It is important to recognise that the capital adequacy requirements of a captive insurance are likely to be significantly lower than an insurer writing policies for unrelated parties. This factor should be considered and, if necessary, adjusted for in order to determine the appropriate level of capital to use when calculating the investment return. Differences in capital adequacy between captive insurance and arm’s length insurers typically arise because of regulatory and commercial factors. Insurance regulators frequently set lower regulatory capital requirements for captive insurances. A primary commercial driver for arm’s length insurers is capital efficiency. In order to attract investors and customers, arm’s length insurers will target a strong credit rating by holding a level of operating capital which is in excess of the regulatory minimum. At the same time, arm’s length insurers will attempt to maximise their return on capital results. They will try to hold the optimum amount of capital to meet these opposing drivers. Captive insurances have no commercial imperative to seek a credit rating nor to optimise their return on capital in order to attract investors. Reasonable adjustments may need to be made to ensure that the comparable investment return is restricted to the capital that the captive insurance needs under relevant regulatory requirements (plus a reasonable operating buffer to minimise the possibility of inadvertently breaching the regulatory requirement) to accept the insurance risk rather than the level of capital that might be needed by an independent insurer. Adjustments may be needed to account for differing capital adequacy requirements between different regulators and different categories of insurance business ...

The remuneration of the captive insurance can be arrived at by considering the arm’s length profitability of the captive insurance by reference to a two staged approach which takes into account both profitability of claims and return on capital. The first step would be to identify the captive insurance’s combined ratio. This can be determined by expressing claims and expenses payable as a percentage of premiums receivable. The benchmarked combined ratio achieved by unrelated insurance companies indemnifying similar insurance risks can be identified. The benchmarked combined ratio can then be applied to the tested party’s claims and expenses paid to arrive at an arm’s length measure of annual premiums and thus underwriting profit (premiums receivable less claims and expenses). The second step is to assess the investment return achieved by the captive insurance against an arm’s length return. This step requires two further considerations: (a) the amount of capital held by the captive insurance, and (b) to the extent to which the captive insurance invests in controlled investments (e.g. intra-group bonds, loans, etc.), the rate of investment return achieved by the captive insurance on those investments. The sum of underwriting profit from step one and investment income from step two gives total operating profit (see Section B.5 of Chapter III on multiple year data) ...

It is important to recognise that the capital adequacy requirements of a captive insurance are likely to be significantly lower than an insurer writing policies for unrelated parties. This factor should be considered and, if necessary, adjusted for in order to determine the appropriate level of capital to use when calculating the investment return. Differences in capital adequacy between captive insurance and arm’s length insurers typically arise because of regulatory and commercial factors. Insurance regulators frequently set lower regulatory capital requirements for captive insurances. A primary commercial driver for arm’s length insurers is capital efficiency. In order to attract investors and customers, arm’s length insurers will target a strong credit rating by holding a level of operating capital which is in excess of the regulatory minimum. At the same time, arm’s length insurers will attempt to maximise their return on capital results. They will try to hold the optimum amount of capital to meet these opposing drivers. Captive insurances have no commercial imperative to seek a credit rating nor to optimise their return on capital in order to attract investors. Reasonable adjustments may need to be made to ensure that the comparable investment return is restricted to the capital that the captive insurance needs under relevant regulatory requirements (plus a reasonable operating buffer to minimise the possibility of inadvertently breaching the regulatory requirement) to accept the insurance risk rather than the level of capital that might be needed by an independent insurer. Adjustments may be needed to account for differing capital adequacy requirements between different regulators and different categories of insurance business ...

The remuneration of the captive insurance can be arrived at by considering the arm’s length profitability of the captive insurance by reference to a two staged approach which takes into account both profitability of claims and return on capital. The first step would be to identify the captive insurance’s combined ratio. This can be determined by expressing claims and expenses payable as a percentage of premiums receivable. The benchmarked combined ratio achieved by unrelated insurance companies indemnifying similar insurance risks can be identified. The benchmarked combined ratio can then be applied to the tested party’s claims and expenses paid to arrive at an arm’s length measure of annual premiums and thus underwriting profit (premiums receivable less claims and expenses). The second step is to assess the investment return achieved by the captive insurance against an arm’s length return. This step requires two further considerations: (a) the amount of capital held by the captive insurance, and (b) to the extent to which the captive insurance invests in controlled investments (e.g. intra-group bonds, loans, etc.), the rate of investment return achieved by the captive insurance on those investments. The sum of underwriting profit from step one and investment income from step two gives total operating profit (see Section B.5 of Chapter III on multiple year data) ...