Managing a captive is like steering a large ship through unpredictable waters. Leaders must mitigate internal corporate risks, navigate underwriting pressures, and respond to claims — all while striving to maintain a healthy balance sheet to protect against volatility.
However, captive management often overlooks a crucial tool: capital modeling. This quantitative approach is essential for optimizing financial resilience and enhancing strategic decision-making. Here, in collaboration with Mercer, we explore how organizations can effectively manage their capital while protecting against various risks, such as underwriting, reserving, catastrophe, and asset risks.
By harnessing the power of capital modeling, organizations can better manage risks and prepare for unexpected challengesAlex Wallace, Principal, Actuarial P&C at Oliver Wyman
Potential investment breakthroughs from capital modeling
Captive insurance companies, subsidiaries established to provide coverage primarily for their parent companies, can derive several significant benefits from capital modeling. For example, in today’s volatile economic climate, we anticipate potential changes in monetary policy that may lead to lower rates. Capital modeling enables captives to proactively adapt to such changes. It also enables them to increase surplus assets, enhance resilience, and maximize returns on capital for the captive owner(s).
The power of capital modeling
Traditional actuarial models encompass a range of use cases, including loss reserving and premium calculation, that leverage historical data to create reliable projections of future claim liabilities. Capital modeling enriches traditional actuarial models and provides a more dynamic, comprehensive, and strategic approach to measuring risk exposures and evaluating financial opportunities.
Keep in mind, captives do not operate in isolation and are part of the organization’s broader ecosystem. Assessing and understanding the parent company’s risk exposures and financial landscape is crucial. Equally as important, the range of risks should not be evaluated in isolation; a unified approach uncovers the advantages of diversification, proving that the total capital at risk is often less than the sum of each individual risk assessed.
Exhibit 1 illustrates this concept. When organizations neglect to utilize a capital model, they tend to assess every risk separately. As a result, risk managers often make suboptimal decisions because they do not consider the overall enterprise perspective. Evaluating risks on a standalone basis can lead to missed opportunities and less effective risk management.
To illustrate this point, consider a hypothetical scenario for “Organization XYZ” and its captive insurance company, in a 1-in-100-year event. Assume that the firm faces underwriting risks related to general liability, workers’ compensation, auto liability, and property. The standalone capital at risk for each of these segments is $50 million, $10 million, $25 million, and $15 million, respectively, totaling $100 million.
However, because these risks are not perfectly correlated — meaning all claims are unlikely to occur at the same time — the capital model indicates that the actual capital at risk is $75 million. This indicates a diversification benefit of $25 million, the difference between the sum of standalone risks and the amount produced by the capital model. This freed-up capital illustrates the value of diversification, which can also be realized across various risk types, geographical areas, and business units.
Strategic investment decisions for captive portfolios
To maximize their financial potential and strike the right balance between reserving and growth, captives need to critically assess their current investment portfolios, which often include money market funds, demand deposits, and bank sweeps. All three are designed for short-term use and are poised to prioritize liquidity in changing economic environments. Unlocking investment returns is a crucial lever for organizations that seek to reduce the overall cost of risks, especially for long-tail liabilities where assets are held for extended periods.
To maximize the impact of their investment portfolio, captives must consider two interconnected factors:
- Risk tolerance: Assessing the likelihood that surplus funds may be needed
- Illiquidity tolerance: Aligning cash flow needs with appropriate liquidity levels
Enhance operational efficiency for captives
With data-driven insights derived from capital modeling, captives are empowered to make intelligent business choices while accurately assessing their risk tolerance. This capability enables organizations to effectively communicate potential risks to stakeholders, fostering a strategic clarity that prepares them for financial adversities.
By quantifying the correlation between various risks, capital modeling helps captives identify diversification benefits and lower their overall cost of risk. This insight allows them to optimize their risk retention levels, leading to substantial cost savings.
Finally, capital modeling integrates investment and risk management strategies. It ensures that investment approaches align with risk management priorities, facilitating effective capital allocation. This holistic approach maximizes investment income and enhances long-term financial security, positioning captives to thrive in a competitive landscape.
Through effective capital modeling, organizations can strengthen enterprise risk strategies, optimize returns on capital, capture diversification benefits, and steer strategic, data driven decisions.
Capital modeling serves as a compass, empowering business resilience and stability
Just as an experienced sailor uses GPS and mapping technology to chart a course, captives can leverage capital modeling to steer their journey toward greater financial stability and growth.
In the vast ocean of finance, capital modeling empowers organizations to embark on a confident voyage toward risk mitigation and sustainable operational resilience. It acts as a north star, guiding captives toward prosperity. As a powerful tool, capital modeling helps navigate volatility, optimizes risk and return, and fosters profitable, long-term success.
