Why Cash Flow Is Key for Captive Insurers

Man Holding Stack Of Hundred Dollar Bills Over Money

May 17, 2018 |

Man Holding Stack Of Hundred Dollar Bills Over Money

The Captive.com "Key Concepts for New Captive Board Members" captive basics series contains several articles about keeping your captive financially sound. (See a complete list of links to these articles under the "Related News" heading at the end of this article.) The lead article in the series discusses the importance of understanding captive insurer financial statements, particularly the cash flow statement. Specifically, it states, "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 [risk retention groups] 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." Therefore, cash flow is key for captive insurers.

This article delves deeper into the cash flow statement and discusses areas in the report requiring board member focus. Board members, especially those without a finance background, ought to gain a greater appreciation for why this single financial statement is such a valuable source of information about how well a captive is really performing.

This discussion breaks things down by specific major categories and walk through the differences inherent in each in terms of accrual and cash accounting. Almost all captive insurers use the accrual accounting method. Entrepreneur.com defines accrual accounting as an "accounting method that records revenue and expenses when they are incurred, regardless of when cash is exchanged. The term 'accrual' refers to any individual entry recording revenue or expense in the absence of a cash transaction."

Therein lies the problem for most nonfinancially trained board members. While a captive may be revenue/net income rich, it is also possible for the captive to be cash poor. And at the end of the day, what matters is whether there is cash on hand when it is needed. For those who doubt this statement, just Google "Lehman Brothers liquidity crisis" for a case study in what happens when you run out of cash.

Here are the categories that captive board members should pay particular attention to.


For most captives, premiums (or contributions) will be the major source of revenue. For primary property/casualty carriers, premiums represent between 65 and 75 percent of their annual revenue. Under accrual accounting, premium revenue is usually recognized ratably over the course of the period of time the coverage policy is in force. So for most captives, this will be 1 year. Premiums are typically billed before the policy is in force, and there is normally very little lag between the billing and collection of the premium. But captive board members should be cognizant of several areas that can impact this difference—installment billing, multi-year contracts, or retro contracts. If offered by the captive policyholders, these setups can result in the revenue recorded differing from the actual cash collected from policyholders. Therefore, board members should pay attention to the premiums receivable account, especially when this account is increasing in size without a commensurate increase in written premiums.


We've covered this topic before in captive basics in the article "Captive Insurance Assets and Investment Policies," but several comments are relevant to this cash flow discussion. First, recognize that investment income is subject to timing differences, which can lead to differences between revenue reported and cash collected. Bonds, which comprise the majority of most captive insurer investment portfolios, typically pay semi-annually, and stocks pay dividends on a quarterly basis. This means that revenue may be reported on the statement of operations, but not yet collected. For most captives, this discrepancy will be minor, but it bears monitoring.

Captive board members should also be aware of the difference between total return and book yield. The latter is composed of the interest and dividends payments referenced above, while the former includes these items plus unrealized gains/losses on the portfolio. Remember, total return only becomes true cash when the security is sold. There is no way a captive can use unrealized gains in the portfolio to pay claims losses and expenses. And unless your captive is tax exempt, realized gains will always be less due to taxes.

A tangential cash flow problem in the investment portfolio is liquidity. In the event your captive needs to raise cash quickly, how rapidly could the securities in the portfolio be converted to liquid cash, and what's the likelihood that there is a shortfall between the market value and the sales price due to a forced sale? Captive board members should also have a working knowledge of the increased liquidity concerns with today's bond market.


Another area where captive insurers have fallen victim to cash flow problems is with reinsurance. The key here is to make sure your reinsurance contracts have some type of interim payment clauses in them. Why is this important? Think about a large property loss, potentially involving some sort of catastrophe. Your policyholders are going to expect you to make payments on these claims as soon as they have submitted notice of their loss and provided reasonable documentation supporting the claim. However, many reinsurance contracts may require the insurer to pay 100 percent of the anticipated loss before seeking reimbursement, and then the reinsurer may have up to 90 days to make its payment back to the insurer. If your captive had to pay a $10 million or $20 million loss immediately and wait for several months to collect against your reinsurers, could you do it? And, in doing so, how liquid is your investment portfolio, and what losses might you incur there as a result of having to sell quickly?


The reason Warren Buffet likes the insurance business is due to the float involved. Float can best be described as the timing difference that occurs between the collection of premiums and the payment of claims. This timing difference allows for the cash collected from premiums to be invested to generate additional revenue from investment income. For captive insurers, cash flow problems from claims arise from a number of factors. 

Does your captive normally generate an underwriting profit, or are you reliant on investment income to pay losses? Relying on investment income is a recipe for a cash flow crisis at some point in time. Any number of things can trigger the crisis—larger than anticipated losses (severity), a larger number of claims (frequency), a change in the tort environment, higher than anticipated claims inflation, adverse development, or reinsurance (as mentioned above). Captives, because of their size, are more susceptible to the above scenarios triggering a liquidity event (lack of available cash). 

From a claims perspective, management should prepare a monthly cash flow estimate—how much actual cash is on hand, how much cash inflow is anticipated, and how much cash outflow is required to pay claims and expenses. Part of the rationale for captives to have a more conservative investment policy is to ensure there are sufficient liquid short-term investments to cover anticipated and unanticipated shortfalls in cash flow from daily operations. A captive board never wants to be in a position to have to explain to its policyholders why there is going to be a delay in settling a claim.


To reinforce these concepts, captive board members should have their auditor do a presentation on cash flow, including the various issues specific to insurance companies that the auditor has seen. This can be an invaluable part of a risk management program and can potentially prevent problems before they occur.

May 17, 2018