Captives Formation:Captives Formation: How and When How and When

Charlie Woodman, CPA

SVP, Risk FinanceMarsh

CAS Ratemaking Seminar

March 27, 2003

André Lefebvre, FCAS, MAAACredit & Market Risk Executive

Royal & SunAlliance

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Discussion PointsDiscussion Points

Risk and Risk Financing Perspectives

Single Parent Captive

Group Approach

Critical Considerations

Stop us at any time for questions

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Risk / Capital Risk / Capital RelationshipRelationship

Amount of loss

Expected

loss

Unexpected loss

Stress loss

Frequencyof loss

Operating Cash Flows /Strain on Working Capital

Buydown Debt/Reacquire EquityOpportunity

Capital Allocation /Budgeting / Revaluation

Capital / Resources At RiskCapital / Resources At Risk

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Universe of Risk Finance Universe of Risk Finance From the Insured’s From the Insured’s

PerspectivePerspective Risk Transfer

• Becomes someone else’s risk

Risk Funding Efficiencies• Our risk, our balance sheet, more cost and timing efficient

Off-Balance Sheet• Our risk, someone else’s balance sheet

“Planet Killer” Protection• Our risk, our balance sheet, save our lives.

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Captive Insurance Captive Insurance Company - DefinedCompany - Defined

An Insurance Company, typically owned by non-insurance parent(s), insuring the risks or interests of its owner(s)

Incorporated, Regulated, Capitalized and Accountable

May or May not be a replacement for insurance. Depends on Form (ownership and insured relationship)• Emphasizes the ‘Insurance Transaction’• Insurance Company Operations

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Insurance purchasingContract assessmentRely on brokerLimited Captive Use

Risk transferRisk assessmentStructural risk financing skil l sBasic AnalysisEmergence of ConsultantsGrowth of Captives as engines for risk assumption and tax planning

Risk transfer with limited risk assumption

Risk evaluationLarger risk sel f-assumptionTotal Cost of RiskPortfol io approachCapital markets methodEPS/P&L impactSel f-relevance and new consultingEmphasis on the captive as a flexible strategic platform.

Transfer/Retention/Capital Market structure

1960 1980 2000

Skill Sets

Where Captives Fit into Where Captives Fit into the Risk Finance the Risk Finance

EvolutionEvolution

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Captive Insurance Captive Insurance Company - FormsCompany - Forms

Single Parent - Non Risk Pooling• Wholly-owned, Rent-A-Captive, Trusts• Emphasis on Risk Funding and Cost / Funding Efficiencies

Group Owned- Risk Sharing / Risk Pooling• Group, Association Captive, Risk Retention Group• Emphasis on Risk Transfer replacement / Alternative

“insurance”

This distinction is critical in assessing the merits of a program.

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Spectrum of Risk Spectrum of Risk FinanceFinance

Risk Transfer Risk Funding

Single ParentCaptives

Rent-a-Captive / Cell Facilities

Self-insuranceTrusts

First DollarRisk Transfer Guaranteed Cost

Group CaptivesPoolsRRGsReciprocal Exchanges

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Current Captive Current Captive Insurance Program Insurance Program

EmphasesEmphases Cost Savings Risk Management Facilitation Business Enhancement

Insurance / Risk Transfer Replication (Group Emphasis)

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Single Parent Captive Single Parent Captive RealityReality

Individual Reporting Concern and a Consolidated Entity

A Single-Parent Captive Insurance Subsidiary, insuring the risks of the parent and affiliated operating brother-sister concerns, is only self-insurance in its most sophisticated form.• Risk Retention Levels and Captive Utilization are two different

considerations.• If a concern cannot afford to increase its risk retention levels

without a captive, then they certainly cannot afford to assume more risk with one.

No one needs a captive insurance subsidiary.

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Current Single Parent Current Single Parent Captive Insurance Captive Insurance

Program EmphasesProgram Emphases Cost Savings

Risk Management Facilitation

Business Enhancement

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Cost SavingsCost Savings

Long-term: “Seasoning” / Risk Management Point Facility

Short-term: “Business Case”

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SeasoningSeasoning

“Seasoning” / Risk Management Point Facility Extends the Corporate Risk Management

“Commitment” to It’s Own Risks Engages in Insurance under the Insurance Industry’s

Mechanisms and Measurements Regulated and “Grounded” Reinforces Relationships with (Re)insurance Markets Hard to quantify

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How (Re)insurers How (Re)insurers evaluate captives as evaluate captives as

Risk PartnersRisk Partners Where domiciled

How long in existence

Strength of captive’s financials

Who manages captive

Insurance program dynamics

Actuarial support

Owner proactivity and commitment

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Business CaseBusiness Case

NPV of Cash Flows - Short Term Business Case cost Savings

• Accelerated Tax Benefits - Qualified Insurer• State (& International) Tax Arbitrage• Operating Costs• Opportunity Cost of Capital

Other Quantitative & Qualitative

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Tax RealityTax Reality

The underlying issues which define whether an insurance transaction has occurred or whether a transaction is self-funding are:

• “Insurance Risk” - Insurer must assume a reasonable possibility of incurring significant loss.

