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L. Michelle Bradley and Enoch Starnes of SIGMA Actuarial Consulting Group, Inc. provide a guide to what needs to be addressed after companies with a captive are acquired or merged.
Of the many considerations needed during mergers and acquisitions (M&A), one that may not be clearly defined is the integration of captives. Existing captive structures for the pre-transaction entities will almost certainly need to be re-evaluated, but what should that process look like, and what types of analytics should be reviewed?
It can be difficult to construct an effective strategy on a purely theoretical basis, so let’s consider some common examples and the approaches which might be used to make the best data-driven decisions.
Example 1: Captives and large deductible programmes
One likely scenario is that, for pre-transaction Companies A and B, only Company A is currently utilising a captive to insure one of its key risks. Company B, on the other hand, insures this same risk through a large deductible programme purchased via the commercial market. Should the Company B risk be added to the captive?
What about the captive structure—does it need to be adjusted to fit the new parameters of that combined portfolio? Each of these questions can be difficult to answer from a purely qualitative standpoint, which is where actuarial analytics come into play.
The loss projection component of an actuarial analysis can be crucial to understanding these questions and making the best decision possible. In this case, an actuary would likely be tasked with preparing loss projections on an expected basis and at various confidence levels for Companies A and B separately and for the combined portfolio.
These analytics might also be evaluated for current retention levels and other possible retention scenarios. Once completed, they would be reviewed alongside captive operating costs and market quotes to determine the most appropriate option.
“Another important consideration during this process is the impact of portfolio diversification.”
It may be that the combined portfolio is added to the captive policy, but it’s also entirely possible that the exposures of the two companies are kept separate initially. In the latter case, Company B’s risk may continue to be handled through a large deductible programme, but some portion of the deductible layer could be added to the captive.
Along with the total cost of risk and adverse loss scenarios, another important consideration during this process is the impact of portfolio diversification, aka the “portfolio effect”. It’s possible that differences in geography, operations, and other key factors could significantly affect the combined portfolio of the two companies. These items may not be immediately clear as part of the standard loss projection analysis from an actuary, so it could be helpful to establish those expectations on the front end as something for them to consider and include as part of the actuarial engagement.
Finally, a potential consequence of adding Company B to the captive of Company A is the introduction of collateral issues for the run-off liabilities and possible changes to the collateral profile of Company A’s captive.
An in-depth discussion of collateral is beyond the scope of this article, but the team responsible for handling these negotiations should ensure the following items are adequately addressed and understood:
Timing of transition from the commercial programme to the captive
Existing collateral agreements and prior workpapers related to collateral
The process and timeline for how run-off collateral is released, which could be supported through an actuarial reserve analysis
Example 2: Captives and guaranteed cost programmes
This next example presents a slight modification on Example 1. Here, Company A still insures its key risk through a captive policy, but Company B uses a commercial guaranteed cost policy for that same risk. While many of the considerations and procedures listed above would still be applicable to this situation, another important aspect is education.
If the management team and risk management personnel of Company B remain in place after the merger, it may be vital for them to be educated on the details of risk retention and the use of captives.
The analytics and high-level strategies surrounding captives are the obvious determinants for a successful captive portfolio after an M&A, but an often overlooked aspect is how administration and communication should be handled going forward. In other words, even if Company B’s risk management team understand how captives and risk retention work, they must also understand how they fit into the overall decision-making process.
Example 3: Multiple captives
Another example with potentially more complex repercussions is when Companies A and B are both actively using captives. While the actuarial analytics may be largely presented in a similar format with regard to retention and combined versus separate portfolios, there are often other, less straightforward considerations. These include items such as domicile, captive structure, and tax implications. Of course, an actuary can integrate some of these pieces into its overall analysis, but it’s always best to make sure the relevant tax and captive experts are consulted to make sure the available options are properly understood.
It’s also worth noting that for the sake of simplicity each of these examples is focused on a single risk. The much more likely scenario for real-world M&A is that a significant number of risks and coverages must be considered, some of which may be exclusive to the operational exposure of just one company. The complexities presented here could be compounded when one or more captives are involved.
That said, the solution to an effective outcome is to ensure all parties—management teams, actuaries, captive managers, etc—are involved in discussions at an early stage and included throughout the transaction. This may seem like a daunting task, but proactive communication and transparency are often key factors to a successful merger or acquisition.
Even in situations where the due diligence timeline is relatively brief, the captive strategy can contemplate a delayed transitional period to allow a more in-depth review post-transaction. Each step of the analytical process, from data provision to the presentation of results, should be performed with the objective of positioning the merged companies with an effective long-term strategy.
L. Michelle Bradley is a consulting actuary at SIGMA Actuarial Consulting Group, Inc. She can be contacted at: mb@sigmaactuary.com
Enoch Starnes is a captive and complex risk consultant at SIGMA Actuarial Consulting Group, Inc. He can be contacted at: enoch@sigmaactuary.com
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