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February 2006 Pulse Survey Analysis:
Are Captives Really Necessary?

 In partnership with captive.com, Towers Watson conducted this pulse survey to ask the probing question, "Are Captives Really Necessary."

This analysis was written by analysts at Towers Watson.

The February Pulse Survey proved quite popular, as it elicited 112 responses; 70% were from single-parent captives and the rest from group captives.

Single-Parent Captives

When captive insurance is compared to buying commercial insurance, 92.2% said the captive reduced their overall insurance-related expense. This is what we expected.

However, when we asked how well the captive protected its parent’s balance sheet compared to self-insurance, 78.4% said it did and 21.6% said it did not. In our view, because a single parent’s captive’s balance sheet is rolled up into the parent’s balance sheet, this is similar to self-insurance. Therefore, we believe the respondents may not fully understand the big picture and the true financial benefits that a captive offers. We agree that captives can help protect the balance sheet of affiliates, but not the parent. If the respondents truly felt the captive led to more rigorous risk management that actually reduced losses, then they would have answered correctly.

For the next question, “Compared to self-insurance, my captive reduces the volatility of loss at the parent level,” the answer again should have been “no,” as a captive’s financial results are rolled up to the parent level. Nevertheless, 68.6% said yes, 13.7% said no, and 17.6% were not sure. In our view, a single-parent captive does not necessarily reduce volatility at the parent level upon financial consolidation.

Finally, the response to the question “Does your captive achieve returns on capital comparable to or better than returns that would be produced had that capital been invested at the parent level?” showed a more balanced, if still confusing outcome: 51% said yes, 33.3% said no and 15.7% were unsure. This response likely depends on the parent’s business strategy for the captive: If the captive is designed to make a profit and show a high return on its capital, then it will of course look better than the return on the parent’s core business. A key question is whether this return is better placed in the parent’s business rather than in the captive.

Generally, Towers Watson has never been in favor of “overcharging” business units merely to show a high return on captive capital. We are, however, in favor of making profits in the captive if it is for strategic purposes When captive insurance is compared to buying commercial insurance, 92.2% said the captive reduced their overall insurance-related expense. This is what we expected.

However, when we asked how well the captive protected its parent’s balance sheet compared to self-insurance, 78.4% said it did and 21.6% said it did not. In our view, because a single parent’s captive’s balance sheet is rolled up into the parent’s balance sheet, this is similar to self-insurance. Therefore, we believe the respondents may not fully understand the big picture and the true financial benefits that a captive offers. We agree that captives can help protect the balance sheet of affiliates, but not the parent. If the respondents truly felt the captive led to more rigorous risk management that actually reduced losses, then they would have answered correctly.

For the next question, “Compared to self-insurance, my captive reduces the volatility of loss at the parent level,” the answer again should have been “no,” as a captive’s financial results are rolled up to the parent level. Nevertheless, 68.6% said yes, 13.7% said no, and 17.6% were not sure. In our view, a single-parent captive does not necessarily reduce volatility at the parent level upon financial consolidation.

Finally, the response to the question “Does your captive achieve returns on capital comparable to or better than returns that would be produced had that capital been invested at the parent level?” showed a more balanced, if still confusing outcome: 51% said yes, 33.3% said no and 15.7% were unsure. This response likely depends on the parent’s business strategy for the captive: If the captive is designed to make a profit and show a high return on its capital, then it will of course look better than the return on the parent’s core business. A key question is whether this return is better placed in the parent’s business rather than in the captive.

Generally, Towers Watson has never been in favor of “overcharging” business units merely to show a high return on captive capital. We are, however, in favor of making profits in the captive if it is for strategic purposes of building up a centralized risk financing pool of assets “for a rainy day.”


Group Captives

When captive insurance is compared to buying commercial insurance, 85.2% of group captives answered that the captive reduced their insurance-related expense. Again, this response seems logical, especially during the recent hard market. It would be interesting to know the answer in soft markets.

Whether the captive better protected the owner’s balance sheet compared to self-insurance also got a high 88.9% affirmative response. This response again seems logical, because a group captive is closer to true insurance as the risk is transferred from the policyholder to an outside insurer (the captive), and assuming there is true risk sharing among the group. The policyholder’s risk in the captive is then that of a shareholder. (If the group captive is a cell captive that does not share risk with others, then the answers should be compared to those of a single-parent captive above.)

Does the captive reduce the volatility of loss at the parent level compared to self-insurance? 70.4% said yes, 7.4% said no and 22.2% were unsure. This response is expected, since a group captive creates risk diversification and risk is transferred away from a policyholder compared to self-insurance.

On the question of whether the captive achieved returns on its capital comparable to or better than returns that could have been invested at the parent level, 51.9% said yes, 18.5% said no and 29.6% were not sure. We believe this ambivalence is more logical than that observed above in the single-owner responses, given the use and role of group captives and the many different ownership objectives we encounter.

This raises a major issue: Why do so many group captive programs continually look to reduce the premiums to their captive, and conversely, why do so many divert more funds than necessary from their core business? Shouldn’t they be “just right?”

We asked these questions following the lead articles in the February issue of the Captive Insurance Company Reports: “Captive for Sale and Debate: Are Captives Truly Necessary.” The key reasons one captive owner decided to sell his captive were because he did not believe the captive protected his firm’s balance sheet, nor did it reduce earnings volatility. One survey respondent concurred with the captive seller when he wrote, “Captives are grossly overvalued when considered on a pure economic basis.”

One last comment: There may be another, more cynical interpretation of these erroneous responses. What if many of the respondents were not the owners and users of captives, but the service providers and vested-interest managers — the captive promoters, in other words? These individuals would have had reason to say that everything about captives is “yes” and that there aren’t any “no’s.”

Final Caveat: We are not accountants, and answers to some of these questions really involve accounting interpretations. We invite knowledgeable accountants to comment.

 

captive and ART resources