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The COVID-19 Pandemic: Opportunities and Implications for Captive Insurance

The COVID-19 Pandemic: Opportunities and Implications for Captive Insurance

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The COVID-19 Pandemic: Opportunities and Implications for Captive Insurance explores the challenges presented by today's business and economic upheaval, as well as the hardening insurance market, and what it means for the captive insurance industry.

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Derek Freihaut—Captive Insurance Person of Interest

November 28, 2018

Derek Freihaut, principal and consulting actuary with Pinnacle Actuarial Resources, Inc. (Pinnacle), recently spoke with about the concepts of risk distribution and expected adverse deviation. He also provided his thoughts about the role of an actuary in group captives.   

Tell us about your background and what led to your decision to become a consulting actuary. 

I majored in math and economics at Rose-Hulman Institute of Technology, where I met an alum who worked in the actuarial field and inspired me to begin taking exams. After graduation, I joined a large personal lines insurer and started my actuarial career. As I completed my exams and became increasingly focused on my future career path, I had the opportunity to join Pinnacle as a consultant. Since then, my career has taken me in more directions than I can count, and I continue to get involved in a diverse range of new and exciting projects.

After college, I decided to pursue an actuarial position because I wanted a profession that would build on my areas of study and allow me to apply that knowledge in a business role. I really enjoyed my early actuarial work and learned a lot about how the traditional insurance market operates while pricing personal and commercial lines coverages. When I had the chance to join Pinnacle, I jumped at the prospect of dramatically expanding the scope of my project work. Since then, both the clients with whom I work and the projects with which I am involved have far exceeded any of my expectations. I moved away from doing just traditional rate making toward working in the alternative markets with self-insured companies, captive insurance companies, and risk retention groups (RRGs). The variety of people with whom I collaborate is tremendous and always keeps me excited about what's coming next. 

What I did not expect when I got into consulting, however, is that the wide range of people I get to work with would be what I most enjoy. As consultants, we get to work with all kinds of clients and companies. Some of my favorite experiences have been working with customers outside of the traditional insurance industry. Explaining insurance to people who don't live in it every day isn't always simple, but I enjoy the opportunities to work with and learn from those in different industries.

Explain more about your role at Pinnacle and what differentiates the firm in the marketplace.  

I am a principal and consulting actuary with Pinnacle. My clients and roles include the following.

  • Traditional personal and commercial lines insurers that I advise on matters relating to setting rates and financial reporting of unpaid claims liabilities
  • Captive insurance companies and self-insured entities that I advise on matters relating to financial reporting of unpaid claims liabilities and funding
  • Accounting firms that I assist in their audit of numerous insurance companies
  • Reinsurers that I assist with risk transfer analyses and financial reporting of unpaid claim liabilities

We have over 28 credentialed actuaries, many of whom are widely recognized as industry thought leaders. Pinnacle is known for our expertise, our communication skills, and our customer service. We pride ourselves on our ability to explain complex issues in an easily understandable way and on helping our clients make better business decisions.   

Tell us more about Pinnacle's position in the alternative market space in terms of the types of services you offer.

Pinnacle's consultants have been active in the alternative market space for over 30 years. We work with some of the largest group captives in the world, with small enterprise risk captives (ERCs), and with everything in between, including self-insureds, single-parent captives, and RRGs. Given our length and breadth of experience in the space, we have relationships with many of the captive managers, auditors, lawyers, third-party administrators, fronting insurers, reinsurers, and regulators that work in the alternative markets.

As the actuaries working with various programs, our consultants regularly perform annual funding and reserve studies for captives, RRGs, and self-insured programs. We've developed a wide variety of industry benchmarks to help provide the most credible projections possible when working with smaller or new programs. These diverse benchmarks allow us to more closely match them with an individual program's specific exposures and results. Our expertise in the various forms of self-insurance—pure captives, segregated cells, RRGs, agency captives, large-deductible plans, and ERCs—enables us to provide our clients with valuable actuarial insights and to help them make better business decisions. For new formations, we work with clients on feasibility studies, which typically include a projection of a program's performance over several years. 

We understand Pinnacle has particular expertise in the area of group captives. Tell us more about the role of the actuary here.

