5 Questions for Captive Insurance Companies in 2021
January 20, 2021
Welcome to 2021. Let's hope the optimistic predictions for this year turn out to be true. My New Year's reading includes 5 Questions for 2021, a report by Jason Thomas, head of global research at the Carlyle Group, published January 13, 2021, on the Carlyle website. It is worth reading in and of itself, but I thought I might adapt its global investing theme for the captive industry.
These are questions I believe captive managers and boards should be asking as they survey the environment in which they operate. Frankly, there are a lot more than five questions that should concern captive leaders. However, these are the ones I put at the top of my list. Readers are always welcome to respond with their top questions as well.
Obviously, reinsurance is a major concern for most captives. A captive insurer's ability to underwrite risks important to its owner(s) is directly correlated to its ability to secure the necessary reinsurance coverage needed to limit its exposure. One of the websites that I follow to stay on top of developments is Reinsurance News. Worth noting are two recent articles based on analyses by Aon and Morgan Stanley of the state of the markets.
"Capital Supply Sufficient To Meet Foreseeable Reinsurance Demand: Aon," a January 14, 2021, article by Charlie Wood, concerned the supply of capital within the reinsurance industry. "Overall, supply is considered sufficient to meet foreseeable reinsurance demand, but is likely to be deployed at better terms than have prevailed previously," the article says, citing Aon analysts' findings. However, the Aon analysts note some areas of concern, according to the article, including "the ultimate cost and distribution of COVID-19 losses" and "social inflation's potential threat to casualty reserves."
In "Analysts See Potential for More Notable Rate Rises at Upcoming Reinsurance Renewals," a January 8, 2021, article by Luke Gallin, Morgan Stanley commented on the outlook for reinsurance pricing in 2021, after the preliminary results of the January 1 renewals became available. According to the article, Morgan Stanley analysts noted, "Risk-adjusted gains in the mid-single-digits is a marked improvement on the flat to –5 percent rate movements witnessed in Jan[uary] 2020, but … remains below expectations."
Not surprising then, the question for captives as we begin 2021 regarding reinsurance is, Will capacity be available and at what price? Failure to either secure the requisite capacity or to underprice its cost can be detrimental to the captive's financial stability.
One of the Carlyle report's five questions for 2021 is, "What does the Fed's new policy framework mean for asset prices?" For captive insurance companies, there are two components of their investment portfolios that bear watching. One is quality, and the other is yield.
Kroll Bond Rating Agency publishes updates on its outlook for fixed-income asset classes. I would recommend reading its outlook on both commercial mortgage-backed securities and asset-backed securities. While not all captives hold these asset classes within their investment portfolios, a significant number do. Both commercial real estate and asset-backed securities face significant headwinds that could impact creditor ratings and hence pricing.
For captives, the question that should be asked is, How strong does our overall portfolio look, and are there sectors and/or securities we should be concerned about? With rates this low, downgrades and credit defaults will have an appreciable effect on a portfolio if they materialize.
We have never witnessed such a rapid transformation of work as the pandemic has caused. If I had told you early in 2020 that almost all work would be conducted remotely and business travel would come to a standstill, how many of you would have laughed me out of the room?
The pandemic has had a profound impact on how business is conducted. Many of the major tech firms have announced that they will continue to allow staff to work remotely in 2021. As the Carlyle report states, "In the US, as the pandemic dragged on and 'back-to-the-office' imperatives diminished, people not only fled cities for suburbs but also left many major metro areas entirely, with significant out-migration from New York, Chicago, and California. Will the ongoing exodus from crowded and high-cost metro areas force employers to embrace remote work to compete for talent, exacerbating the slump in high-density markets?"
For captive insurance companies, this new reality could turn out to be either a blessing or a curse. The question for your captive is which of these it's likely to be. For captives that utilize captive managers, what will happen to their workforce? Before the pandemic, we had talked about the war for talent. Should the economy pick up the way economists are suggesting in the latter half of 2021, this war will reignite but with drastically different rules. Now you can work from anywhere, so how will your captive manager deal with this new reality?
Conversely, for those captive insurers bold enough to consider the idea, you could conceivably hire your own management team. This could result either because you are located in a part of the country that is now favored by educated individuals or because you embrace the remote work concept.
I need to tread lightly here because people may perceive this as a political statement. My guess is the regulatory environment is likely to become stricter with the change of administrations. Recent announcements concerning the proposed directors for both the Securities and Exchange Commission ("Gary Gensler, Biden's Pick To Head SEC, Has Reputation as Tough Regulator," by Martha C. White, NBC News, January 18, 2021) and the Consumer Financial Protection Bureau ("Biden's Lead Picks for the Securities and Exchange Commission and the Consumer Financial Protection Bureau Show He's Making Compliance and Regulations Great Again," by Jack Kelly, January 19, 2021, Forbes) would suggest this is likely on a federal level.
While insurance continues to be highly state regulated, as federal regulation becomes stricter this has a spillover effect on state regulation. The industry as a whole needs to be cognizant about how this plays out and stay vigilant. Areas you should think about include rating and pricing models, taxation, and closer integration of worldwide captive insurance regulation.
Strategy and Planning
While I list this last among the five questions, my opinion is that it is the most important. The amount of change we witnessed in 2020 should convince anyone to pay more attention to strategy and planning. I wince when I hear statements concerning the vaccine rollout like the following: "people are thinking we had months and months to prepare for this." We thought a vaccine would eventually be developed, yet no one had the foresight to begin to plan for how to handle its distribution? Running a business this way would lead to chaos. Leaders are paid to think about eventualities.
This is true for captives as well. There is no excuse for not using war-gaming as a strategic tool. In my 40-plus years, I've heard all the excuses: it takes too long, it's too complicated, we don't know the answers. It all boils down to leadership. If you serve in those positions for your captive, you have a fiduciary obligation to think strategically.
As always, we encourage your feedback and commentary. Please feel free to email John Foehl directly at [email protected].
January 20, 2021