maintained for
each member -- policy-year accounts and surplus accounts. A separate policy-year
account is maintained for each member for each year in which the member
participates. The member policy-year account balances are calculated monthly
until all claims for a particular policy year are closed. Net earned investment
income is allocated monthly to the member policy-year accounts, and to
the member surplus accounts, in proportion to the cash balances retained
in each account. Negative balances are not charged interest, however.
Periodically, the financial status
of a policy year is reviewed with respect to declaration of premium credits.
Negative balances do not attract dividends or credits. These negative
balances are first allocated to the accounts of those members having positive
account balances are first allocated to the accounts of those members
having positive account balances for the policy year. Then, credits are
allocated to those members with positive account balances.
It really works: HARRG's system
returns ìsurplusî in the form of premium credits in future
years. An estimated 41% of member premium paid from the first policy year
will be returned in the form of premium credits to HARRG liability members.
This estimate assumes that actual losses will equal ultimate losses certified
by HARRG's independent actuaries. The amount of premium credit by members
will vary, depending on individual member performance.
It is easy to understand how the member
accounting system can be used to demonstrate prospectively how the existing
or potential member's future net cost could be better than any competitive
alternative.
CICR comment: Except that members
have to have the patience to wait several years after the close of the
policy year before receiving the premium credit.
Surplus accounts/equity dividends:
The second type of account maintained on a member-by-member basis is the
member surplus account. This is comprised of: (1) member surplus (capital)
contributions and (2) equity and/or premium dividends that are allocated
by the board of directors.
Each member that joins HARRG or HAPI
is required to make a surplus (capital) contribution. The current policy
is to require a contribution equal to 50% of the policyholder's first
annual premium.
One of several common goals in the
HARRG and HAPI mission statements is to provide a reasonable rate of return
on member surplus contributions. This is accomplished through board approval
of equity dividends.
Equity dividends are declared and
allocated from total surplus before premium credits are calculated. Of
course, the company has to have enough net income to allocate these dividends.
Equity dividends are declared but not paid. The equity dividend is allocated
from the general surplus account to individual members' equity accounts.
The members' equity accounts remain with the company as part of the retained
surplus.
All members receive allocation of
equity dividends to their surplus accounts regardless of the condition
of the policy-year accounts for any year which they participated or their
individual underwriting accounts. Each policy year is expected to cover
losses and expenses from the total of premiums, investment income, reinsurance
recoveries, and other revenues. If a policy year has a net loss, the net
loss is first charged against the surplus accounts of the members that
have negative policy-year balances for that policy year. If a net loss
balance still remains after this allocation, the balance is allocated
proportionally to all remaining positive member surplus account balances.
CICR comment: There's nothing
like graphic display of the member account to show the overall financial
advantage of the captive. Above, we reproduce just one of Salisbury's
charts, showing premium credits expected on the basis of current policy-year
results. From it we see that the first policy year (1988) shows a large
overall premium credit of 41%, and the third year almost 20%. One reason
for the difference is two more years of accumulated investment income.
Another reason might be more conservative loss reserving (IBNR) for the
more recent years. A third reason might be that more competitive rates
have been charged in the more recent year.
Implementing a member accounting
system: A member accounting system is easier to explain than to implement.
Here are some tips:
The first tip is not to attempt to establish
a member accounting system without a computer system. At HARRG/HAPI, we
use a 486 personal computer. The customized software has been developed
under contract with Saber Tech, and New Hampshire-based software development
firm. The design for the software is on the author developed in 1978 and
has applied to numerous applications in workers' compensation, liability,
property, and unemployment compensation programs. A second tip is to customize
software to fit the unique needs of each captive, even if generic software
seems to be available. No package program fits all of any individual captive
insurance company's needs.
End Part One
CICR believes that membership accounting is the key
to group or association captive success, and welcomes explanations of
how individual models work. There are various ways of demonstrating the
current and future success of a captive through membership modeling, and
HARRG/HAPI's is one. We thank John Salisbury, CEO of the captive, for
allowing us to explain it in its entirety.
