Captive service providers—A critical element

Use care when selecting third-party service providers

By Michael J. Moody, ARM, MBA

Tracing the history of the captive insurance company movement over the past 30-plus years, one can see that captives have moved from unique funding mechanisms to a mainstay in the overall risk-financing community. The captive industry has shifted from a somewhat exclusive option for select, mainly Fortune 500-type companies, to a more vital risk-financing option that services almost every line of business and market sector. With well over 5,000 captives worldwide, they have clearly become a major component of the alternative risk marketplace, and most experts agree that growth will continue.

Over this timeframe, a number of trends have arisen within the captive industry. However, one of the core practices within the industry is the reliance on third-party service providers to be responsible for the majority of the captive’s operations. Captives have exemplified how to successfully utilize outsourcing. For the most part, whether single parent captives or group captives, they depend heavily on various outside organizations to provide key services for their day-to-day operations.

Service providers to the captive industry come in all sizes—everything from large international operations to smaller independent firms. Among the more important service providers that captives must consider are captive managers, claims managers, reinsurance brokers, auditors, lawyers, actuaries, investment managers, and consultants. In most cases, the specific services provided by each of these groups can be designed to fit the particular needs of the captive.

Each service provider has an important part to play in the overall operation of the captive. However, one of the most critical service providers remains the captive manager. In many instances, that person is a key component to the long-term success of a captive. As such, special care must be taken when selecting a captive manager.

Attention to detail

Historically, there have been few requirements placed on captive managers. In many domiciles, most captive managers can start operations with a minimum of time or effort. Further, there is little ongoing analysis of their work product in most domiciles. However, recent developments in several key domiciles would appear to indicate that this trend is changing—and changing rapidly.

Late last year the South Carolina Department of Insurance issued a media advisory that stated that the insurance director was establishing new standards for captive managers. Among other things, the new standards would include specific requirements for factors like character, reputation, and financial responsibility as well as insurance experience. The South Carolina Department of Insurance noted the importance of the captive manager in the overall success of the captive when it stated that, “the success of captives starts with maintaining the highest standards for captive management companies.”

The South Carolina director also points out that captive managers are one of the regulator’s most valuable assets. By implementing a more regulated environment, the Insurance Department hopes that the state can build on its quality reputation. Additionally, the insurance director believes that this type of standard will become an accepted practice throughout all domiciles.

Last year also marked the beginning of a more regulated environment for captive managers in Bermuda. That was the year that the Bermuda Monetary Authority (BMA) implemented the “Insurance Manager On-Site Review Program.” The program was intended to provide an efficient means of supervising Bermuda’s captive insurance managers. The BMA will do this primarily through an evaluation of the effectiveness and compliance of the corporate governance and internal control systems of captive managers.

The BMA notes that the review will include on-site visits, filing required documentation and prudent meetings with senior management. In implementing the new program, the BMA states it is “in line with international standards of risk assessment and management and has been well received by the industry.” In that regard, it should be noted that the Cayman Islands has a similar program in place.

A word to the wise

Pamela Woodroffe, CPA, founder and president of Collins Consulting and CC Consulting Bermuda Ltd., points out that there are various items to keep in mind when selecting and retaining a captive’s service providers. Since 1992, Collins Consulting has been conducting operational reviews of captives and RRGs in addition to conducting numerous full-scope financial examinations in accordance with NAIC standards for the District of Columbia’s Insurance Department. Based on her experience, she offers the following suggestions for captive owners to consider.

She notes that captives typically come together in one of two ways. In the first scenario, the originators of the captive hire an independent consultant to assist them with starting up the captive. The consultant obtains an understanding about the owners of the captive and then assists the owners with developing a feasibility study which includes the selection of the service providers.

In this case the consultant makes recommendations based on the individual needs of the captive. Regarding this aspect, Woodroffe states that it is important to make certain that the consultant has an independent view and has the knowledge the owner needs to move ahead. “They should have fresh, current information upon which the owner can make decisions,” she says.

