All organisations manage risk. Some manage risk better than others. All face a certain amount of risk not adequately treated by its current enterprise risk management (ERM) process giving rise to residual risk. The need to assess and manage residual risk is a cornerstone of ERM. Some would say that residual risk is an ERM opportunity to increase enterprise value.
A captive insurance company (captive) is a strategic risk management tool used by many organisations to manage risk and address residual risk. For example, the 2001 terrorist attacks on the World Trade Center in New York City focused risk managers’ attention on the impact that a single event can have on multiple exposures across the enterprise. This event highlighted the need for a mature ERM programme to manage the interdependency of risk and the resulting residual risk. Captives are an essential strategic ERM tool that continue to evolve as organisations address an evolving and increasingly complex risk environment.
Captives are also privately held companies not generally subject to the same regulatory scrutiny as its publicly owned parent, for example. Single parent and group captives, however, are owned by public, private, and nonprofit organisations. A common thread among all captives regardless of its parent(s) legal structure is the obligation to manage the captive following best governance practices and standards that exceed regulatory compliance.
Some captive managers apply Sarbanes Oxley (SOx) principles to the management of a privately held captive to ensure that the proper controls are in place to prevent fraud, enable accurate financial reporting, and provide a superior level of governance. Moreover, there are multiple layers of captive regulation such as the domicile regulations, captive manager’s financial reporting and compliance, actuarial loss forecasting and reserve certification, and the external audit. Why then is so much being written about the need for independent directors on captive boards?
The importance of independent directors for captive regulation and operation is growing, in part, because it can increase the likelihood that the captive parent(s) (member insured) will achieve its risk financing goals. Independent directors have proven successful in improving the member insured’s governance. Why not provide the same benefit to the wholly-owned insurance subsidiary, the captive?
Successful organisations, for-profit or not for profit, are focused on meeting the needs of its stakeholders. To this end, organisations are focused on meeting environment, social, and governance (ESG) standards because it is the right thing to do, and will also improve an organisation’s reputation, value, and access to capital. A captive’s stakeholders include its member insureds third party claimants (customers, visitors, or patients), regulators, reinsurers, and service providers, among others. I would argue that the captive’s stakeholders also include the member insured’s investors, employees, vendors, credit rating agencies, community, and regulators. And all of them would have an interest in the successful operation of the captive. The captive’s highest priority, therefore, is to protect the financial security of its member insureds increasing stakeholder value.
The current pandemic has proven how beneficial a captive can be to its member insureds as a source of capital in turbulent times. Why then put a captive at risk, unnecessarily, by not providing it with the benefit of an independent voice with the appropriate risk management expertise? The captive board has a legal duty to act in the best interest of the captive, but member insured operational factors can destabilise the board’s decision-making process. The captive board can be influenced by factors unrelated to the captive’s best interest because of their competing role as an officer or manager for the member insured, which can adversely impact liquidity and solvency. An independent director can prevent this from happening.
The Merriam-Webster dictionary defines ‘independent’ as “not subject to control by others”. The Stanford University Business School Corporate Governance Initiative defines outside independent directors as outside directors with no “material relationship” to the company [including the member insureds or captive insurance company]. An outside director is one that is not an employee of the firm and contributes to the organisation by advising management on strategy and operations, drawing on their professional experience. Furthermore, they monitor the company to ensure that executives act in the best interest of shareholders. The New York Stock Exchange further defines an independent director as one who the board “affirmatively determines” has no “materiality relationship” with the company “either directly or as a partner, shareholder, or officer of an organisation that has a relationship with the company”. Vermont, for example, does not require an independent outside captive board director but examines the character, reputation, financial responsibility, insurance experience, and business qualifications of the officers and directors or members of the governing board. Therefore, the independent director can bring stability to the captive management process because of her independence, integrity, and appropriate experience. To this end, the independent director must have the necessary governance, risk management, and alternative risk financing/transfer experience to be effective. Moreover, the effective independent director will:
-Assist the captive strategic planning process, including designing and creating solutions to manage -the member insured’s evolving risks
-Enable the captive board to analyse better and evaluate programme options
-Enable the captive board to avoid making decisions without regard to merit
-Be a trusted adviser that can act as a control against fraud
-Provide oversight for the captive’s ERM programme
The Airmic 2019 Captive Governance Guide does an excellent job of explaining both the benefits of and the qualifications of an independent captive director. The qualified independent director will provide the needed balance, objectivity, and perspective to ensure that the captive not only meets its regulatory and stakeholder obligations but exceeds them. I would also argue that the independent director will improve the captive’s ability to access underwriting capacity from the reinsurance and capital markets. Investors such as BlackRock and Vanguard examine an organisations’ financial condition, cash flow, governance, sustainability, ESG data and ratings, among other material information, to identify and evaluate risk before investing its clients’ money. Why wouldn’t reinsurers seek ESG information about the captive and its member insureds before agreeing to commit its investors’ capital to provide programme terms?