• Notions of Risk - Form

• Risk Transfer / Risk Distribution - Risk of loss must be legally transferred from one legal entity to another, which pools the risk among other risks so as to increase predictability, and reduce adverse loss uncertainty.

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Accelerated Tax Benefits Accelerated Tax Benefits - - Qualified InsurerQualified Insurer

Insurance Premiums are Deductible over the policy term “Casualty” losses are subject to “Economic Performance” for tax Accounts and “set-asides” are not economic performance Incurred Basis (incl. IBNR) vs. Paid Basis

• SubChapter L of the IRC Accelerated Recognition, not an accelerated realization

• i.e. Already recognized for financial reporting• No “above the line” accounting benefit• Consolidated Cash Flow Benefit• Note: Basis of tax benefit is actual premium deduction from insured to

Group Captive

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Tax Facts & Tax Facts & CircumstancesCircumstances

Third Party Writings Approach

Captive

Parent

Sub Sub Sub Sub Sub Sub

Deductible

Outside Business

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Tax Facts & Tax Facts & CircumstancesCircumstances

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Other Business Case Other Business Case ComponentsComponents

State (& International) Tax Arbitrage Operating Costs WACC / Opportunity Cost of Capital

• Capitalization• Losses as Premiums• Discount rate on enhanced cash flows

Other Quantitative & Qualitative• (Re)insurance• Internal Costs & Resource Commitment• Recognitions and Materiality• Corporate Culture

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Captive Operating CostsCaptive Operating Costs

Start-up Fronting, if applicable. Management Measurement: Audit & Actuarial Legal & Regulatory (Re)insurance Pools and Participations Premium-based Taxes

• Direct / Reinsurance• Federal Excise Taxes• Self-procurement / Direct placement.

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Design Components and Design Components and IssuesIssues

Coverages Structure

• Direct Writer• Reinsurer

Capitalization & Collateral Domicile

• Cost• Regulatory• Other

Premiums & Operating Expenses Premium Taxation

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Program Evaluation or Program Evaluation or “Feasibility”“Feasibility”

Risk Assessment / Self-Assessment Insurance Marketplace Risk Quantification Qualitative Issues Pro Forma Structure & Design Time - Urgency versus Commitment Capital Cultural

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Capital Cost - A Capital Cost - A Sensitive IssueSensitive Issue

Captive After-tax Present Value Advantage/(Disadvantage) Captive

InvestmentRate 5.50% 6.50% 7.50% 8.50% 9.50% 10.50% Break-even

5.50% $2,078,848 $137,561 ($1,527,474) ($2,956,416) ($4,183,296) ($5,236,996) 6.58%6.50% $4,726,281 $2,448,695 $495,275 ($1,181,367) ($2,621,352) ($3,858,703) 7.80%7.50% $7,719,697 $5,059,230 $2,777,535 $818,990 ($863,470) ($2,309,723) 8.99%8.50% $11,098,256 $8,002,927 $5,348,452 $3,069,847 $1,112,158 ($571,154) 10.16%9.50% $14,905,180 $11,317,045 $8,240,184 $5,598,999 $3,329,584 $1,377,843 **10.50% $19,188,154 $15,042,678 $11,488,196 $8,437,089 $5,815,319 $3,560,238 **

Break-even * * 6.26% 7.09% 7.94% 8.79%

* Captive Investment Rate Break-even Value at the Specified Parent Time Value Money is Not Within The Scenario Range Selected.** Parent Time Value Money Break-even Value at the Specified Captive Investment Rate is Not Within The Scenario Range Selected.

Parent Time Value Money

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UnderwritingUnderwriting

Traditional risk

• Professional Liability/Medical Malpractice

• Workers compensation, auto and general liability

• Products/completed operations, errors & omissions, environmental

• D&O, Surety, Property?

• Employee Benefits: Voluntary LTD, Optional Life, Health coverages?

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Estimated Operating Estimated Operating Expenses - Single ParentExpenses - Single Parent

Start-up costs - $50k Annual Captive Management Fee - $50 - 75k Annual Assurance

• Audit - $15k• Actuarial - $25k

Legal & Regulatory - $15k Premium Tax (if applicable)

• US Federal Excise Tax - Avoided under IRC Sec. 953(d) ‘domesticating election’

Other (I.e. Annual General Meetings, travel, etc.) - $10k

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Other ConsiderationsOther Considerations Operational

• Directors & Officers• Committees• Meeting Structure & Timing

Financial• Timing, Distribution & Format• Investments

Structural for Group Emphasis• Fronted / Reinsurance• Retro rated• Capitalization

Administrative Consensus, Agreement, Voice, Relevance, Commitment

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Group Captive RealityGroup Captive Reality

A Group Captive is dependent on its members and its advisors.• Risks of the few may become the risks of the many.• The Assets of the many may become the assets of the few.

