Measuring the risk

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Once the objectives of the study are defined and the potential risks to be included in the analysis are identified, the data analysis can begin. The data and financial analysis is the heart of the feasibility study. In the end, this analysis (that includes a competent actuarial study) will likely play the biggest role in determining whether a captive is going to be an appropriate alternative risk financing solution. Just keep in mind that it is not the only factor in this decision. A good feasibility study will evaluate the myriad of issues that go beyond the pure Financial considerations to get the best picture of whether a captive is an appropriate investment.

In terms of measuring the pure financial considerations, the following are some of the key components:

Retained risk and loss projections- The feasibility study will identify which risks the captive is willing to retain and at what levels.

Expense budget for the captive- The captive insurance company is and must be run like a separate, self-sustaining business. Therefore, it must have a clearly defined operating structure with associated expense budget. The CFS provides the owner the opportunity to fully understand and define this expense structure.

Tax impact- Tax implications should never be the sole or even predominant reason for forming and running a captive insurance company. In fact, if there is no other compelling reason to form a captive beyond some tax advantage, you can expect the IRS to challenge the captive’s existence. However, there is nothing wrong with an organization forming in such a way as to produce a favorable tax outcome.

The taxes that should be addressed include:

  • U.S. (or other country) income tax
  • Excise taxes
  • Excess and surplus lines taxes
  • Domicile premiums taxes
  • Local premium taxes
  • Other taxes/assessments

Premium strategy- The captive will need to ensure that it has a clearly established premium rate structure and individual rates for each line of coverage. By presenting these premiums by line-of-coverage, the captive owner will be able to estimate the total expected premium contribution, which will help determine the overall required capital necessary to support the captive.

Capitalization- The reason there is a capital requirement is to ensure that the captive can support the risk that it is assuming. It makes sense for the captive to be adequately funded but not over-funded. Ultimately, capital requirements will be determined by a combination of captive-funding needs and the domicile’s statutory requirements. The quality of the capital estimate will be based on the quality of the information used to arrive at those estimates. That includes the credibility of loss projections, the quality of the rate-setting process, and the claim-management procedures that will be put in place among other processes.

Pro forma financial statements- Since the captive will be an independent operating insurance concern, it will need to show profit and loss projections. A five-year horizon for the pro forma financials is appropriate. These financials should include:

  • Income statements and balance sheets
  • Five-year pro forma results
  • Presentation of tax consequences
  • Financial assumptions (interest rates, growth rates, cost of capital, etc.)