Introduction: Capital opportunities for captive insurers with legacy liabilities

Many (re)insurance companies carry legacy liabilities on their balance sheets that no longer align with their current strategic goals. This practice is equally relevant to captive insurance companies. Such legacy liabilities, whether in run-off portfolios, discontinued lines of business, or aged claims, tie up capital, limit operational flexibility, and hinder the efficient deployment of resources for current and future underwriting opportunities.

Fortunately, a range of solutions exists to help insurers transfer, mitigate, and/or achieve finality on these legacy exposures. These strategies vary in complexity, nature of finality, and regulatory involvement, but all share a common goal: improving capital efficiency and strategic alignment. The following table summarizes the key exit solutions commonly used in insurance.¹

Captive run-off solutions often combine several of the mechanisms described above—most commonly LPTs, novations, or commutations—to achieve finality and release trapped capital within the captive structure. The choice of approach depends on the captive’s jurisdiction, the nature of its remaining liabilities, and the objectives of its parent organization.

This paper focuses on legacy liabilities within captive insurance companies and presents a practical, data-driven framework for evaluating potential exit strategies, including quantifying the prospective capital release associated with transferring or commuting such liabilities. The discussion centers on two primary mechanisms—LPTs and novations. The framework employs a simplified model requiring only minimal inputs and is intended to provide preliminary insights and indicative metrics that can serve as a foundation for captive owners to explore more detailed solutions and engage with advisors, reinsurers, and regulatory stakeholders.

Insurance entity’s motivation to transfer legacy/run-off liabilities

Insurance entities seek to transfer or extinguish legacy liabilities for several reasons, including capital optimization, risk mitigation, and operational efficiency.^2,3

• Capital optimization: This allows companies to free up capital tied to non-core liabilities and redeploy this capital toward core business and growth opportunities.
• Risk mitigation: Long-tail exposures carry significant uncertainty; therefore, transferring liabilities can reduce risk of adverse development.
• Operational efficiency: Managing legacy liabilities can be resource intensive; transferring these liabilities allows companies to focus on active underwriting and other business initiatives.
• Regulatory and rating agency considerations: Shedding legacy liabilities can influence regulatory capital requirements by reducing reserve volatility and demonstrating proactive risk management.
• Facilitating strategic transactions: Simplifying deal structures for companies seeking an exit solution can make the company more attractive to potential buyers.
• Access to specialist expertise: Run-off specialists possess dedicated resources and expertise in managing and resolving complex legacy claims.

Although the motivations for captive insurers mirror those of commercial carriers, captives are typically more closely tied to the strategic risk management objectives of their parent organizations. As these priorities evolve, older lines of coverage may become capital-inefficient. Additionally, with lean staffing, captives may find that managing legacy claims creates an outsized operational burden. By transferring or commuting these non-core liabilities, captives can streamline administration, align more closely with current parent objectives, and free up capacity and capital to address emerging risks.

Simplified loss portfolio transfer/commutation model for captive insurers

The purpose of this section is to outline a simplified model that can jump-start the process for a captive owner to consider a transfer of their legacy liabilities. It supports decision-making for captive owners by indicating whether pursuing a transaction may be in the captive’s economic interest. The model is designed to generate meaningful output with the minimum amount of claim and financial inputs.

The process involves determining the amount of required capital to support the portfolio of liabilities, and then partitioning this capital into the amount provided by the buyer (buyer’s capital at risk, including an expected return) and the amount provided by the captive seller (required risk margin).

The first step is to calculate a probability distribution of potential reserve outcomes around the seller’s booked reserves in the captive. Based on this distribution, the next step is to determine the level of surplus needed to support the reserves given a selected probability level (e.g., the 90th percentile, which corresponds to a one-in-ten-year adverse outcome). The surplus supporting the reserve portfolio is then calculated as the difference between the reserve value at the selected percentile and the booked reserve amount. The choice of percentile may be dependent on regulatory requirements, risk tolerance, or the collateral requirements imposed by the fronting carrier.

Estimating the unpaid loss distribution

The approach described in this paper builds on a presentation by John Dawson at the 2020 Casualty Loss Reserve Seminar⁴, titled “A Practical Approach for Estimating the Unpaid Claim Liability Distribution.” The methodology relies on several key inputs:

• Claim counts refer to current open claim counts and an estimate of late reported (“IBNR”) claim counts. For mature or legacy portfolios, IBNR claims should generally be modest relative to open claims.
• The Actuarial Central Estimate (ACE) reserve is used as a proxy for the mean reserve, together with a reasonable range around it, usually derived from an actuarial reserve review. For example, a typical range may be something like −10%/+15% of the booked reserve.
• Industry benchmarks for the variability of the reserves relative to the mean (i.e., the coefficient of variation (CoV)) for different lines of business—longer-tailed coverages’ reserves typically exhibit a higher CoV than shorter-tailed lines.

