Optimizing Your Captive's Risk Profile: 5 Key Considerations
A few years following its launch in the early 2010s, a captive insurer decided to review its original retention levels to see if they remained aligned with its parent company’s financial objectives when the captive was established. As companies change, their optimal retention levels may as well.
If you own a captive, you need to determine how much risk to retain to maximize captive value. It’s a simple question. Answering it isn’t so easy, but you can start by considering these five key factors:
- Confidence levels. The funding for a retained limit grows with increasing confidence level. Confidence level refers to the amount of funding required for the captive owner to be “X% confident” it can pay its claims in full. A captive may be funded at the “actuarial expected level,” representing the median expected loss, or at another (typically higher) level. Once you choose the confidence level, the estimated ultimate losses could be determined at several alternative per occurrence and aggregate retention levels. These funding estimates would be complemented by the premium for excess insurance attaching above the captive retention to afford coverage up to the desired gross limit.
- Excess insurance pricing. Market cycle, dislocations in market prices, attachment point/limit, experience of the underlying insured, and the nature of the coverage affect excess insurance pricing. While a lower captive retention level reduces balance sheet volatility, it may mean unpalatably high excess insurance premiums. The optimal solution balances the volatility of retained losses with the cost of associated excess cover.
- Overall cost of risk. Use a simple equation to calculate overall cost of risk: Captive loss funding at the selected confidence level + excess insurance premium + captive operating and administrative expenses = overall cost of risk. The captive owner should seek to minimize this total amount to optimize its risk profile. This minimum “sweet spot” of retained losses plus excess premium plus expenses lies within a range of potential retention scenarios.
- Opportunities and issues with lower retention. A lower retention level produces less volatility on the captive balance sheet and a lower risk of high frequency and/or severity claims. However, the lower retention typically costs more than a higher retention in the end and reduces cash flow, which otherwise could generate investment income between collection of premium and ultimate claim payouts.
- Opportunities and issues with higher retention. Captive owners may elect a higher retention, reducing sensitivity to market changes and excess coverage costs. Further, the more loss that is retained, the greater the incentive for cost control. Conversely, a higher retention typically requires greater internal expertise (or the need to hire a third-party administrator), and it may provoke interdepartmental cost allocation issues within the parent company.
In sum, captive owners must review the costs of funding for losses at several tolerable retention levels in tandem with the costs of excess cover and administrative costs required to achieve its parent company’s gross coverage objectives. But optimizing the captive’s risk profile can provide significant value to the organization.
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