The goal is the replication and replacement of insurance and a group purchase of excess coverages / reinsurance• Can be a problem to insurers, due to risk concentration.

Works best when the ‘motivation’ is high.• Industry abandonment or extreme over-pricing.• Commitment to changing industry risk practices.• Creating a group “voice.”• Communication and consensus already exists or a centralizing

entity coordinates the efforts.

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Quantification is CriticalQuantification is Critical

Especially in the Group Captive• In any transaction, if Garbage In, then Garbage Out.

Assessment and Quantification• Counter-party risk will exist in a group environment

Will form the bulk of premium determination and payment terms

Will dictate design and risk layers Will define flexibilities

Specific Reinsurance

Severity Fund

Frequency Fund

$200,000$200,000

$400,000$400,000

$1,000,000$1,000,000

$25,000$25,000 Deductible

Aggregate Reinsurance

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Actuarial IssuesActuarial Issues

Retention Level• Attachment Point• Per Occurrence Limit• Aggregate Limit

Pricing• Pure Premium• Expenses• Profit & Contingency

Dynamic Financial Analysis

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Factors Influencing Factors Influencing Retention LevelRetention Level

Financial Wherewithal of the Insured Financial Wherewithal of Insurers Risk Philosophies Insurance Market Conditions

Cost / Benefit Analysis

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Risk Transfer Savings

Risk

Current Program

Risk FinancingAlternatives

The Efficient Frontier 1

1The efficient frontier is the point at which there is no greater expected reward for a given level of risk, and vice versa

The Risk Finance The Risk Finance FrontierFrontier

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Retention Level Retention Level Decisions: Appetite Decisions: Appetite meets Opportunitymeets Opportunity

Property - Probability Distr ibution

0%

2%

4%

6%

8%

10%

12%

14%

Losses / (Gains)

Prob

abili

ty

Unlimited $500K Retn $1MM Retn

$500,000 Retention

$1,000,000 Retention

Unlimited Retention

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Multi-Risk ComparisonMulti-Risk Comparison

Probability Distr ibutions - Individual Risks

0%

2%

4%

6%

8%

10%

12%

14%

Losses / (Gains)

Prob

abili

ty

Prop. @1MM W.C. @1MM Prod. @1MM Auto @1MM

Auto Liability

Property

Workers Comp

Products Liab.

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““Portfolio Effect”Portfolio Effect”

Probability Distr ibutions - All Lines

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

Losses / (Gains)

Prob

abili

ty

All Lines- Treated as Combined All Lines- Treated as Separate

Retained Risk @ 85th Percentile -

Risks Treated In Combination

Retained Risk @ 85th Percentile - Risks Treated In Isolation

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$1MM per loss

$3MM per year - Aggregate Losses Retained

Defined amount of losses to be retained and funded through the captive

The Retention

Common Characteristics Common Characteristics of All Captivesof All Captives

$1MM/$3MM

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$1MM/$3MM

$MM Specific Excess/ $MM Aggregate

Excess / Risk Transfer

If available and / or affordable / reasonable

Common CharacteristicsCommon Characteristics

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Segregated cell captive with

individual excess coverage

$3MM/$18MM

$5MM/$8MM

$1MM/$3MM

$3MM/$16MM

$2MM/$9MM

Individual Limits

HG 1 HG 2 HG 3 HG 4 HG 5

Segregated Cell

AlternativesAlternatives

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$3MM/$18MM

$5MM/$8MM

$1MM/$3MM

$3MM/$16MM

$2MM/$9MM

HG 2 HG 3 HG 4 HG 5

Combined LimitsGroup captive with shared

excess coverage

Group Pooling

Common CharacteristicsCommon Characteristics

HG 1

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Group CaptiveGroup Captive

Specific Reinsurance

Severity Fund

Frequency Fund

$200,000$200,000

$400,000$400,000

$1,000,000$1,000,000

$25,000$25,000 Deductible

Aggregate Reinsurance

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Pricing IssuesPricing Issues

Similar to Pricing• “High Deductible”• “Excess Reinsurance”

Methodology• Traditional methods

o Aggregateo Frequency / Severity

• Monte Carlo simulation models

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Pricing Issues - Cont’dPricing Issues - Cont’d

Data• Use insured own experience• Supplement using “industry” data

o Similar company/industryo Bureau

Correlation of Risks Risk Loads

• Captives which only insure the risks of the parent and affiliates / subsidiaries are only self-insurance in its most sophisticated form (i.e., no real risk transfer)

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Dynamic Financial Dynamic Financial AnalysisAnalysis

DFA’s goal is to provide management with:• solid information about the interaction of decisions from all

areas of company operations;• a quantitative look at the risk-and-return trade-offs inherent

in emerging strategic opportunities; and• a structured process for evaluating alternative operating

plans. Captive insurance companies are well-suited for DFA

application

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ConclusionConclusion

Questions

Thank you