Ask the Experts: The Dynamics of Captives & an Uncertain Economy
We are all feeling the impacts of inflation, and as the word “recession” continues to be a popular one among political, economic and social conversations, we thought we would sit down with our captive insurance experts (Karin Landry, Prabal Lakhanpal and Peter Johnson) to get their two cents on how a possible recession or economic downturn interplays with risk and financial management tactics, with a focus on captives. Here’s what they had to say.
1. What are some possible impacts of a recession on captive insurance companies?
Peter: Changes in risk profiles driven by economic changes (examples include commercial auto frequency moved down then up, cyber ransomware on the rise, healthcare workers’ compensation programs utilized, excess liability/umbrella rates increased substantially, etc.). This also impacted the commercial market and captives often stepped in to fill the gap.
Prabal: Changes in exposure units: a recession may lead to reduction in workforce and therefore a change in insurance spend. On the employee benefits side, during times of uncertainty we typically see an increase in disability claims as well as a spike in usage of health insurance. When taken together with the change in exposure units, benefits programs may see a reduction in performance.
Karin: A continued increase in captive interest. Clients are looking at different ways to save money during a recession. For those organizations that already have captives, risk managers will need to prove the value of the captive, as typically there are a lot of dollars funding reserves that management wants access to in order to improve cash flow during a period like a recession.
2. Are there steps captive owners can take to safeguard their captive against a recession? If so, at what point should they implement them?
Peter: We recommend having service provider and reinsurer relationships in place to be enable the ability to make quick changes and file a captive business plan change to adapt according to the market.
Prabal: For existing captives, we advise undertaking a captive optimization or “refeasibility study” every few years, and this will be especially important if we enter a recession. This process assesses captive performance against original goals, aims to realign the captive according to changes in corporate objectives or priorities, evaluates impacts from recent regulatory changes and/or market trends, considers additional lines, analyzes the domicile, and so forth. Captive optimization helps organizations understand the vulnerabilities of your captive and help you shore them up.
Further, have your actuaries undertake stress testing of the captive to ensure financial stability and consider getting rates as a captive, where appropriate. Then, implement a dividend return policy, which ensures that in the time of need, there is a clear outline of how the parent organization can access any surplus in the captive. Be careful here as you don’t want the parent entity drawing down the surplus so much that the captive loses financial strength.
Karin: Risk managers should determine whether or not their captives are optimally funded. They should calculate the value of the captive to the organization before it becomes a management issue. They should explore other lines of coverage to determine whether or not it will save money, improve investment income, and/or increase cash flow for the organization going forward.
3. How would a recession affect underwriting?
Prabal: Insurance companies have two main revenue streams: 1) underwriting income and 2) investment income. In a recession environment, investment income becomes less likely or harder to come by. Therefore, underwriters are laser-focused on ensuring underwriting income, resulting in tighter underwriting standards. For example:
Peter: Carriers often tighten underwriting standards and may refuse to underwrite certain risks and/or business types all together. We’ve seen this for certain casualty lines like cyber, GL, and excess liability. Carriers may also be forced to remove manual rate discounts and/or increase rates all together while narrowing coverage at the same time.
Karin: Because underwriting practices may tighten, risk managers must understand their organization’s risks better than the marketplace. You could find that your experience is better than the book of business at the carrier level. If this is the case, a captive may make sense.
4. What about reserving?
Peter: To the extent a carrier’s or a captive insurer’s reserves are in a strong position due to favorable experience, reserve releases can be expected and may offset some of the poor 2022 investment experience we’ve experienced. The opposite also holds for exposures with loss trend on the rise that are driving up overall loss costs.
Prabal: Actuarial stress testing of the captive also comes into play here to ensure stability and dividend return strategy so that there is a consistent approach.
Karin: For captives that book discounted reserves, changes in the discount rates will affect the level of reserves captives carry. For those lines of coverage that are sensitive to recessions like workers’ comp and disability, the impact of negative experience should be factored into the reserving process.
5. Could the economic environment cause changes in captive methodology or the lines placed within a captive?
Peter: We’ve seen captive owners become more interested in captive utilization particularly when they feel like carrier coverage and pricing is unjustified based on their own loss experience.
Prabal: Captive optimization helps with optimal capital utilization. In a recession where capital is scarce, companies benefit from being efficient with how they use it.
6. What sort of pressures might captives face during a recession in terms of loan backs or dividends to the parents, or any impacts on capitalization?
Peter: We’ve certainly seen dividend policies put into place for certain clients that have been hit harder during the recession than others. Some have looked to access their captive capital that was built up to significant levels over the years.
Karin: As noted earlier, management may see the reserves of the captives as a pot of money to access; proving the value of the captive negates that issue.
7. The Great Recession around 2008 caused a stall in captive formations. Do we think that could happen again?
Peter: It seems fairly unlikely to have a similar scenario to 2008 since a portion of the collapse was driven by extremely poor mortgage underwriting standards in place. But anything is possible.
Prabal: Further, unlike in 2008, the commercial markets are still in a hard market cycle. This will likely be accentuated in a recession and therefore yield an increase in captive formations.
Karin: Because capital is scarce during a recession, this may spur the use of cell captive programs as opposed to pure captives to meet the needs that risk managers have to control costs and minimize price increases.
8. Anything else related to economic volatility that captive owners and risk managers should keep in mind?
Prabal: One thing would be the potential to free up captive capital by using loss portfolio transfers. The current interest rate environment is likely to create a preferential market for these opportunities.
Karin: Organizations’ hurdle rate might change as a result of the recession. This would necessitate looking at the opportunity costs associated with captives and their reserving process. Additionally, organizations should evaluate their insurance partners to make sure they are sound as they will be grappling with some of the same recession issues noted here. I wouldn’t be surprised if some of the insurers experienced difficulties and either left the marketplace, contracted and changed the coverage levels that they offer, and/or focused in on certain risks while excluding other risks from their policies in accordance with market shifts.