captive insurance: risk & financial implications

McGriff, Seibels & Williams, Inc.

Captive Insurance:Risk & Financial Implications

Ryan Erickson McGriff, Seibels & Williams, Inc.Trey Tasker, ACAS, MAAA McGriff, Seibels & Williams, Inc.

Geoff Welsher Marsh, Fleet SolutionsKevin Doyle Artex Risk Solutions

The Value Equation of Captives◦ The impact of risk information◦ In comparison to commercial insurance◦ Real vs. advertised value

Value by Type of Captive◦ Single Parent

Pure - 831(a) or 831(b) Sponsored - 831(a) or 831(b)

◦ Group Parent Group Captive Risk Retention Group

Success Stories/Panel Discussion

Agenda

Overview - Risk Financing Options

RiskFinancingOptions

Share

Retain

Transfer

Unfunded -------------------

Pre-Loss Funding ---------

Post-Loss Funding --------

Group Captive

Risk Retention Group

Group Dividend Program

Non-Insurance Contracts -

Insurance -------------------

Derivatives -----------------

• Indemnification Agreements• Hold-Harmless Agreements

• Guaranteed Cost• Loss-Sensitive Programs

• Futures and Forwards• Options

• Self-Insurance• Deductible Programs

• Captive Insurance Company• Limited Risk Programs

• Line of Credit• Contingent Capital

Insurance Pricing Continuum

Self-insuranceGuaranteed Cost

Und

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Ra

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Clas

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Expe

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Rati

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Smal

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Fron

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Less Information

More Information

What happens when the retention grows?

This is when captives can be useful.

Commercial insurance offers certain benefits

Some of these benefits can be achieved by◦ Self-Insurance◦ Single-Parent Captives◦ Group Captives◦ Risk Retention Groups

Commercial insurance offers some benefits that captive insurance does not offer

Captive insurance offers some benefits that commercial insurance does not offer

Captives vs. Commercial Insurance

The Benefits of Commercial InsuranceBasic View

RiskTransfer

CatastrophicHazard Events

Uncontrollable Hazard Events

ProtectDir & Ofc

CostReductions

Efficiency of Diversification

Accelerated Tax Deduction

DocumentedExpense

External Demands

Debt-Related Covenants

Regulatory Requirements

Customer Expectations

Service Expertise

Assessment of Hazard Risks

Prevention of Hazard Losses

Handling of Hazard Claims


RiskTransfer



ProtectDir & Ofc

CostReductions



DocumentedExpense

External Demands




Service Expertise




1. This perspective is very Hazard-focused.


RiskTransfer



ProtectDir & Ofc

CostReductions



DocumentedExpense

External Demands




Service Expertise




2. A case study of large companies suggested that they could easily

replace all but two of these benefits.


RiskTransfer



ProtectDir & Ofc

CostReductions



DocumentedExpense

External Demands




Service Expertise




3. These items are valuable.How do we replace these items?

The Benefits of Captive InsuranceBasic View

RiskTransfer

Frequency ofHazard Events


CostReductions

Better LocalKnowledge


DocumentedExpense

External Demands


Service Expertise

These items are among the benefits of captives.

Benefits Overlap

Commercial Insurance

CaptiveInsurance(Single-Parent)

Restores full tax

deduction

Better local knowledge

Documents full expense

ProtectDir & Ofc

Debt-related covenants

Severity ofhazard risks

Frequency of hazard

risks

Regulatory requirement

s

CustomerExpectations

Expertise in risk

Cost Coverage Capacity Control• Cash Flow • Availability • Increase • Regulation• Reinsurance • Broaden • New Risks • Claims

• Cost Savings • Tailored • Build Limits • Reserves

• Formal Cost Documentation

• Uninsurable Risks

• Access to Reinsurance

• Profit Center Potential

• Investment Income

• Focus Risk Mgt Efforts

• Tax Deduction Restoration

• Enhance Loss Prevention

• Stabilization

“Advertised” Benefits of CaptivesFinancial and Non-Financial

Sufficient knowledge of loss potential to identify insurance cost savings by adjusting retaining liabilities that are overpriced in the insurance market;

Opportunity for owners of private companies to transfer wealth to later generations on a tax-efficient basis for estate planning purposes;

Sufficient volume of annual losses to generate accelerated tax deductions in excess of the costs required to capitalize and maintain the captive;

Sufficient volume of annual losses to create annual cost stability by adjusting self-insured liabilities in reaction to the insurance market;

Sufficient capitalization and long-term commitment to self-insure uninsurable or prohibitively expensive exposures;

Create a profit center for external marketing to change the customer dynamics by offering insurance enhancements to customer contracts, rather than unilaterally pushing risk at customers; and/or

Internal marketing to elevate awareness of the self-insurance program throughout the financial and operational culture of the parent company.