In our August issue we explained the general ideas behind
the allocation methods and membership modeling used to ìKeep Your
Captive Competitiveî that had been developed by Mr. Salisbury. We
promised more details on how it works, but got sidetracked by anti-fronting
news. In this issue we describe the membership system in some detail,
and explain actual examples line by line.
To summarize Part I, there are two
types of accounts maintained for each member: policy-year accounts and
surplus accounts. The policy-year accounts are updated monthly until all
claims in a particular policy year are closed. Investment income (or loss)
is allocated monthly on the basis of the balances of member policy-year
accounts and member surplus accounts. The net investment income allocations
are used to demonstrate the growth of the member's surplus contribution(s)
and to show the contribution that investment income makes to the net income
(loss) of each separate policy year.
Here is the way premiums, investment
incomes, expenses, and losses work in the HARRG/HAPI system.
Step 1:
The net income for each of the companies is determined at the end of each
year. If net income is sufficient, an equity dividend allocation is made.
The equity dividend allocation for each member is equal to the amount
of investment income earned on the member's surplus account. The equity
dividend allocation is a designation of a portion of the total retained
earnings.
Step 2: The balance of the
one or more policy-year accounts of each member is calculated. Member
balances equal all the revenues paid in (see page 3 for what constitutes
revenues), plus the allocated investment income, minus losses incurred
(including IBNR) and a proportionate share of expenses.
Step 3: A total is calculated
of the income minus expenses for each of the policy years a member has
participated in the program. A potential premium credit is then calculated
by multiplying the 90-day T-bill rate times the available income minus
expense balance. The tentative premium credit amount is then subtracted
from the estimated account balance (see last line of policy-year account
model). If the prospective premium credit will not reduce the estimated
account balance below zero, the premium credit is provided. No premium
credit is provided to members with negative estimated account balances.
Step 4: The premium credit
is applied as a source of revenue in the next policy year of each member.
The credit goes to reduce the amount of premium bills each member for
the next policy year. The premium credit is offset as an expense on the
prior-year accounts of the member.
CICR comment: The premium credit
allocation in effect conservatively anticipates what the investment income
earnings will be on prior policy-year balances. Those prior policy-year
balances are composed of loss reserves and any net income balances.
One aspect of the HARRG/HAPI model
that we like is the way the member recovers underwriting profit from his
own account, a recovery that may be reduced by subsidies to members with
negative underwriting balances. If modeled correctly and presented simply,
this demonstration should help keep the member with the most favorable
loss experience form succumbing to tempting lower-priced competitive offers.
On page 4 is a sample of a member's
accounting report that summarizes the status for all lines for one policy
period. The report is in four sections:
1. Surplus:
This section starts with the surplus contributed and includes all adjustments,
usually increases. The lines on the report are:
- Surplus contributed: This is the amount
the member public housing authority (PHA) contributed at the time it
joined the program.
- Surplus refunded: This line item accounts
for any surplus returned to a member. HARRG/HAPI does not plan to do
this unless a member withdraws.
- Designated surplus: At the end of each
year, and if the program has net income, the board designates equity
dividends to member surplus accounts. If there is sufficient net investment
income, the amount of the equity dividends will be the pro rata share
of net investment income of the member's surplus account balance.
- Net investment income on surplus: This
is the individual member's share of undesignated net investment income
earned on the surplus account balance.
- Total surplus & net investment income:
This is the total amount of the individual member's surplus account
and the undeisnated net investment income.
2.
Revenues:
This sections starts with premium collected and adds other revenue items:
- Premiums collected: Premiums received from a
member are booked when actually received.
- Premium credit applied: If premium credits are
allocated to the member because of favorable experience in prior years,
this is where it will appear.
- Investment income: A monthly proration of net
investment income (loss) is made on the basis of the balance of the
policy-year account.
- Reimbursable received: Deductible repayments
paid in by the member. the amount received is recorded in the month
it is received.
- Transferred from other members: the total negative
policy-year account balances of those members with poor loss experience
are shared by all the members with positive policy-year account balances.
