Captive Insurance and Capital Modeling: A Strategic Guide

Editor's Note: This article, "Captive Insurance and Capital Modeling: A Strategic Guide," is reprinted with permission from Oliver Wyman. It originally appeared in their 2025 report titled Navigating Financial Waters: Leveraging Capital Modeling for Investment Strategy and Risk Management. We are pleased to rerun this content on Captive.com to support ongoing education around capital optimization and enterprise risk strategy in captive insurance.

Let's unravel the complexities of capital modeling. Capital modeling is a crucial tool for organizations to effectively manage their capital while safeguarding against various risks such as underwriting, reserving, catastrophe, and asset risks—all while seeking to enhance financial resilience and preparing for the unexpected.

Traditional actuarial models encompass a range of use cases, including loss reserving and premium calculation, that leverage historical data to create reliable projections of future claim liabilities. Capital modeling enriches traditional actuarial models and provides a more dynamic, comprehensive, and strategic approach to measuring risk exposures and evaluating financial opportunities. By harnessing the powerful insights derived from capital modeling, organizations can look to enhance their resilience, improve decision-making, and better prepare for uncertainties that may lie ahead.

Keep in mind, captive insurers do not operate in isolation and are part of the organization's broader ecosystem. Assessing and understanding the parent company's risk exposures and financial landscape is crucial. Equally as important, the range of risks should not be evaluated in isolation; a synergized and unified approach uncovers the advantages of diversification, proving that the total capital at risk is often less than the sum of each individual risk assessed.

Exhibit 1 below illustrates this concept. When organizations neglect to utilize a capital model, they tend to assess risks in isolation, treating each one separately. As a result, risk managers often make suboptimal decisions because they do not consider the overall enterprise perspective. Evaluating risks on a stand-alone basis can lead to missed opportunities and less effective risk management.

Illustrative Case Study: Managing Your Captive with Capital Modeling

To further illustrate this point, let us examine a hypothetical situation regarding the capital at risk for "Organization XYZ" with a captive insurance company in a 1-in-100-year scenario. Assume that "Organization XYZ" faces underwriting risks related to general liability, workers compensation, auto liability, and property. The stand-alone capital at risk for each of these segments is $50 million, $10 million, $25 million, and $15 million, respectively, totaling $100 million. However, because these risks are not perfectly correlated (all events/claims are unlikely to occur at the same time), the capital model indicates that the actual capital at risk is $75 million. This indicates a diversification benefit of $25 million, which represents the difference between the total stand-alone risks and the amount produced by the capital model. This freed-up capital illustrates the value of capturing diversification. Moreover, diversification benefits can also be identified across various risk types, geographical areas, and business units.

Capital modeling helps corporations address these key inquiries:

CAPITAL MANAGEMENT

• Capital requirements: How much capital do we truly need to protect against volatility?
• Capital calls or additional capital needed: What is the likelihood of needing to draw capital from the captive insurer's owners or parent company? Under what market conditions are we likely to need to make additional capital calls to fund claims or other financial obligations?
• Decision triggers: What capital thresholds should prompt specific business actions, such as issuing a letter of credit or distributing dividends?

RISK STRATEGY

• Risk communication: What is our overall cost of risk across all lines? How can we effectively convey our changes in risk exposure to key stakeholders?
• Investment strategy impact: Based on our outstanding liabilities, how do we optimize your investment strategy to maximize returns and minimize risk, while staying within organizational risk appetite?
• Captive strategy: Do we have enough capital for growth and expansion? Would adding additional coverages reduce our overall total cost of risk?
• Reinsurance strategy: How much reinsurance is appropriate for our enterprise needs?

Potential Investment Breakthroughs from Capital Modeling

Captives are more than just entities that pay claims; they can also manage substantial assets to support their liabilities and maintain capital for adverse outcomes. The asset base presents significant untapped investment potential. Implementing capital modeling may provide various benefits, such as strengthening the enterprise risk strategy and identifying capital that can be deployed in higher returning asset classes to optimize overall return on capital. For instance, if an organization only holds capital reserves in low-yield, liquid assets, it risks missing out on higher returns from more diversifying investments. This oversight could result in lost opportunities to enhance the captive's profitability, lower risk, and increase its surplus.

By leveraging capital modeling, organizations can effectively assess the opportunity cost of holding capital. For example, why settle for low-yield investments that could be allocated across diversifying investment strategies that can drive revenue growth, maintain liquidity, and/or strengthen risk mitigation efforts?

To further illustrate this point, let's take a closer look at how historical and projected interest rates could impact your investment strategy (see Exhibit 3). Between March 2022 and November 2023, the Federal Reserve made significant moves to combat inflation, raising interest rates from near-zero levels to over 5 percent. This dramatic shift created a unique opportunity for organizations, particularly in the realm of money market investments.

However, in this uncertain and fluctuating economic climate, we anticipate potential changes in monetary policy that may lead to lower rates. Capital modeling enables captives to proactively adapt to changes such as changing interest rates. Organizations can remain agile and stay ahead of the curve by being dynamic while following a well-thought-out long-term investment strategy. This approach may significantly enhance the financial outcomes for a captive. With effective capital modeling, captives can safeguard their investments and uncover new growth opportunities. This approach allows them to potentially increase surplus assets, enhance resilience, and maximize returns on capital for the captive owner(s).