“Real” Benefits of CaptivesFinancial and Non-Financial






Agenda



Share

Retain

Transfer

Unfunded -------------------



Group Captive




Insurance -------------------

Derivatives -----------------







Pros◦ Avoids “add-on costs” for small losses◦ Avoid excessive carrier loss estimates◦ Increases incentive for loss control◦ Facilitates unbundling of services

Cons◦ Defers premium expense and its tax reduction◦ Retains frequency risk◦ Increases capital requirement◦ Creates need for fronting insurer◦ Creates need for LOCs

Impact of Self-InsuranceRisk-Taker

Pros◦ Avoid frequency risk◦ Reduces surplus requirement◦ Allocates capital to high margin layers◦ Benefits from client’s incentive for loss control◦ Improves flexibility in reserve adjustments

Cons◦ Loss of premium revenue◦ Potential loss of service revenues

Impact of Self-InsuranceInsurer

Insurance Flow of Funds

Self-InsuredRisk

Guaranteed CostInsurance Program

Large DeductibleInsurance Program

Client

Claimant

Demand Payment Carrier

Claimant

Demand Payment

Client

Promise Premium

Carrier

Claimant

Dem

and Paym

ent

Client

Prom

ise

Premium Pa

per

Payment

Insurance Flow of Funds

Carrier

Claimant

Dem

and Paym

ent

Client

Prom

ise

Premium Pa

per

Payment

ReinsurerPromise

Premium


“An insurance company formed under special purpose insurance laws to insure the exposures of its owners and/or affiliated companies.”

Types of Captives◦Pure (Owner’s Capital)◦Sponsored (or Rent-a-Captive)◦Shared (or Group)

Captive Insurance CompanyDefined

Captive Flow of Funds “A”

Insuring Agreement Indemnity

Agreement


Carrier

Claimant

Dem

and Paym

ent

Client

Prom

ise

Premium

ReinsurerPromise

Premium

CaptivePremium

Promise

Payment

Pape

r

Captive indemnifies the deductible.

Captive Flow of Funds “B”

ExcessCarrier

Claimant

Dem

and Paym

entCaptive

Prom

isePrem

ium

Reinsurer

Promise

Premium

Client

Prom

ise

PremiumCaptive directly insures, with

support.

Captive Flow of Funds “C”

FrontingCarrier

Claimant

Dem

and Paym

entCaptive

ReinsurerPr

omise

Premium

Reinsurer

Promise

Premium

Client

Prom

ise

PremiumCaptive reinsures the direct

insurer.

Greater knowledge and understanding of insurance buyers on the value a captive program can bring to an organization

Trends toward higher deductibles, higher premiums, more coverage exclusions, and less need for commercial insurance

Favorable changes in the tax environment, including precedent-setting case law

Desire by risk-takers to grow capacity for uninsured exposures

Pro-active moves in anticipation of “hard market” pricing

Desire of risk management to become a profit center

Desire for greater flexibility in program design

Captive Insurance CompanyDrivers of Growth

The “pure” captive is capitalized by its owner and insures only the risks of its shareholder or affiliated companies.

The “sponsored” captive is a fully capitalized captive facility available to a single owner for a fee.

Group captives may be formed as stock or mutual companies, but they require willingness to share risks with other insureds.

Captive Insurance CompanyTypes

831(a) is the insurance company tax regs for most insurance companies◦ More than $1.2 million in premium per annum◦ Taxes on both underwriting income and investment

income

831(b) is the insurance company tax regs for small insurance companies◦ Up to $1.2 million in premium per annum◦ Taxes on investment income only

Captive Prospect Profile831(a) vs. 831(b)

TaxCode Pure Sponsored Group Captive RRGs831(a) Yes Yes Yes Maybe831(b) Yes Yes NO NO

Single-Parent Owner Group Ownership

Financially strong parent

$5 million or more in premium for 831(a) or $1.2 million or less in premium for 831(b)

Willingness and capital to retain risk

Senior management commitment to risk management objectives

Desire for “real” benefits as discussed

Captive Prospect ProfilePure Captives

Financially strong parent

$1 million or more in premium for 831(a) or $1.2 million or less in premium for 831(b)

Willingness and cashflow to retain risk

Senior management commitment to risk management objectives

Desire for “real” benefits as discussed

Captive Prospect ProfileSponsored Captives

Frictional fixed costs

Unfavorable loss experience

Increased regulatory requirements◦ Captive jurisdiction◦ IRS Safe Harbor tax position

Time commitment of corporate staff

Opportunity cost of capital investment

Without reinsurance◦ Substantial additional capital needed◦ Risk-bearing capacity limited to parent’s balance sheet

Captive Challenges

Captive Players (Cash Flow “C”)

Fronting Insurer

Reinsurer

Captive Reinsurer

InsuredPremium

Premium

Premium

Claims

Claims

Claims

Consultant/Broker

Manager/Sponsor

Third-Party Admin

Insurance Broker

Reinsurance Broker

Insurance Market

Reinsurance Market

Feasibility Study Cost of Capital Business Plan Design Financial Pro-Formas Actuarial Projections Legal Incorporation Regulatory

