Captive 101 – Start the JourneyAnne Marie Towle, Willis, SVPMichael Meehan, Milliman, ConsultantGerald Yoshida, Char Hamilton, Yoshida & Shimomoto, AttorneyKrista Twesme, Mortenson, General Counsel

AGENDA Introductions What is a Captive Why Form a Captive Feasibility Study Incorporating a Captive Captive Operations Captive Governance Lessons Learned & Captive Challenges

Section One

What is a Captive?

What is a Captive?

Vital financial tool 

A limited purpose, licensed insurance company, the main business 

purpose of which is to insure the risks of the captive’s owners

A risk assumption vehicle

An insurance or reinsurance company

Specifically established to insure or reinsure 

the risks of its parent or associated third parties

Types of Captives?

Single Parent/Pure Captive

Group or Risk Retention Group

Association

Agency

Protected/Segregated/Sponsor Cell Structure

Branch

Types of Captive Utilization?

Infrastructure for providing transparency, validation, and rationalization of retained risk positions

Enhancing risk management efforts

Accelerating tax treatment of deductible liabilities

Retained Risk Finance

Reinsurance market cost of risk transfer is less than commercial retail cost of risk transfer

Better use of capital to retain risk than transfer it

Managing total cost of risk

Risk Transfer Rate Arbitrage

Federal programs (TRIA)

Reinsurance capacity, which may not be otherwise accessible in commercial retail market (trade credit risk, +10 yrpollutions risks) 

Access to Capacity

Franchisee programs

Consumer facing insurance programs (warranty, service contract, point of sale insurances, etc.)

Affiliate business (vendors, VAPs, distributors, etc.)

Agency captives  3rd party business

Entrepreneurial Utilizations

Lines of Coverage

Self‐Insured Medical Stop‐Loss (non‐ERISA)

Reputation/Brand/Loss of Income Risks

Intellectual Property (patent, trademark, copyright) 

Product Recall Coverage Medicare “Fraud and 

Abuse” Insurance Lease Residual Value Risk Punitive Damages  Non‐traditional BI

EMERGING

Workers’ Compensation Auto Liability General Liability Professional and Products 

Liability Director and Officer 

Liability Employment Practices 

Liability Environmental Liability Product or Service 

Extended Warranty Property and Business 

Interruption (BI)

TRADITIONAL

EE Benefits  Terrorism (TRIA) Shipping Coverage Title and Private Mortgage 

Insurance Equipment Maintenance Construction Exposures Trade Credit Risk Cyber‐Risk Managed Care Errors and 

Omissions

EXPANDED

Section Two

Why form a Captive?

The unwillingness/inability of insurers to 

provide cost effective insurance

The need for new capacity for certain 

risks

The drive control to frictional and non‐

loss costs

Lack of confidence in the traditional 

markets ability to differentiate and 

provide stable protection

The enhanced focus on loss prevention 

and intelligent claims handling

The opportunity to take risk and profit 

positions in affiliate business

Global consistency

Direct access to global reinsurance 

markets

Why Companies Form Captives?

Control over your insurance 

destiny

Improves Cash Flow

Enhanced Risk 

Management Efforts

Reduce costs long term

Broader coverage access, 

options and terms

Returns underwriting 

profits and investment 

income

Why is it important to you?

3 Models for Retained Risk Financing

Reputation/Brand/Loss of Income Risks

Intellectual Property (Patent, Trademark, Copyright) 

Product Recall Coverage Punitive Damages 

Coverage International Kidnapping 

Protection Trade Credit Risk Professional and Products 

Liability Cyber‐Risk

CAT EXCESS

Property Business Interruption Environmental Liability General Liability Auto Liability Multi‐National EE Benefits  Product or Service 

Extended Warranty Clinical Trials risks Construction Exposures Equipment Maintenance

GLOBAL FRONTING

Workers’ Compensation General Liability Auto Liability Product or Service 

Extended Warranty Construction Exposures Environmental Liability Property and Business 

Interruption Equipment Maintenance EE Benefits  Self‐Insured Medical Stop‐

Loss (non‐ERISA)

DEDUCTIBLE REIMB.

Section Three

Feasibility Study

Captive Development Process

Review Current Insurance 

Program and Risk Appetite

Formal Feasibility Study

Decision to Proceed

Business Plan Development

Captive Application, License, 

Incorporation and 

Capitalization

Commence Operations

Feasibility Study

Feasibility Analysis

Establishing core

objectives

Data Collection

Program Design

Actuarial Analysis

DomicileSelection

Regulatory,Tax & Legal

Analysis

Review Current Insurance 

Identify Risk Philosophy

Evaluate overall impact to 

organization

Financing options

Coverage requirements

Ancillary coverages

Establish Timeline

Select captive experts

Establishment of Core Objectives

16

Data CollectionBasic InformationCompany specificGoalsConstraints

OperationalAccount backgroundManagement (claims and risk)

Loss InformationElectronicDetailed claim runLarge loss listing (outliers)

ExposuresHistorical and prospective (payroll, vehicles, sales, etc.)Descriptions/locations

17

Data CollectionExpense AnalysisWill vary by:Type of programDomicile

Other AssumptionsChallengesSingle Company versus Group Program

18

Program DesignInsurance StructureWill vary by:Types of insurance Retentions LimitsDirect Reinsurance

Type of Captive

Ownership Structure

19

Actuarial Analysis        “Formal Feasibility”

Why is an Actuarial Feasibility Study Necessary?