This line item is the amount transferred from other members to pay for
the poor loss experience of a member.
- Total revenues: This is the total of all revenues
attributable to a member.
3. Expenses:
This section includes all the losses paid, for all years. It also includes
the proportion of other expenses. Loss reserves or unpaid losses are recognized
in the ìReservesî section, below.
- Administration and underwriting: the allocation
is a proportion of earned premium for the policy year.
- Premium taxes: The state premium taxes
paid are recorded in each member's account in the month they are paid
by the company.
- Reinsurance: The treaty reinsurance expense
is allocated in proportion to member earned premiums. If the company
purchased faculative reinsurance for a specific member, the amount is
also booked in this account.
- Unallocated loss expenses: these are expenses
incurred by the company claims management staff are not specifically
charged to an individual claim. Starting in 1991, unallocated claim
expenses will be broken out of administration and underwriting expenses.
The major proportion of unallocated claim expenses will be allocated
to members that have claims. The allocation will be based on each member's
proportion of the cumulative number of days all claims are open during
the policy period. Those members without claims will bear a small proportion
of unallocated claims expenses.
- Nonreimbursable claims paid: This line
item is charged in the month in which a claim payment is made. It reflects
the amount of claims paid in excess of the member's deductible or self-insured
retention.
- Reimbursable deductible: This is the amount
of claims paid out within the member's deductible. It is booked in the
month in which any claims payments are made.
- Premium refunds: The amount of any premium
refund made to a member is recorded in the month the refund is made.
- Premium credit expense: this line item
records the amount transferred from one policy year to another policy
year as premium credits. A member that has a positive policy-year account
balance qualifies for a premium credit or premium dividend. Premium
credits are recorded as an expense in this line item. Premium credits
are also recorded as revenue in the policy year to which credits are
applied.
CICR comment: This seemed complicated
to us until Salisbury explained that premium credits from this year would
show up here as an expense, which would go to reduce the member's underwriting
account each policy year. The premium credit to another year shows up
in that year, in the revenue section, which evens everything up.
- Member distributions: this account is
to record any premium dividends that are paid to a member.
- Transferred to other members: the total
negative policy-year account balances of those members with poor loss
experience are shared by all the members with positive policy-year account
balances. this line item shows the amount of funds transferred to other
members to pay for the poor loss experience of those members. It is
the corollary of the line item ìTransferred form other membersî
in the ìRevenueî section.
- Total expenses: This shows the total expenses
for the policy year.
- Revenues minus expenses: This is the amount
of the policy year balance available to cover any outstanding claims,
claims development, or claims that have been incurred but not reported.
- The next line, Interest basis, is the
total surplus and interest, from the ìSurplusî section,
plus the balance on the line ìRevenues minus expenses.î
It is used for calculating investment income.
4. Reserves: This section recognizes
all changes to loss reserves for an individual member's account, starting
with known claims that have some time to be paid off, and adding IBNR
and development amounts recommended by HARRG's actuaries.
- Change in reserves: This line item reflects
changes in claims case reserves.
- Change in IBNR: This is the change in
member's allocation of reserved for incurred but not reported claims
for the whole company. The allocation is based on earned premium except
where a specific IBNR calculation has been made for a member by HARRG's
actuary. The change is adjusted annually following the actuarial loss
reserve certification.
- Total change in reserves: this is a running
total balance of outstanding care reserves and IBNR.
- Estimated account balance: This line item
represents the net income that would exist if: (1) all claims were closed
in amounts that equal the outstanding reserves and IBNR for the policy
year, and (2) there were no additional allocation of losses of other
members. Both assumptions are why the term ìestimatedî
is used in the table for this item. It is the most important figure
in the whole chart.
CICR conclusion: Keeping separate
accounts for participants in a group captive can get complicated, as this
article demonstrates. It's worth it if the end result demonstrates to
the members the present and future value of staying with the captive insurance
venture. In future issues CICR will be looking at the application of membership
modeling to future planning, dividend strategy, and long-range marketing
plans for group captives.
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