Licenses/Fees

Additional Capital Management Salaries Actuarial Reserves Actuarial Pricing Legal Review Auditor Services Regulatory Fees Premium Taxes Claims Services Investment Mgt Fees Reinsurance Premiums

Captive Planning Issues

• Incorporation and Operating Costs: The formation and operation of a captive entails various expenses including:

Start-Up CostsAnnual Operating Costs



Share

Retain

Transfer

Unfunded -------------------



Group Captive




Insurance -------------------

Derivatives -----------------







Group Captive – Summary Risk sharing built in the structure

◦ Less control of shared loss experience◦ All members share in reinsurance limits◦ Benefits of portfolio theory

Cost sharing built in the structure◦ Homogeneity of the membership◦ Lower admin costs than pure captives◦ Lower cost for shared reinsurance

Risk reduction through◦ Underwriting◦ Loss control

Group Captive – Basics #1 Control

◦ Premiums paid to insurance entity owned by insured◦ Superior loss control, claims handling and other unbundled

services◦ Premium costs heavily weighted toward member loss

history

Financial◦ Insured shares in underwriting profit and investment

income, via dividends paid to policyholders/owners◦ Group purchase of reinsurance and services can reduce

operating costs◦ Collateral requirements (usually Letters of Credit) for

(i) capitalization of the captive, and (ii) collateral support of each member’s retention.

Group Captive – Basics #2 Stability

◦ Insured does not subsidize poor risks◦ Insulation from cyclical marketplace◦ Reinsurance Accounts for approximately 10% -

20% of Total Premium◦ Less volatility in year over year pricing – losses

capped

82%

18%

Approx. 18% of TCOR is subject to Insurance Industry Swings

Group Captive – Basics #3 Greater risk involved in a Group Captive

◦ Member approval process – annual loss control, financial review

◦ Collateral in place to protect bad debt exposure◦ Fronting carrier/reinsurance provided by ‘A’ Rated

carriers

Risk Sharing – Averages 2% - 7%◦ Allows for tax deduction of premium◦ Reduces individual member exposure to

catastrophic claims◦ Risk Sharing a “wash” – both absorbing and causing

Risk Retention Group - Summary Same Advantages of Group Captive

◦ Risk sharing built in the structure◦ Cost sharing built in the structure◦ Risk reduction through

Plus Reduced Regulation◦ Domiciled in one state, operate in many◦ No state guarantee fund assessments

Risk Retention Group – Basics #1

Operates similar to a group captive, yet is regulated under federal legislation.

Can operate in all fifty states yet only required to be licensed in its state of domicile.

Insureds must be owner and owners must be insureds.

Can only write liability lines of risk, cannot underwrite workers compensation.

No state guarantee fund assessments

Risk Retention Group – Basics #2

Does not require a fronting insurance company.

Capital requirements serve as the collateral for RRG. No specific collateral requirements required for the retention since there is no fronting company.

Insureds fund capital requirements, typically a 2-to-1 ratio, in addition to premium.

Equity is based upon stock valuation which is done by an independent party.

RRG’s access reinsurance markets to share risk.

Benefits OverlapCommercial Insurance

CaptiveInsurance(Group Owned)

Restores full tax

deduction

Better local knowledge

Documents full expense

ProtectDir & Ofc

Debt-related covenants

Severity ofhazard risks

Frequency of hazard

risksRegulatory

requirements

CustomerExpectations

Expertise in risk

Compare and ContrastProgram Guaranteed Risk Retention Group Sponsored Pure Large Self-InsuredFeature Cost Group Captive Captive Captive Deductible Risk

Amount of Risk Transfer

Full Moderate/Full Moderate/Full Some Some Some None

Amount of Risk Sharing

None Some Some None None None None

Speed of Risk Expense

Full Full Full Full Full Moderate Some

RegulatoryScrutiny

None Minor Minor Some Some None None

Premium Documentation

Full Full Full Full Full Moderate Some

Premium Deductibility Full Full Full Moderate/Full Moderate/Full Moderate None

Balance Sheet Impact

NoneExpected Dividend

Expected Dividend

LimitedUnpaid

LimitedUnpaid

LimitedUnpaid

Unpaid

Amount of Capital Needed

$0 $0 $0 Varies $250k or more $0 Judgment

Cost of Administration

$0 Built in Built in $30k - $100k$50k once, and

$50k - $150k$0 $0

Timeline forImplementation

7 - 30 days 30-60 days 30-60 days 30-60 days 60-90 days 7 - 30 days No time

Ease ofUnwind & Exit Easy Easy Moderate Moderate Tough Moderate Tough

UPPER SCALE: None Minor Some Moderate Significant Major Full






Agenda