Strategic Investment Decisions: A Delicate Balancing Act

Captive insurers often take a conservative approach by maintaining high liquidity to meet their claim obligations. While this strategy provides a safety net, it can also lead to the opportunity cost or the loss of potentially higher returns from other investments. To maximize their financial potential and strike the right balance between reserving and growth, captives need to critically assess their current investment portfolios, which often include money market funds, demand deposits, and bank sweeps. All three options are designed for short-term use and are poised to prioritize liquidity in changing economic environments. Unlocking investment returns is a crucial lever for organizations who seek to reduce the overall cost of risks, especially for long-tail liabilities where assets are held for extended periods.

Current Challenges: Face the Headwinds

A key question for captive owners is as follows: Can your short-term investment strategy keep pace with rising inflation and increasing liability costs? Two recently evolving market developments may have significant influence on these pressures:

• Tariffs may drive up replacement and repair costs, directly inflating claim expenses.
• Social inflation is driven by more lawsuits and higher payouts, often influenced by public attitudes toward organizations. This results in increased costs for businesses, particularly in their insurance claims.

Seizing Opportunities: Harness the Tailwinds

Despite these challenges, captives can forge a resilient long-term investment strategy that endures inflation and supports business growth. Incorporating money market instruments, bonds, equities, and alternative assets into a long-term investment strategy can maximize yields, diversify economic exposure, and potentially enhance returns to counter rising liability costs.

The first step in managing a captive's investments is to take a quantitative approach by conducting an asset allocation exercise. This process enables the ability to strategically allocate capital across different asset classes, and considers several important factors, including liquidity requirements, cash flow patterns, and investment horizon.

Using Monte Carlo simulations to create an efficient frontier of optimized portfolios, captives can develop effective investment strategies. This concept involves a set of optimal portfolios that maximize expected returns for a given level of risk or minimize risk for a specific return. By applying this approach, captives can align with their financial and risk management objectives, potentially optimizing their risk-return profile while ensuring they maintain sufficient liquidity to cover potential claims.

Set Sail for Potential Success: Unlocking Optimal Portfolio Selections

To maximize the impact of their investment portfolio, captives must consider two interconnected factors:

• Risk tolerance: Assessing the likelihood that surplus funds may be needed
• Illiquidity tolerance: Aligning cash flow needs with appropriate liquidity levels

Charting Your Voyage: Developing a Strategic Investment Policy

Captives function as stand-alone, independent legal entities and may encounter distinct liabilities and risk-return profiles that differ from those of their parent companies. Establishing an investment policy statement (IPS), a formal document that outlines the guidelines and objectives for managing the investment portfolio, is a foundational step in acknowledging these differences in a governing document.

A strong investment strategy starts with a tailored IPS that reflects the captive's unique risk profile, appetite, and liquidity needs. The IPS outlines return objectives, income requirements, and acceptable risk levels, often differing significantly from the IPS used by parent company treasury departments.

Steering Ahead: Gain a Competitive Edge with Effective Capital Modeling

Capital modeling offers several advantages that can help enhance the operational efficiency of captives.

One of the primary benefits is informed decision-making and risk awareness. With data driven insights derived from capital modeling, captives are empowered to make intelligent business choices while accurately assessing their risk tolerance. This capability enables them to effectively communicate potential risks to stakeholders, fostering a strategic clarity that prepares them for financial adversities.

Another key advantage is risk optimization and diversification. By quantifying the correlation between various risks, capital modeling helps captives identify diversification benefits and lower their overall cost of risk. This insight allows them to optimize their risk retention levels, leading to substantial cost savings.

Finally, capital modeling integrates investment and risk management strategies. It ensures that investment approaches align with risk management priorities, facilitating effective capital allocation. This holistic approach maximizes investment income and enhances long-term financial security, positioning captives to thrive in a competitive landscape.

Capital Modeling, a Compass That Empowers Business Resilience and Stability

Capital modeling is more than just a numerical assessment; it serves as a vital compass that guides captives through the unpredictable waters of financial management. By applying the insights gained from capital modeling, captives can effectively navigate their financial strategies and strike a balance between risk management and investment potential.

This dual focus allows captives to address potential risks while seizing promising investment opportunities to enhance their economic value. Additionally, capital allocation decisions are crucial. Captive owners aim to minimize their capital contributions to the captive, enabling them to allocate resources across the balance sheet to areas that may yield higher returns on investment. This approach maximizes return on capital for the parent company while ensuring prudent financial management of the captive.

Just as an experienced sailor uses Global Positioning System and mapping technology to chart a course, captives can leverage capital modeling to steer their journey toward greater financial stability and growth.

In the vast ocean of finance, capital modeling empowers organizations to embark on a confident voyage toward risk mitigation and sustainable operational resilience. It acts as a North Star, guiding captives toward prosperity. As a powerful tool, capital modeling helps navigate volatility, optimizes risk and return, and fosters profitable, long-term success.

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