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
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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
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Data CollectionExpense AnalysisWill vary by:Type of programDomicile
Other AssumptionsChallengesSingle Company versus Group Program
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Program DesignInsurance StructureWill vary by:Types of insurance Retentions LimitsDirect Reinsurance
Type of Captive
Ownership Structure
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Actuarial Analysis “Formal Feasibility”
Why is an Actuarial Feasibility Study Necessary?
What are the Components of a Typical Feasibility Study?
Evaluation of Results
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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
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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
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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
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Expense AnalysisFronting FeesReinsuranceClaims Administration, Loss PreventionCommission & BrokerageManagement FeesLegal, Audit, Actuarial, & ConsultingLetter of CreditOther (Travel, Board Meeting, D&O)Taxes & Assessments
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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
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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
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Premium and Loss RatiosRequired Premium = Losses + Expenses + Contingency Margin
Actual Premium: Based on Rates and Rating Plans
Loss Ratio = Expected Losses
Estimated Premium
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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)
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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
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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
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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
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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