In the interest of closing merger and acquisition (M&A) 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—its retained liabilities could present substantial financial risk for the acquirer. Post-acquisition, a firm might discover that the actual runoff of claims of the legacy business it purchased are higher than the value estimated pre-sale.
Consider the case of a healthcare provider that bought a regional hospital system. Prior to the acquisition, the regional hospital retained risk in multiple areas, but its major source of risk was medical malpractice lawsuits. The regional hospital self-insured its professional liability exposures through a captive insurance company domiciled in Bermuda, with a multimillion-dollar retention to save on annual insurance costs. At the time of the transaction, the regional hospital system had established a $10 million reserve for these liabilities. Three years after the acquisition closed, the company has paid a total of $20 million for medical incidents that occurred prior to the transaction. One of those incidents was a case concerning complications from premature delivery of a baby. That case was settled for $5 million, even though case reserves at the time of the acquisition were only $100,000.
To mitigate financial risks, a company considering an M&A deal that would involve some form of self-insurance must look for potential potholes and learn how to avoid them. Here are four risks to be wary of:
1. Understated Claim Reserve Liability
Because the reserve liability is inherently uncertain and difficult to estimate in any business, companies on the selling block may, in some cases, understate their claim reserve liability. Even with well-intentioned best efforts, an acquisition target’s management team may be off in their estimate. The challenge is exacerbated in growing firms, which are often more difficult to reserve because their risk profile is changing rapidly.
This creates challenges for the acquirer. When an acquisition target’s listed claim reserve liability is too low, that can inflate the company’s reported equity value, which poses a major risk in the transaction.
Unpaid claims and related expenses are typically estimated and therefore uncertain, so making sure they’re accurate requires an additional level of scrutiny. The target company’s reserves should include provisions for both claims reported and claims incurred but not reported (IBNR).
Acquirers should commission a credentialed actuary to carefully examine the accuracy of a target company’s unpaid claims and related expense liability estimates. The actuary should also determine whether any further investigation is necessary. The buyer should review the actuarial work supporting the reserve calculation, focusing on the data, methodologies, and assumptions utilized in the analysis. Depending on the significance of the liability, the buyer may want an independent actuarial analysis performed as of the transaction date.
Risk 2: Changes in Reserving Practice
To determine whether the earnings numbers used for pricing an M&A deal are accurate, buyers often perform a quality-of-earnings analysis of the target company’s financials. They’re generally looking for unusual or one-off items. The quality-of-earnings analysis should also consider whether the target company has made changes to its reserving practice.
Consider the impact on a company’s financial statements if its third-party actuarial firm were to change actuarial methodology or its accounting team were to adjust accounting procedures between reserve-evaluation periods. Such a change might result in decreased reserves and lead to an artificial inflation of calendar-period earnings. Thus, buyers need to be strict when examining the M&A target’s quality of earnings, to ensure that changes in reserving methodologies have been properly adjusted.
Acquirers would also be prudent to look into changes to the target’s claims-handling practices, as they can significantly impact reserve-liability estimates. Acquiring companies should note the speed with which the target company has paid claims, as well as any changes in case reserve practices, because they can disrupt the actuary’s analysis, which is typically based on historical claims payment and reporting patterns.
Risk 3: Large-Claim Volatility
Companies that self-insure experience greater cost fluctuations than do companies that fully insure their exposures externally with fixed up-front premiums. Because paying claims takes time and some claims are reported late, the cost of self-insurance claims may not be fully realized for years, which increases the uncertainty of the unpaid-claims estimate in a merger or acquisition.
One mega-claim or a bundle of larger claims can significantly increase self-insurance costs, especially when the company maintains a high retention. Acquirers should take note of any atypically large claims activity in the target’s captive insurer, as this might lead to irregular earnings. In addition, the acquirer should take any potential future large-claim settlements into consideration when arriving at a purchase price. Performing an independent claims review can help in assessing the risk of claims in the pipeline. The review should focus on claims that present the most risk—i.e., those with the potential to become large and costly.
Risk 4: Inadequate Captive Funding
If the target company is having liquidity problems, there is a greater risk the parent company will raid the assets of the captive to meet other funding needs. Acquirers should give special consideration to captives of distressed firms.
Review the captive’s insurance operations and financial statements to make sure the captive isn’t either over- or under-funded. Remember that most captives are required to have enough assets to pay off their existing liabilities, as well as surplus assets to cover the possibility of higher-than-expected claims activity. If these additional funds were not present, a parent company might 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 independently reviewed to mitigate the risk of unexpected financial responsibility for existing claims.
Following a Transaction
If, after examining all the risks, the acquirer determines that a target is worth acquiring and management lands on a fair price, the work of the finance and risk management staff still isn’t done. The following steps will help ensure the target retains as much value as possible post-transaction.
- Gauge the combined company’s risk appetite. Post-acquisition, the combined company will be larger and likely more diverse. Thus, it may be smart to raise the newly combined company’s self-insured retention or insurance limits. Working with an actuary or a broker to explore the best coverage options will help the newly formed company determine its optimal retention levels.
- Expedite systems integration. After a merger or acquisition, the new organization will need to determine how to handle claims and manage risks as one company. It’s not uncommon for two claim systems to run concurrently during a transition period, but the company will want to develop best practices over time to eliminate redundancies. Bringing in a third party can help expedite the process.
- Consider unwinding the captive. The merged company may want to consider consolidating the target’s captive into its own or running off the existing claims. Consolidation generally reduces costs; running multiple captives at once would be costly. Also, as there are fewer claims left outstanding, the ratio of variable claims payments to fixed captive overhead expense makes running a separate captive less and less attractive. Because existing claims could take years to run off, the company may want to perform a loss-portfolio transfer of the remaining outstanding claims.
Jim Toole is a managing director at FTI Consulting, where he leads the life and health actuarial team in the Global Insurance Services practice. He is also a contributor to FTI Journal. Toole has more than 25 years of management and technical experience in the life, health, P&C, and captive-insurance industries, including a variety of roles leading consulting firms and insurance companies.
Robert Stewart is a director at FTI Consulting in the Global Insurance Services practice, and is also a contributor to FTI Journal. He is a credentialed property-casualty actuary with more than 10 years of insurance and reinsurance experience.