From these inputs, the model derives the CoV of the unpaid loss distribution. Using the CoV in conjunction with the ACE, a lognormal distribution is parameterized to represent the variability of unpaid claim outcomes. The lognormal distribution is commonly used in actuarial practice to model insurance losses and facilitates estimation of reserve amounts at selected probability levels. As noted above, the excess of the reserve at a given percentile over the mean reserve forms the basis for determining the surplus required to support the reserve portfolio in the context of a commutation, novation, or portfolio transfer.

Once the total surplus requirement has been estimated, it can be partitioned between the buyer and the seller. Following the framework developed by Stephen Philbrick in “Accounting for Risk Margins,” the seller’s share—commonly referred to as the risk margin—represents the market premium a third party might reasonably require to assume the risk of adverse development.

Philbrick’s paper further defines the methodology for allocating surplus between the two parties. Under this approach, once the total surplus supporting a reserve portfolio is determined, the surplus can be allocated using the following key inputs:⁵

• Payout patterns: Derived either from the seller’s data or from appropriate industry benchmarks
• Rate of return (ROR): The target rate of return required by the buyer
• Risk-free interest rate (i): The rate corresponding to the duration of the underlying liabilities

The buyer’s contributed surplus is the difference between the overall surplus needed at the 90th percentile and the seller’s surplus contribution. Using these calculations, the model can estimate the potential surplus released, including any collateral freed from a fronting carrier. This output provides captive owners with actionable insight on whether to distribute dividends or redeploy capital toward new coverages.

For example, as shown in Table 2, consider a portfolio of workers’ compensation reserves with a central estimate of $9.2 million across 148 open claims. Assuming a 15% target return for the buyer, a 5% risk-free discount rate, and using the 90th percentile of the unpaid loss distribution of $12.0 million to determine required surplus, the model calculates total surplus backing the reserves of $2.8 million, allocated as $0.6 million to the seller (i.e., the risk margin required on these reserves) and $2.2 million remaining surplus allocated to the buyer.

The seller’s required contribution would therefore equal the discounted reserves of $8.1 million plus $0.6 million of surplus, or $8.7 million, representing the total funds necessary to support the transaction while achieving the buyer’s expected return. In turn, the $2.2 million of surplus attributed to the buyer represents capital that the captive owner (seller) could release; for example, through a dividend to the captive’s shareholders or redeployment of capital to support new business written through the captive.

Ultimately, the captive owner (seller) must assess whether contributing an additional amount of approximately $0.6 million, in addition to the discounted reserves of $8.1 million, is justified by the operational and strategic benefits of fully exiting the reserve portfolio, which includes release of collateral held.

As an additional benefit to the captive, the model can estimate the savings in claims handling expenses that occur when a reserve portfolio is transferred, as well as overhead expense savings from no longer servicing the associated portfolio of reserves.

Conclusions and capital considerations for captives with legacy liabilities

For potentially a relatively small cost, captive owners and insurers can unlock significant value by transferring legacy liabilities, improving capital efficiency, reducing risk, and streamlining operations. The model provides a framework for assessing potential benefits and serves as a first step in evaluating whether a transaction is worth pursuing.

Although the model does not determine final deal pricing, it helps inform the decision to engage in negotiations. Key challenges can include:

• Reserve adequacy disagreements
• Incomplete data
• Reinsurance complications
• Regulatory approvals
• Operational transition concerns
• Insufficient captive collateralization

With thoughtful planning and collaboration among actuarial, legal, and regulatory stakeholders, liability transfer solutions can be executed effectively while maintaining transparency and regulatory compliance.

¹ The descriptions of exit and legacy liability solutions summarized in this table draw primarily from the NAIC Restructuring Mechanisms (E) Working Group White Paper on Insurance Restructuring Mechanisms, which provides an overarching regulatory framework for mechanisms such as loss portfolio transfers, adverse development covers, assumption reinsurance/novation, and statutory business transfers (including IBT- and Part VII–type structures). Supplemental industry sources were reviewed to provide additional context on market practice and transaction features.

² Stenson, E. (Host). (n.d.). Legacy Transactions and their Capital Benefit for Insurers (No. 7) [Audio podcast episode]. In Guy Carpenter’s Fo[RE]sight. https://www.guycarp.com/insights/2023/12/legacy-transactions-and-their-capital-benefit-for-insurers.html.

³ Stanbaugh, J. (2022, November 10). Unlocking capital efficiencies and leveraging reinsurance: How legacy solutions can help carriers. Gallagher Basset. https://insurers.gallagherbassett.com/insights/unlocking-capital-efficiencies-and-leveraging-reinsurance-how-legacy-solutions-can-help-carriers/.

⁴ Dawson, J. (2020, September). A Practical Approach for Estimating the Unpaid Claim Liability Distribution [Seminar presentation]. Casualty Loss Reserve Seminar. https://www.casact.org/sites/default/files/presentation/cs1-apracticalapproachtoestimatingtheunpaidclaimliabilitydistribution-fileid-255558.pdf.

⁵ Philbrick, S.W. (1997). Errata and additional material related to “Accounting for risk margins”. Casualty Actuarial Society E-Forum, 105–110. https://www.casact.org/sites/default/files/database/forum_97wforum_97wf105.pdf.