Don’t Fall Captive to Self-Insurance Risks in M&A
In the pursuit of deals, acquirers often overlook a potentially serious pitfall. If a target company self-insures or has a captive - an insurance company that is owned by the insured - the acquirer could face substantial financial risk due to the retained claims exposure. To mitigate that risk, it is important to spot the potential pot holes and learn how to avoid them. Here's what you need to be wary of.
Risk 1: Understating Claim Reserve Liability
When companies understate their claim reserve liability, it can inflate their reported equity value, thereby posing a major risk to the acquirer. Because unpaid claims and related expenses are estimated and therefore uncertain, it deserves an additional level of scrutiny. The target company’s reserves should include a provision for both claims reported and claims incurred but not reported (or IBNR).
To mitigate the risk of under-reserving, acquirers should consider commissioning a credentialed actuary to carefully examine the accuracy of a target company’s unpaid claims and related expense liability estimates. An actuary can be helpful in determining whether any further investigation is warranted and is capable of performing a full independent actuarial analysis, if needed.
Risk 2: Changes in Reserving Practice
Consider the impact that an adjustment to accounting procedures or actuarial approach would have between reserve evaluation periods. Such a change could potentially result in a reserve decrease and lead to an artificial inflation of calendar period earnings. Acquiring companies need to be mindful when examining the target’s quality of earnings to ensure changes in reserving methodologies have been properly adjusted.
Acquirers would also be prudent to monitor changes to claims handling practices, as they can significantly impact reserve liability estimates. Acquiring companies should note the speed in which claims were paid as well as any case reserve practice changes because they can disrupt the actuary’s analysis.
Risk 3: Large Claim Volatility
One mega-claim or a bundle of larger-claims can significantly increase self-insurance costs, especially when the company maintains a high retention. Self-insured claim costs fluctuate over time and it may be years before the claims finally runout, so there is the risk of late development on existing claims.
Acquirers should take note of any atypically large claims activity, as this might lead to irregular earnings. Any potential future large claims should be considered when arriving at a purchase price. Performing an independent claims review can help in assessing the risk of future claims.
Risk 4: Inadequate Captive Funding
For a target company with liquidity constraints, there is a greater risk the assets of the captive will be raided for the immediate needs of the parent company. Special consideration should be given to captives of distressed firms. If the captive loans the parent company money or is not receiving premium payments when due, this is a red flag.
Review the captive’s insurance operations and financial statements to make sure the captive is not over or underfunded. Remember that most captives are required to have enough assets to pay off their existing liabilities, as well as surplus assets to cover higher than expected claims activity.
If these additional funds are not present, a parent company will have to extend more capital to keep the captive afloat. The quality of the captive's assets should be reflected in the purchase price and be independently reviewed.
Following a transaction:
If, after examining all the risks, you determine that a target is worth acquiring, and you land on a fair price, your work still is not done. The following steps will help ensure your target retains as much value as possible post-transaction.
- Gauge Risk Appetite: Given the larger scale and diversity of a company post-acquisition, it can be smart to raise a company’s self-insured retention or insurance limits. Working with an actuary or a broker to explore the best coverage options will help determine optimal retention levels.
- Systems Integration: After a merger or acquisition, the newly-formed organization will need to determine how to best handle claims and manage risks as one company. It’s not uncommon for two claim systems to run concurrently during a transition period, though the company will want to develop best practices over time to eliminate redundancy. Bringing in a third party can help expedite the process.
- Captive Unwind: If the due diligence process identified a captive during the transaction, the merged company may want to consider consolidating the captive or running off the existing claims. Because existing claims could take years to run-off, the company should consider performing a loss portfolio transfer of the remaining outstanding claims.