20
bermuda captive | 2010
In an Organisation for Economic Co-operation and Development (OECD) report titled Risk Management & Corporate Governance, which was prepared after the financial crisis of 2008, the main finding stated that: “The balance between risk-taking (the life blood of the free market) and risk avoidance is no longer functioning. Similarly, the balance between remuneration and ethical behaviours no longer operates appropriately. The oversight of these two principal balancing acts, which should be exercised by the board does not function properly because the assurance functions are not given sufficient weight.” While it is true that the scope of the OECD report was large banks and large financial institutions, the message is clear: the corporate governance, risk assessment and risk management functions in US and UK corporations are broken.
The avowed crisis in corporate governance, risk management and compliance (commonly referred to as GRC in large public companies), coupled with globalisation, captive tax challenges by the IRS in the US and Solvency II in the European Union, have caused captive managers and boards to face an increasing level of awareness and responsibility for GRC.
Captive boards must be prepared to step up their governance and
oversight activities in all areas of GRC, but particularly their risk assessment and risk management activities.
GRC should not be viewed as a series of half-executed board-level policies that are initiated to satisfy some checklist or other regulatory requirement. It should not be viewed as a ‘bolt-on’ to the business operations, but rather, as an overriding framework within which the business runs and operates. The main problem, in A.M. Best’s view, is that GRC is one of those pesky investments of resources where the costs are abundantly clear, measurable and timely, but the benefits are fuzzy as to their direct source and how they will manifest themselves at some point in the future. But manifest themselves they do.
A.M. Best has been publishing insurer insolvency statistics since
1969 in the form of an annual insolvency study, which captures rated and non-rated insurer impairment, including captives. According
to this study, the leading causes of insurer impairment that pertain particularly to captives are deficient loss reserves and inadequate pricing (38.1 percent), rapid growth (14.4 percent) and overstatement of assets and investment problems (8.9 percent). These three causes of impairment combined account for 61.4 percent of all insurance insolvencies but represent a higher proportion of captive impairments.
All of these primary causes of impairments were related to some
form of mismanagement in the opinion of A.M. Best. The implication is that all of these causes of impairment can trace their roots to the failure of management and the board to properly assess and address the risks of the company.
Deficient loss reserves and inadequate pricing When loss reserves are found to be deficient, the insurer must
strengthen its reserves, thereby depleting its capital and surplus—in other words, the margin of safety between solvency and insolvency. Impairments from this generally manifest themselves in casualty insurers either during or shortly after a soft market.
A captive that writes a material amount of casualty business is prone to this area of risk due to the myopic scope of most captives’ actuaries, who generally use industry loss patterns to supplement the captive’s loss experience when setting reserves, particularly incurred but not reported (IBNR) reserves. This makes the captive’s reserves prone to development, either positive or negative, depending on how closely the captive loss experience correlates with the industry figures. Additionally, most captives outsource their claims-handling to a third- party administrator (TPA).
The outsourcing, while efficient from an expense perspective, can isolate the day-to-day claims-handling and case-reserving practices from management. The TPA is generally given a set of ‘claims-handling instructions’ that detail procedures and some sort of reserve and/or settlement authority. In addition, management may or may not have access to adjuster notes, which bring additional colour to the day-to-
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