What are the Components of a Typical Feasibility Study?

Evaluation of Results

20

Why is an Actuarial /Feasibility Study Necessary?

Forms the basis for measuring the financial viability of the proposed captive

Helps to identify potential advantages and the potential risks of operating a captive insurance company

Risk IdentificationRisk Quantification

May be required for licensing/application process

May be required for presenting to the reinsurance market

21

Loss AnalysisReview of Past Loss Experience

Actuarial Adjustments

Internal Factors (e.g. loss control)

External Factors (e.g. laws)

Loss Rate = Losses per unit of Exposure

Expected Losses = Loss Rate x Expected Exposures

Confidence Levels

22

Loss Analysis ‐ Example

LossAccident Incurred Development Ultimate Exposures Adjustment / Loss

Year Losses Factor Losses (in 00's) Trend Rate

2012 500,000 1.200 600,000 800,000 1.061 0.7962013 400,000 1.500 600,000 900,000 1.040 0.6932014 300,000 2.000 600,000 1,000,000 1.020 0.612

Total 1,200,000 1,800,000 2,700,000 0.694

Selected 0.700Projected Exposures 1,200,000

Expected Losses 840,000

23

Expense AnalysisFronting FeesReinsuranceClaims Administration, Loss PreventionCommission & BrokerageManagement FeesLegal, Audit, Actuarial, & ConsultingLetter of CreditOther (Travel, Board Meeting, D&O)Taxes & Assessments

24

Expense Analysis ‐ ExampleExpense Amount

Fronting Fees 10.0%Reinsurance 10.0%Claims Administration, Loss Prevention 5.0%Commission & Brokerage 5.0%Management Fees 50,000Legal, Audit, & Actuarial 40,000Letter of Credit 10,000Other (Travel, Board Meeting, D&O) 10,000Taxes and Assessments & Fees 6,000

Note: Expenses expressed in % form represent % of premium

25

Other Assumptions(for Pro Forma Financial Projections)

Premium GrowthCapitalization ‐ Amount and FormRate of Return on InvestmentsLoss Payout PatternIncome TaxesAdverse Scenario

What is Included in a Typical Actuarial Feasibility StudyLoss Rates/Loss Ratios/PremiumsExpectedAdverse

Pro Forma Financial StatementsTypically 5 YearIncluding loss payout projections

Evaluation of Results

26

27

Premium and Loss RatiosRequired Premium = Losses + Expenses + Contingency Margin

Actual Premium: Based on Rates and Rating Plans

Loss Ratio =         Expected Losses

Estimated Premium

28

Pro FormasFinancial Analysis

Various loss scenariosVarious attachment pointsVarious reinsurance structures

Prospective pro forma financial statements5 year prospective financial statements including income statement, balance sheet and cash flow

Expected payout patternsExpected incorporation and ongoing expenses Investment modelingSurplus and capital contributionsReflect specific domicile(s)

29

Pro Forma Financials – Income Statement1/1/2015- 1/1/2016- 1/1/2017- 1/1/2018- 1/1/2019-

12/31/2015 12/31/2016 12/31/2017 12/31/2018 12/31/2019

UNDERWRITING INCOMEGross Written Premium 1,400,000 1,428,000 1,456,560 1,485,691 1,515,405Net Earned Premium 1,260,000 1,285,200 1,310,904 1,337,122 1,363,864

UNDERWRITING DEDUCTIONSLoss and Loss Expense Incurred 840,000 856,800 873,936 891,415 909,243Expenses 396,000 406,900 418,177 429,847 441,924

Total Underwriting Deductions 1,236,000 1,263,700 1,292,113 1,321,262 1,351,167

Net Underwriting Income 24,000 21,500 18,791 15,860 12,697

INVESTMENT INCOMENet Investment Income 20,345 38,866 50,069 57,983 64,388Profit (Loss) Before Tax 44,345 60,366 68,860 73,843 77,085

Federal Income Tax (including deferred) 15,077 20,525 23,413 25,107 26,209

Net Income 29,268 39,841 45,447 48,736 50,876

SURPLUSOpening Surplus 1,000,000 1,029,268 1,069,109 1,114,556 1,163,292Income for Period 29,268 39,841 45,447 48,736 50,876Capital Contributions 0 0 0 0 0Ending Surplus 1,029,268 1,069,109 1,114,556 1,163,292 1,214,167

