In the first instalment of a two-part article, Brian Foley suggests that it might be an opportune time for the Irish regulatory authorities to think about monitoring captive insurance companies differently

This month sees the publication of a publicly available report that outlines a series of financial benchmarks for Irish captive insurance companies. This article describes the background to the 2004 Irish captive financial benchmarks report produced by ProAct Consulting. It also discusses the implications of tougher EU solvency standards, as well as investigating the repercussions of the introduction of a UK FSA CP190-like solvency standard on Irish direct writing captives, and identifies a number of topics that have been newsworthy among the Irish captive community in the last twelve months.

The raw material underlying the ProAct Consulting Irish captive financial benchmark report comprises three years of financial statements (profit & loss account and balance sheet) of direct writing captive insurance companies, as filed with the Companies Registration Office (CRO) in Dublin.

Captive insurance companies eligible for inclusion were identified by consulting the directory of captive insurance companies published in the March 2003 supplement to Global Reinsurance - Special Report Dublin.

This listing of captive insurance companies was supplemented by information from Department of Enterprise, Trade and Employment (DETE) (now the Irish Financial Services Regulatory Authority (IFSRA)), specifically the 2002 insurance annual report.

The following specific criteria were applied to select the captive insurance companies that should be in the database:

- the insurance company is authorised to write one or more of the direct classes of insurance 1 to 18; and

- the company should be in existence for at least two full financial years prior to 31 December 2002. In the majority of cases, three years of financial statements are included in the database.

Any companies that had gone into voluntary liquidation or administration in the intervening period were not considered. The final tally for the database was 52 captive insurance companies, including two companies which were dubbed 'supercaptives', both wholly-owned subsidiaries of large UK organisations. The premium volumes and balance sheets of the supercaptives dwarfed those of the other 50 primarily corporate captives. In fact, the gross written premium volume of the two supercaptives was over 50% of the total of the sample (and an even higher percentage of the net premium volume). The average tax paid in 2002 by the supercaptives was over EUR12m; the average tax paid by the other 50 captives in the database was EUR170,000.

To allow for a level playing field of comparison for the 50 captives, the two supercaptives are omitted from the comparative statistics.

The Companies Acts and insurance regulations lay out the precise format of the profit & loss account and balance sheet for a captive insurance company. Typically, there is very little difference between the presentation formats of captive insurance company financial statements of the various audit firms. However, we did notice some instances of variations in 'house style'. Perhaps the most significant difference between the audited financial statements was the treatment of reinsurance recoveries and unearned premium reserve (UPR) in the balance sheet. Most audit firms treat expected reinsurance on claims outstanding as an asset, but in a minority of cases reinsurance on claims outstanding was offset against gross claims outstanding on the liability side of the balance sheet. Many insurance practitioners prefer to see reinsurance recoveries on the asset side as it makes it easier to assess the importance of reinsurer security. Though less significant, a second area of inconsistency was the treatment of foreign exchange gains or losses. The regulations appear to allow this item to be separately identified in the non-technical account or included as a component in operating income. Finally, it was interesting to observe the number of companies that transferred all investment income earned by the company into the technical account. Purists might argue against this approach, but it is a common sense method of doing things. Apportioning investment income between balance sheet items and ongoing activities is a fiddly exercise that generally has little bearing on the underwriting result in these days of low interest rates.

The notes to the financial statements contain a wealth of additional detail, some of which is quite revealing. In particular, the 'net operating expense' item in the profit & loss account is the sum of a number of different components, such as:

- acquisition costs;

- changes in deferred acquisition costs;

- reinsurance commissions/rebates;

- foreign exchange items; and most importantly

- administration expenses.

To allow for a more meaningful statistical comparison, we allocated 'net operating expense' into these separate categories.

In the case of the 52 selected captive insurance companies, the profit & loss account (both the technical and non technical accounts) and balance sheet for the last three years are entered in the database in original currency. Where appropriate, these are then converted into euros using the exchange rates applicable at the balance sheet evaluation date.

