Captive Insurance as an Alternative Investment
Alternative investments are a popular way to diversify a portfolio. Examples of alternative investments include private equity funds, distressed securities, and commodities. In general, any investment that is not a stock, bond, cash, or real estate may qualify as an alternative investment. These investments traditionally deliver above-market returns and provide overall portfolio diversification. Alternative investments generally have low correlation with traditional finance investments and are protected against systemic market risk.
According to PwC’s asset management practice, the alternative investment sector is anticipated to grow 11.2% annually through 2020. If true, this would make alternative investments a $15.3 trillion dollar industry in the next four years.
Captive insurance companies are insurance companies. Properly managed captives provide substantial returns on investments, often exceeding 40% return on underwriting profit. Thus, captive insurance companies qualify as alternative investments and should be evaluated as part of a holistic investing strategy in order to increase the investors’ returns while simultaneously controlling and minimizing enterprise risks.
Historically, captive insurance has been a popular investment vehicle. The incorporation of a captive is a commitment from management to make money in the insurance industry. There are a number of publicly traded insurance companies that originated as captives. For example, Gold Medal Insurance Co. was a captive for General Mills, and Allstate was originally the captive for Sears & Roebuck Co. Currently, Allstate Corporation is the largest publicly held personal lines insurer in the U.S. and is the 2nd largest personal property and casualty insurer in the U.S. as measured by statutory direct premiums written.
Investment managers are a critical function of the captive insurance model. Assets placed in reserves for captives must be professionally managed by licensed managers. Any managers whose clients own companies should be aware of the value of captive insurance as a captive is a tremendously valuable financial vehicle for an investor to add to his portfolio.
Investing in Insurance
Insurance as an investment is not a novel concept. Syndicates with Lloyds of London have invested in insurance for centuries and possess a tremendous financial track record. The U.S. multinational conglomerate, Berkshire Hathaway, is another example of solid insurance investing. Berkshire Hathaway has substantial insurance investment positions, including GEICO, an automobile insurance company, Gen Re, a global reinsurer, and Berkshire Hathaway Insurance, a bond insurance company designed to insure municipal and state bonds. These investments generated an aggregate surplus of over $136 billion as of December 31, 2016.
Although Berkshire Hathaway invests in traditional insurers, the business models for a traditional insurance company and a captive insurance company are identical. The insurer assumes the risk of loss from persons or organizations that are directly subject to certain risks. These risks include property, casualty (liability), health, accident, financial, or other perils arising out of an insurable event. Insurers must maintain minimum statutory capital levels in their domicile of operations and must ensure solvency in order to pay the claims of the insured.
Captive insurance differs from traditional insurance in minor ways. The biggest difference is that the captive generally only underwrites the risks of the parent entity or entities providing the capital to create the company. Further, captives are less regulated than traditional insurance companies, which opens up new insurance opportunities, such as insuring hard-to-quantify risks and investing reserves in private equity assets (depending on the captive’s domicile).
Insurance Investment Metrics
Investors should view insurance as two distinct operations: underwriting and investing.
Traditionally, underwriting is the practice of accurately pricing risk and covering risks by placing the underwriter’s name under the total amount of risk the underwriter agreed to accept. Hence the term, “underwriter.” Modern underwriters generally manage premiums, assist with setting and taking down reserves, and manage the overall profitability of the insured risks. Factors affecting underwriting profitability include catastrophic losses and poor risk management.
For traditional insurers, underwriting strategy manages risk by employing disciplined pricing and risk selection. This generally develops profitable books of business throughout market cycles. Actuaries work closely with underwriters to provide sophisticated analytical, catastrophe loss and risk modeling techniques to ensure an appropriate understanding of risk, including diversification and correlation effects, across product lines and territories. This ensures that losses are contained within risk tolerance levels.
Investing is the second operation of an insurance company. The investment objective maintain liquidity and ensure healthy reserves on hand for losses. Investment quality and diversification are also considerations and are incorporated into any healthy investment strategy.
Most insurance companies, including captives, do not permit leverage or complex credit structures in investment portfolios on funds reserved for losses. Unencumbered funds may be invested with considerably more flexibility.
Assets held in reserve are invested in liquid investments in order to ensure that they are available to pay claims. Pre-tax investment income is invested in a balanced portfolio of cash, cash equivalents, bonds, and other assets. Captives may invest a portion of their unencumbered funds in private equity in order to maximize the investment returns. However, conservative investments are generally necessary for reserves in order to keep reserves on hand for claims. Solvency is one of the key considerations of any captive investment professional.