Some reinsurers are refusing to underwrite certain classes of business based upon ESG standards and incorporating ESG data into its underwriting process. Certainly, reinsurers are currently examining the governance and financial condition of a captive’s member insured before offering terms. The presence of an independent director will improve the captive’s case that it has strong leadership, governance standards, risk control, and protects its stakeholder rights and interests.
The current pandemic has taught us valuable lessons about business continuity management and resilience. Organisations will continue to use captives to design innovative risk management and risk financing solutions for evolving business continuity threats such as business disruption, cyber-attacks, and catastrophic property perils such as storm surge, to name a few. This innovation will require access to both reinsurance and capital markets. And the independent director will enhance this process.
Furthermore, the captive must provide economic, and risk management value to its member insured’s while managing its own operational, financial, and strategic risks. An independent director acting in good faith without conflicts of interest will bring the necessary objectivity needed to reduce the captive’s enterprise risk. An independent director can also be an arbiter to diffuse any potential differences between the captive board and its captive manager, actuary, auditor, and reinsurance broker. Again, the captive is a private company and not usually subject to the same regulatory scrutiny, depending on the domicile, that a publicly traded company would be in terms of governance, including the need for an audit committee.
Often, the full captive board acts as the audit committee, for example. An independent director, however, can take on the role of an audit committee, providing an objective and disinterested conduit for the captive service providers much the same way that a formal corporate audit committee does for whistleblowers and the internal and external auditors.
I would think that the member insured’s audit committee would want the captive to provide this control against possible fraud, and other governance failures. A well-governed captive must manage its underwriting, compliance, reinsurance credit, liquidity, and solvency risks without concern for the member insured’s budget and cost of risk allocation issues.
Moreover, the member insured’s board, whether the organisation is publicly traded, private, or not for profit, has ultimate responsibility for the oversight and governance of the entire enterprise, including its captive. Boards must ensure that the organisation is addressing its material risks. If the captive board loses its objectivity threatening its liquidity or solvency, it could trigger a credit rating review or event-driven liability for the member insured’s board.
There are several potential drawbacks to using independent directors.
An independent board member may not be as familiar with the member insureds operations, operational and strategic risks as would an inside director. Inside directors can also co-opt an independent director.
Furthermore, an independent director may not be qualified to advise on captive insurance operations. The member insured can overcome these potential drawbacks by selecting the appropriate individual.
The Airmic 2019 Captive Governance Guide does go into some detail about how the independence of independent directors can be impaired.
The question, however, should not be whether an independent director is an appropriate governance standard for a single parent or group captive, but how do we manage the risk that an independent director’s independence could become impaired.
The Airmic guide does provide this guidance. The member insured, for example, should assess the board performance annually, establish term limits, and avoid selecting an independent director with any close family ties to the captive board, vendors, or member insured employees involved with the captive operation.
In conclusion, the independent director, if adequately vetted and managed, at the very least, should positively impact the captive’s access to underwriting capacity as well as the acquisition and cost of directors’ and officers’ liability insurance for the captive board.
Moreover, it will provide the control needed to ensure that the captive will have the solvency and liquidity to be there to support its member insured’s business continuity recovery from the next adverse event that impacts the entire enterprise.
The independent director, if responsibly managed, will provide the necessary stability needed for innovative and effective captive insurance programmes.