The 2004 Irish captive financial benchmarks comprise the following three series of metrics:

1. simple comparative statistics, e.g. average auditor's remuneration;

2. accepted captive standards (IRIS tests); and

3. solvency scores.

One item identified in the notes to the financial statements and captured in the financial statement database is 'auditor's remuneration'. In 2002, the average auditor's remuneration was EUR14,400, equivalent to 3.2% of average administration expenses.

Table One shows the median, upper and lower quartile results from the database for auditor's remuneration to help illustrate the range of estimates.

The average auditor's remuneration increased by 14% per year over the two years of the study. Interestingly, all of this increase appears to have occurred in the first year.

When looking at auditor's remuneration as a percentage of administration expenses, the ordinal statistics are better indicators than the arithmetic average, as a couple of captive insurance companies had very high administration expenses which significantly skewed the total of administration expenses for the sample of 50 companies.

From year-end 2001, most direct writing Irish captives were required to engage an actuary to sign-off a Statutory Actuarial Opinion (SAO).

Should 'actuaries' remuneration' be identified separately in the notes to the financial statements as well? Perhaps this decision should be made by a show of hands among the auditors? Taking tongue out of cheek, it is only fair to point out that the additional cost of the SAO and supporting actuarial report is a bone of contention for many captive owners. Several captive managers have commented on the 'sticker shock' when seeing one or two cost proposals for an actuarial reserving study. However, we have heard anecdotal evidence that many actuarial firms have toned down high initial fee estimates. Based on a survey of a number of captive managers, the estimated median cost of a SAO is between 100%-120% of the auditor's remuneration, which translates to approximately 6.7%-8% of the total administration expenses.

The actuary is required to certify that the reserves held on the balance sheet are at least equal to his/her best actuarial estimate of the liabilities.

Naturally, this requires some interaction between the audit partner and the signing actuary. Both parties wish to avoid a situation where the actuary states that the held reserves are inadequate, and the actuary's conclusions are not known sufficiently in advance to remedy the situation.

The risk of these circumstances occurring can be significantly reduced if a clear timetable is established at the start of the actuarial process.

Assuming a 31 December financial reporting date, producing draft actuarial numbers based on third quarter data is an approach that minimises year-end surprises.

This timetable format has two other advantages. IFSRA, the Irish regulator, has expressed a desire to see the actuarial work completed by the end of the first quarter. Also, the captive manager may, with the actuary's cooperation, be able to use the actuarial conclusions from the draft report stage in reinsurance renewal negotiations.

Accepted captive standards A Tillinghast publication entitled 'TRACS: The road to successful captive management' outlines a series of recognised and accepted captive standards.

It provides a useful instruction manual for a risk manager or captive manager who wishes to explore various financial performance measures for an individual captive insurance company.

The ratios specified in the monograph include those traditionally used by financial analysts to provide an indication of the financial health of an insurance company. Probably the most famous set of insurance company ratios are the IRIS (Insurance Regulatory Information System) ratios promulgated by the National Association of Insurance Commissioners (NAIC) in the US.

These IRIS ratios were designed to act as an 'early warning system' for insurance companies in potential financial distress. Unusual ratio values, i.e. those outside of an acceptable range generate an 'orange light'; four or more orange lights and the insurance company was deemed to be a 'red light' case, indicating a greater level of regulatory supervision was necessary.

There are twelve IRIS test ratios. Seven of the ratios are calculated for each of the 52 captives in our database. Standalone financial statements do not provide sufficient information to estimate IRIS ratios 10 through 12. A breakout of claim activity between incurred claims attributable to the latest financial year, and the activity for all prior financial years (the 'run-off') is required. Without this information it is not possible to tell if a poor underwriting result is due to bad experience in the current year, or due to deterioration on prior year loss reserves.

Table 2 below outlines the first seven IRIS tests and shows comparative statistics for the Irish captive database.

- The second part of this article will be published in the September issue of Global Reinsurance.