Investment management is best handled by financial professionals with proper accreditation and knowledge of the capital markets and institutional investing. Investment professionals managing portfolios for investors who own businesses should consider captives as a valuable investment opportunity to add diversity and value to the overall investment strategy.
Captive Insurance Investment Value Proposition
While traditional insurance is often a great investment, captive insurance offers many advantages over traditional insurance carriers.
- Captive insurance is tax advantageous. In the U.S., premiums paid for business insurance are deductible under Section 162 of the Internal Revenue Code. With captives, these revenues are also deductible. However, instead of forfeiting these premiums to third party entities, captive insurance companies capture these premiums and their associated underwriting profits. This creates a tremendous tax advantage for the parent company as it is permitted to deduct premiums paid for its own insurance and invest those premiums as reserves until claims are paid (if ever). If no claims are paid, then the reserves are eventually taken down and may be returned to the parent in the form of long term capital gains.
- Captive insurance companies provide tailored insurance for the parent organizations. This means that captives can insure risks generally unavailable or unaffordable on the marketplace. For example, cyber and reputational risk liabilities are increasingly large risks for a company’s online presence, but traditional insurance carriers generally overprice coverage or simply do not offer it at all. Captives can price out proper premiums for the risk and provide coverage to the parent at a tax advantage basis.
- Captive insurance stabilizes the parent company’s insurance premiums as captives are not subject to hard and soft market swings. This means that when the insurance market hardens and premiums go up, the captive’s premiums are unaffected and the parent’s financials weather the insurance storm. This stability provides for better financial modeling and projections.
- Captives provide direct access to the global reinsurance markets. This cuts out several brokers and middlemen, which means that captives can reinsure the parent’s risks cheaper than traditional carriers. Consequently, the overall insurance costs may be reduced through a captive program.
- Captive insurance companies turn a cost center into a profit center. The incorporation of a captive into the corporate structure introduces a new stream of revenue into the corporate hierarchy, creating an additional weapon for the company in the marketplace. As captives continue to proliferate through the market, more competitors will employ captives as part of a profitable risk management strategy providing additional capital at lower risk than competitors.
- There are no crowds with captive insurance. Historically, the best returns for alternative investments were gained before the crowds discovered them. Investors late to the game end up chasing vanishing returns. Captives are subsidiary creatures of private companies and the investment value of the captive is a function of the health of the parent company (the insured entity). If the insured entity incurs few claims, then captive insurance is a profitable investment. This means that captive insurance’s value is not a function of the overall investment market. The value of the captive rests in the profitability of the parent company.
Imagine the following scenario. The owners of Company X are currently paying $1,200,000 annually for workers’ compensation insurance. After several years without a major incident, Company X’s insurance carrier raises premiums. Since Company X has a great loss history, the owners are concerned that they are overpaying for insurance and they investigate alternative risk solutions. Their broker recommends them to consider incorporating a captive.
During the captive incorporation process, it is determined that Company X is overpaying for premiums and can reduce their annual WC spend to $1,003,030. WC programs are controlled lines and require a fronting carrier. The captive’s first year of operations profitability would look something like the following:
|Gross Written Premium Workers Comp||$1,003,030|
|Less Excess Carrier Premium||-$150,455|
|TOTAL Premium to Captive||$852,576|
|Captive Back Office Management Fee||$85,258|
|Senior Living Brokers||$85,258|
|TCI Management Fees||$12,000|
|Net to Potential Loss Fund||$643,560|
|Plus Invest Income||$19,110|
|Loss Fund + Investment Income||$662,670|
|Less Estimated Ultimate Loss (50%)||-$426,288|
|Net Profit /( Loss ) before Tax||$236,382|
|Underwriting Profit Margin||28%|
This underwriting profit margin outpaces virtually any other investment in the marketplace. Further, Company X now has the ability to control claims through the selection of defense counsel (assuming the fronting arrangement permits) and can exercise greater cost control. Further, the captive is now a second stream of income of nearly a quarter million in the first year alone. As the captive grows over a 5 year period we see increased profit margins:
Captive insurance is a powerful financial weapon that should be discussed by management. The benefits of captive insurance extend beyond risk management. These entities are tax efficient vehicles that add a new stream of revenue to a business. Consequently, they are a low risk tactic through which to add value to an investment portfolio.
Investment managers should discuss whether captives are a good fit with their client’s companies. These captives may end up providing greater returns than any other offering on the market.