Stop chasing your audit trail
We’re often asked: “Why do you have an audit performed on your clients’ captives every year? It’s an added expense.”
We’re often asked: “Why do you have an audit performed on your clients’ captives every year? It’s an added expense.” Our firm specialises in creating and managing captives for middle market clients. Yes, we do have annual audits performed, and here’s why:
- As captive managers, it’s our fiduciary responsibility. Simple as that: it’s the right thing to do.
- All or our captives make money. In these times of financial instability, our captive owners are doing everything they know how to do to maintain profitable businesses, and their captives are an added profit centre. When our captive owners go to their financial institutions for whatever financial transaction they’re making, that audited financial statement is just another ‘arrow in their quiver’ that supports their businesses.
- Many of our clients have health care-related businesses. They don’t just have Internal Revenue Service (IRS) or cash flow concerns. They receive federal and state reimbursements and they have Medicare/Medicaid concerns. If their reimbursements are questioned, all reimbursements stop until the question is resolved. These clients cannot afford to have their insurance expenses called into question. Their audited financial statements go one step further in validating their insurance companies and protecting their reimbursements.
Even for offshore captives, these audits in the past have been primarily functions and procedures reviews. They are beginning to look more and more like forensic audits due to the 2009 implementation of the International Financial Reporting Standards (IFRS) for Small- and Medium-sized Entities (SMEs).
While these standards are less rigorous than those for public companies, their details become more and more time consuming. For example, it isn’t enough to supply confirmation from financial institutions with electronic or faxed signatures. All confirmations must be original signatures, of which we keep a receipt, of course. In this electronic age, does this step guaranty more veracity or security?
One of the primary functions of the standards is to ascertain that the captive is, in fact, an insurance vehicle and not just an investment tool. While this may be ‘spot on’ for the 831(b) rulings for small insurance companies, most clients are just as concerned about their insurance benefits as they are about the financial implications. The two are not separable.
In keeping with our fiduciary responsibilities as a manager, IFRS for SME requires all payments from the captive to be supported by a contract or approved invoice. As simple and straight-forward as this requirement appears, all of our telephone conversations must now be documented by a follow-up email, all of our meeting notes must be ‘approved’ by our clients—the list goes on. It’s as cumbersome for clients as for accounting departments.
Clearly, the biggest impact for our clients is in the area of the captive’s investments. While offshore venues tend to have broad guidelines for investments, the IFRS puts the captive manager in the spot of second-guessing its investment adviser by requiring additional verification of the values of investments held.
Captive managers are responsible for ascertaining that the methods used to attribute a value to the securities are appropriate and reflect the fair value. So where in the past we, as captive managers, relied on the professional expertise of our captive’s investment advisers and their monthly statements to account for our clients’ investments, we must now go to a third party source and validate our advisers’ work—not just on a monthly basis, but also at year end.
We must know which sources our advisers’ used for valuation and find another pricing source to corroborate that for each security held. The expectation is that we, as captive managers, know that investments are properly measured and carried on the books.
This oversight activity is not limited to investment advisors. Third party administrators and actuaries are also meant to adhere to more rigorous standards.
Captive managers are encouraged to use third party administrators that also have internal controls audits performed regularly. Auditors routinely request copies of SSAE16 (formerly SAS70) reports to validate the administrator’s functions and procedures. And it’s not enough just to provide randomly requested loss files in addition to monthly and annual loss runs. Third party administrators are requested to confirm the details in those files of loss expenses paid, expenses payable, reserves and reserving methods, and so on.
Third party administrators work hand-in-glove with actuaries. And it’s the actuary’s responsibility to take loss data and make educated guesses as to what the final payments and payout patterns will be based on mathematical probabilities. It’s a captive manager’s responsibility to make sure that the actuaries are licensed and that they specialise in the line or lines of coverage of the captive being audited.
While this process is a few hundred years old and certain lines are more predictable than others, it’s still an educated guess. Now what we see are auditors second guessing the ‘guess’. When an actuarial firm submits a range of reserves from most aggressive to most conservative, auditors are requiring written statements from captive owners as to why they might have chosen any number but the mid-point.
There are as many reasons for maintaining a reserve number as there are for owners to decide to form a captive. When a professional offers their opinion, is it the outside audit firm’s responsibility to discount that opinion?
These meticulous procedures are intended to add value to the audit and ferret out unscrupulous captive managers and their clients. Isn’t it fascinating that it also increases billable hours?
As you can see, I’m a supporter of audited financial statements, but not of invasive procedures that are expensive, redundant and self-serving. I’m not convinced that the more stringent guidelines will prevent Enron-like companies from circumventing sound business practices, nor will it prevent unethical auditors from turning a blind eye to those unsound business practices.
In the mean time, captive managers are still charged with providing a business model that supports their clients’ risk transfer needs and improves the ability of those clients to maximise their companies’ profits.