Net written premium/Surplus 1.224 1.202 1.176 1.149 1.123Reserves/Surplus 0.620 0.952 1.121 1.219 1.274

30

Pro Forma Financials ‐ Balance Sheet1/1/2015- 1/1/2016- 1/1/2017- 1/1/2018- 1/1/2019-

12/31/2015 12/31/2016 12/31/2017 12/31/2018 12/31/2019ASSETSCash and Short-term Investments 932,943 1,326,842 1,584,355 1,786,962 1,956,678Letter of Credit 750,000 750,000 750,000 750,000 750,000Deferred Federal Income Taxes 30,732 53,455 69,239 81,005 89,988TOTAL ASSETS 1,713,675 2,130,297 2,403,594 2,617,967 2,796,666

LIABILITIESOutstanding Loss and Loss Expense Reserve 638,598 1,017,940 1,249,841 1,417,802 1,547,306Federal Income Taxes Payable 45,809 43,248 39,197 36,873 35,192Unearned Premium Reserve 0 0 0 0 0TOTAL LIABILITIES 684,407 1,061,188 1,289,038 1,454,675 1,582,499

CAPITALInitial Capital 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000Capital Paid In 0 0 0 0 0Income Earned 29,268 69,109 114,556 163,292 214,167TOTAL CAPITAL 1,029,268 1,069,109 1,114,556 1,163,292 1,214,167

TOTAL LIABILITIES AND CAPITAL 1,713,675 2,130,297 2,403,594 2,617,967 2,796,666

31

Evaluation of Results

Adequacy of CapitalAdequacy of Reserves (for LPT)Adequacy of PremiumMinimum Number of ParticipantsSolvency MeasurementsPremium / SurplusReserves / Surplus

How Much Initial CapitalWill be Required?

Will Be Determined Based on:

Type of risk insured and limits providedVariability of loss projectionsRisk Margin / Selected probability levelPotential for AssessmentsFinancial strength of parent companyRegulation / RegulatorOther Factors

32

Capitalization and surplus requirements

Receptiveness of regulatory environment

Quality of local infrastructure

Availability of expertise within your 

industry

Stability of regulatory environment

Domicile Selection Flexibility of investment portfolio

Ease of entry & exit 

Experience in business under 

consideration

Efficient financial outcomes

Flexibility with distribution of profits

Regulatory, Legal & Tax Analysis  Pre‐formation issues: Structure & Ownership

What are the requirements within the framework of the applicable laws?

Classes of owners; preferential rights; rights on liquidation Capital & surplus requirements and sources Voting Other considerations (e.g., insurance company for tax purposes)

Tax implications for owner(s), the captive, and policyholders

Underwriting and doing business issues Fronting Coverages, policy forms, and reinsurance and related agreements Doing an insurance business outside the state of domicile

Other regulatory, legal and tax issues due to the nature of the parent & captive

Regulatory, Legal & Tax Analysis 

Anticipating ongoing operational issues:

Changes in the approved business plan due to: Growth or downsizing of captive and captive program Changes in structure, ownership or leadership Ensuring continuity of understanding at the 

parent/owner level Other considerations (e.g., insurance company for tax 

purposes)

Anticipating exit strategies

Section Four

Incorporating a Captive

Incorporation

New Captive

Approval by Owners

Draft business

plan

Meet with Domicile

Submitbusiness

plan

Approval & Incorporate

Capitalize & Commence Operations

Section Five

Captive Operations

Operations

Management Actuarial Legal

Audit/Tax Underwriting Regulatory

Claims Risk Management

Section Six

Captive Governance

Structure and CultureGovernance Structure: Forms: stock, LLC, mutual, reciprocal Statutory and Regulatory Requirements

• Pure captives vs. RRGsGovernance Documents (e.g., Articles of Incorporation & Bylaws)

• Ownership, voting, and liquidation rights• Optional super‐majority requirements

Committee Charters; Board Policies & Procedures Shareholder and Participation Agreements (Cell Companies)

Structure and CultureGovernance Culture – tone:Board or Governance Composition:

• Parent/RRG centric – internal directors• Mix of internal and independent directors• Reciprocal: SAC and Attorney‐in‐Fact

Duties and Responsibilities of Directors & Officers• Duties and authority per law and governing documents• Fiduciary responsibilities & conflicts of interest

Tone at the top Everything’s okay until its not okay – and by then its probably too late

Section Seven

Lessons Learned & Captive Challenges

Lessons LearnedApproach the Captive as you would your losses; the more control and involvement you have, the less likely costly mistakes will be made

You must have in place the systems to adequately monitor all aspects of the Captive ‐Accounting ‐Auditing ‐Financial reporting ‐Overall captive management ‐Underwriting and premium pricing ‐Tax management

Conclusion

Questions