In the other approach, the originators of the captive appoint a captive manager at the inception of the process and let the captive manager recommend the service providers that they work with most closely. A good captive manager should strive to build relationships with service providers that are best suited to meet the needs of the client.

While there are benefits to both approaches, Woodroffe says, “new and existing captive owners need to ensure that service providers are adequately meeting their needs, regardless of how the relationship got started.” All too often the captive owners settle for mediocre service because they don’t believe that they are in a position to rock the boat. Or they stop paying attention to the service they are receiving from their service providers once they have been engaged. Woodroffe recommends that the selection of each service provider “be carefully weighed and their performance be reviewed on a regular basis to ensure the captive is getting the services they need to be successful.”

As was noted above, the role of the captive manager cannot be minimized. As a result, Woodroffe points out that it is not adequate to just get references. “You should also get a list of existing and prior clients, particularly in the domicile in question and speak directly to the other captive owners,” she says.

Woodroffe also states that it is very important that the captive manager “have a good relationship with the domicile’s regulators.” Of course, specific knowledge of the type of captive and the line of business is also important when selecting a captive manager.

Other key roles

Another early service provider decision is the legal counsel. Here, Woodroffe says it is important to make certain that “they take a real interest in the captive and have a good working relationship with the regulators.” Legal counsel should stay involved closely enough with the captive to ensure that it continues to act in accordance to the insurance statutes.

Actuaries are also an important member of the captive service team and, as such, can have an impact on the long-term success of the captive. Woodroffe strongly believes that “it is worth the extra money to partner with an actuary that insists on validating the information that he receives both during the feasibility phase and annually once the captive is up and running.” Too often captive owners underestimate the risk of using assumptions that are outdated and therefore risk that the ultimate projections could be significantly off.

In terms of the external auditor, Woodroffe believes that the captive board has an obligation to select a CPA firm that fully understands captives and insurance accounting. She also notes that “there are a lot of changes taking place in the audit standards that are going to place a greater weight on the CPA firm and the captive manager in gathering evidence during future audits.”

These changes, which were announced months ago, should be discussed with the captive and its other service providers prior to the start of the audit so there is ample time to prepare. Captive owners should seek out CPA firms that are proactive when there are changes to accounting or auditing procedures.

Just like insurance companies, the biggest expense of the captive is handling and paying losses. Being able to track loss data is as critical as being able to analyze it. Captive owners should look for TPAs with an excellent IT infrastructure that allows the data to be easily managed. TPAs that offer online access either to view or input data can bring a lot of efficiency to the process which can both save the captive money and increase its efficiency.

Woodroffe also believes that the captive should seek out a TPA that has a geographic spread of resources that meets the captive’s greatest needs. And most important, “it is critical that the TPA have a lot of experience handling claims in the captive’s particular line or lines of business.”

Finally, besides safeguarding the captive’s assets, investment managers “should know the investment options which will most closely match the needs of the captive.” With the rapidly changing economic environment, Woodroffe points out, “it is no longer acceptable for your investment manager to solely rely upon the rating agencies to tell him the market value of your investment.” She also adds, “Your investment manager needs to understand the specific risks associated with that type of investment that he is recommending and be able to communicate it to you.”

Conclusion

Third-party service providers are still at the heart of the captive movement. And while some large organizations have taken the majority of these services in-house, they are the exception rather than the rule. As a result, it is incumbent on the captive’s board to go the extra mile to make certain they are receiving the types and quality of services that are in the best long-term interest of the captive. And while domiciliary regulators are working towards assuring that service providers are qualified, a captive’s board members must remain attentive and inquisitive.

Pricing pressures within the insurance industry have already spilled over to captive service providers. Many believe that the current trend of mergers and acquisitions will reduce the service provider options that are available. Despite this, the service provider community needs to keep up with the rapidly changing needs of captives as risk managers expand the usage of their captives. And as Woodroffe notes, “Captive owners should not be shy about questioning their service providers if servicing issues begin to appear.” If needed, an independent audit of a service provider(s) should be undertaken before erosion in services damages the long-term viability of the captive. *

For more information:
Collins Consulting
Web site: www.collinsconsult.com