Diana Hardy and TJ Strickland of Rives & Associates discuss investment strategies for captive insurers and outline the steps that need to be taken
It happens more than you think, you receive a financial statement from a captive manager at the start of an audit and see “investment in limited liability company (LLC)” on the balance sheet. The first thoughts as an auditor are “great, more required procedures and more costs ... wish we could have been involved in the initiation”. Alternative investments within a captive insurance company can entail many different forms: investments in LLCs, loans, real estate, life insurance policies, and many more. Before auditing alternative investments, there are many steps a captive owner should take.
As a captive owner, alternative investments can serve as a means to providing a strategic direction in building the investment portfolio and hedging against loss experience. The first step as a captive owner is to discuss the alternative investment with the captive manager. The captive manager will be able to assist in determining if the investment meets the Investment Policy Statement (IPS) based on risks managed by the captive. Furthermore, the captive manager will assist in determining compliance with regulatory requirements. This is the point at which the captive manager should be reaching out to both the regulator and independent auditor. At least, it’s the point we wish they would reach out. Having input at the initiation of an alternative investment allows the independent auditor to evaluate what type of audit evidence will be required for the valuation of the alternative investment. Valuation is key from an audit perspective. Having input from the start with the auditor assists the captive manager in maintaining the proper documentation needed in completing the audit. Such communication can also help reduce audit costs, which are ultimately passed to the captive owner.
You may be asking, what is the captive manager going to need to maintain to support the valuation of an alternative investment? The answer: it depends.
Investment options
One of the most common transactions we see captive owners attempting is having a captive issue a loan back to the insured/owner. Many domiciles allow this transaction to occur as long as the captive is adequately capitalised and able to meet its policyholder and state obligations. When engaging in an affiliated loan transaction, consider doing the following:
Real estate is also a viable option for captives to invest excess funds, however, one should tread cautiously. In many domiciles, there is nothing keeping a captive from seeking out real estate to be held as an investment. The biggest hindrance is liquidity. An insurance company of any type should have access to funds to meet its short and long-term obligations.
In the event of a claim, an insurer should be able to quickly liquidate any assets to meet its policyholder obligations. Real estate is illiquid in the sense that it could take months or years to recoup your investment. Many captives will not have excess capital to invest in real estate until many years after formation. In the event that real estate is your choice investment, it is important to maintain deeds and up-to-date appraisals of the property.
Life insurance policies are frequently seen by captive insurance companies as investment tools. In the same manner a captive invests in equity or debt securities, life insurance policies provide a return on investment and shouldn’t be conceived otherwise. As discussed above, liquidity should always be one of the focuses of the investor when considering how to invest within a captive.
For life insurance policies, consider a life insurance company with an A+ rating from A.M. Best or another rating agency and a guarantee of the proceeds of the cash surrender value on demand upon surrender of the policy.
Our first scenario, investments in LLCs is an ambiguous term that could mean a plethora of possibilities to the reader of financial statements. Essentially, a captive insurance company can set up a subsidiary LLC to place investment vehicles. This can be harmless but some captive investors attempt to conceal aggressive or unapproved investment transaction because, in their eyes, the investment is no longer in the captive’s control but of the subsidiaries.
Typical investments placed in a subsidiary LLC include rental properties, affiliated debt, and hedge funds, amongst others. In most cases, the subsidiary LLC has to be consolidated with the captive as if the companies are one in the same. For the purposes of the financial statements, there is no concealment of investments held in a subsidiary LLC.
Before considering any alternative investment, it is always best to first visit your IPS and talk with your captive manager. Furthermore, determine if the desired investment requires regulatory approval and that the captive would remain liquid to meet obligations.
Then ultimately, inform your auditor so all parties can work to provide the necessary paper trail and valuation methods. Always remember, the most common answer when approaching an alternative investment will be: it depends!