The role of the actuary in group captives is rather extensive. The actuary is often brought in at the front end of the group captive to help produce the funding projections for new members based on their historical loss experience. On an annual basis, the loss history is updated for the entire program so the actuary can update the projected funding for the entire group. The actuary will also review loss reserves and estimate the incurred but not reported (IBNR) reserves on an annual or semiannual basis. A group captive reserve analysis also requires an allocation of the IBNR reserves to the individual members. The actuary is well equipped to assist the group captive in determining the best method to allocate reserves. 

Beyond reserve estimates and loss projections for captives, what other roles can an actuary play in a group captive insurance program's success?

Captive clients may additionally require actuarial assistance in dealing with a fronting insurer to help them with collateral negotiations (see related article, "Communication Is Key to Successful Collateral Negotiations"), negotiating their reinsurance rates and establishing the appropriate overall funding for the program. Actuaries are also brought in for specific issues related to individual members. For instance, perhaps a member is leaving the group midterm due to an acquisition and an actuary is needed to help the captive determine how much to hold from the member in recognition of the member's incurred but not reported reserves when that member exits.

Pinnacle has developed a new method, expected adverse deviation (EAD), to objectively determine if there are enough independent exposures to create risk distribution in a captive. Explain why a captive insurer needs to be concerned about risk distribution.

When a captive insurance company is trying to determine whether it qualifies as an insurance company, experts typically rely on a four-pronged test involving (1) the presence of insurance risk, (2) the presence of risk transfer, (3) the presence of risk distribution, and (4) whether the insurance contracts meet commonly held notions of insurance. Of these four criteria, risk distribution has received a lot of attention in recent US Tax Court cases. 

What role does an actuary play in assisting a captive insurer in the determination of risk distribution?

Multiple tax court cases have referenced risk distribution and noted the law of large numbers, specifically the need for an insurance company to have enough exposures to make accurate estimates of future losses. When we talk about the law of large numbers and a statistically significant amount of exposures, we are discussing actuarial topics. Pinnacle wanted to take a deeper dive into this issue to help captive owners better understand how risk is distributed in an insurance company and, from an actuarial point of view, help them measure the amount of risk distribution in their captives. 

Explain how Pinnacle developed the EAD method. (Editor's note: "Expected Adverse Deviation (EAD) as a Measure of Risk Distribution" is available for download via Pinnacle's website,

We did a lot of research and looked at a number of different tests that could be performed to determine whether there is risk distribution. Pinnacle ultimately settled on a metric called the expected adverse deviation. EAD represents the average amount of loss the insurance company incurs in excess of the expected losses or the expected amount of adverse deviation to which an insurer or insurance program is exposed. Once we have the company's EAD, we divide it by the expected losses and create an EAD ratio. Pinnacle reviewed the EAD ratios we see in traditional insurance companies and from captives that meet the safe harbor laws. This helped us understand what a typical EAD ratio would look like for a company that has sufficient risk distribution from an actuarial point of view.

Ultimately, what does the EAD model provide for a captive owner?

The EAD ratio is a helpful tool for a captive owner to better understand what impacts risk distribution and can serve as a metric to help determine when sufficient risk distribution is present. We have found the EAD ratio particularly beneficial when used to explain the impact of different decisions on a captive's risk distribution. The EAD ratio can help quantify how different reinsurance structures or the addition or exclusion of certain coverages can impact a captive's risk distribution. For a captive trying to determine if it has enough independent exposures to meet the risk distribution requirements without external reinsurance, an EAD analysis can be an invaluable piece of documentation.

Mr. Freihaut is a principal and consulting actuary with Pinnacle Actuarial Resources, Inc., and has over 10 years of actuarial experience in the property-casualty insurance industry. Mr. Freihaut is a Fellow of the Casualty Actuarial Society and a member of the American Academy of Actuaries. He currently serves on the AAA Committee on Property-Liability Financial Reporting. Mr. Freihaut has considerable experience in assignments involving loss reserving, funding studies, loss cost projections, captive feasibility studies, risk transfer analyses, and personal and commercial lines rate making. He can be reached by email. (Photo of Mr. Freihaut, above, is courtesy of Pinnacle Actuarial Resources, Inc.)

Copyright © 2018, International Risk Management Institute, Inc.

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