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Maximizing Shareholder Value

Jonathan Groves ACII, AIRM
Assistant Vice President
Marsh Management Services (Bermuda) Limited

Captive insurance companies have been in existence for many years. They have served as a financial tool in addressing a host of business issues. But like many financial solutions, the problem for which they were initially conceived has changed or diminished and new areas have emerged.

The textbook definition of a captive insurance company is ‘a wholly owned legal entity established by an individual or an industrial, financial, commercial or governmental organization or organizations to underwrite all, or a selection of, the risks of that organization and its affiliates.’ This definition remains as accurate today as 30 years ago, but its interpretation has changed.

When captives were first being formed, the risks being considered by the parent companies at that time were of a property or casualty nature. Deductibles on the fire or all risks’ policies, workers compensation, automobile liability and general liability were all being insured by captives. If the captive proved successful over a longer time period, retentions could be increased and the premium paid into the insurance market could be reduced. Further development came when captives were used to fund risks for which insurance could not be purchased in the commercial market e.g. pollution or environmental coverage. But what do captives do in the 21st century and how can they be used to maximize shareholder value?

In very simplistic terms, a company can increase shareholder value by a) reducing its cost base whilst maintaining revenue or b) increase its revenue whilst maintaining or reducing its cost base. The latter is often recited as the reason for many mergers and acquisitions that take place in order that cost synergies can be obtained. So, can a captive help in achieving either of these very broad aims? Quite simply put, yes. But its success depends on the strategy of its parent company.

First, let’s consider a few general areas where captive owners have attempted to maximize revenue and shareholder value but have not succeeded as greatly as they would have liked. Perhaps the clearest example of this is from the mid to late 1980s when captive owners sought to underwrite general insurance business in the commercial market place. Reflective of the hardened and hardening market of the time, some captive owners felt they could achieve greater shareholder value for the parent company by exposing their capital base to the risks of numerous other companies. One or two succeeded, but the majority failed. Not only did this decrease value but it also cast a shadow over the future of captives.

This serves to highlight a second area where value hasn’t been realized. An incomplete, incoherent or otherwise unworkable strategy for the captive is also likely to lessen rather than create shareholder value. As we shall see, a captive can be put to a number of different uses and it is therefore essential that its micro purposes be defined in order that it can deliver in the macro. A ‘scattergun’ approach to the way it might be used can easily lead to risks being assumed for which a limited understanding exists, in which claims are dealt with inappropriately and for which premiums are incorrectly set.

The third area is that of assumption of risk which is simply too great an amount for a newly formed company to manage. This may be in terms of policy limits, extent of coverage or frequency with which losses are incurred. All can be equally damaging to the captive and ultimately, to shareholder value.

But in terms of enhancing shareholder value, what part can a captive play? Let’s just consider insurance for a moment. From a financial standpoint, an insurance policy is little more than a short-term contingent letter of credit that provides financial reimbursement should a predefined event occur. It is without recourse as you do not need to repay the principle nor is there any interest due from the Insured on payment of the claim. So, if asked how a letter of credit could maximize shareholder value then one could point to the lowering of the cost base whilst maintaining revenue. Quite simply, we reduce the number of basis points we are paying for the credit facility and consequently lower our cost base. We might assume some additional risk in so doing because the financial state of the institution providing the facility may not be as highly rated as the one first used. And so the parallel can be used with a captive. It is able to reduce the cost of insurance for certain risks and whilst an element of greater risk assumption may exist this can be mitigated by stronger management controls.

To continue with a letter of credit analogy, it may also be a key financial component in adding to shareholder value. Many of the acquisitions over recent years have been funded with various credit or debt arrangements. It may be that a letter of credit is the clinching part of a financing arrangement for an acquisition that will lead to greater shareholder value. So it has played its incremental part. Equally, the captive can be used to achieve a similar purpose. It may be able to provide the elusive cover needed to insure liabilities of a company being sold or to ‘warehouse’ liabilities of a company being acquired e.g. environmental, workers compensation reserves. Limited reinsurance arrangements can then be made but the captive has served to facilitate a much wider deal that is intended to maximize shareholder value.

A captive insurance company can of itself be used to produce actual direct additional revenue for its parent company. One of the

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