In The Hard Market

2. A Primer on Captive Insurance Companies October 5, 2005

3. I. Captive Characteristics & Types II. Uses & Benefits III. Policy Writing Structures IV. Federal Income Taxation V. A Case Study VI. Are You Ready? Feasibility &  Implementation

4. I. Captive Characteristics & Types

5. What is a Single Parent Captive?

6. Characteristics of Captives Formed to insure or reinsure the risk of its owners (and sometimes unrelated parties) Licensed in a captive domicile Regulated under special enabling legislation �Admitted� only in its domicile; non-admitted in all other jurisdictions (unapproved status)

7. Types of Captives Types: Single Parent (Pure) Captive [main focus of this presentation] Group Captives (association captives, risk retention groups) Rent-a-Captive (protected cells, sponsored captives) Branch Captives Organization Forms: Stock insurer Mutual insurer Reciprocal Non-profit LLC

8. Active Captives by Domicile at Year End 2004 (Source: Business Insurance � March 7, 2005)

9. Typical Single Parent Structure � Ownership Flowchart

10. Typical Single Parent Structure �  Policy Flowchart

11. II. Uses and Benefits

12. Captive Toolbox

13. Underwriting Focus Traditional Risk (US and global) Workers� compensation, auto, general liability Property, cargo, surety Professional liability, errors & omissions, directors & officers (side B), environmental Terrorism Risk (TRIA) Employee Benefits Operational and Financial Risks Legacy liabilities (WC, products, divested operations) Customer care: extended warranty, e-commerce, credit life, other Suppliers / dealers / other business partners Contractual guarantees Financial events (trade credit, residual value, other)

14. Captive Uses: Our Clients Say Reduce or stabilize costs / manage cash flow Exert control and avoid market cycles Encourage loss control Custom policy forms and coverages Access to reinsurance markets Rationalize business unit allocations and budgeting process Discipline in risk financing process (actuarial studies, audits, etc.) Accelerate federal income tax deductions

15. Other Considerations Long term commitment (5+ years) Capitalization requirements Operating costs Opportunity cost Potential adverse underwriting results Time commitment from management May be subject to state self-procurement taxes IRS challenges to insurance company status

16. III. Policy Writing Structures

17. Typical Insurance Program Today

18. Insurance Premium & Loss Flow

19. Fronted Captive (Reinsurance Assumed) 

20. Fronted Captive In a fronting arrangement, a traditional insurer provides policies Insurer cedes the desired exposure to captive Result: the financial arrangement is not visible to other parties Allows captive to write any coverage Downside: added costs (fronting fees) and the captive typically needs to provide collateral to the front (e.g. letter of credit, reinsurance trust)

21. Direct-Writing Captive

22. Direct-Writing Captive In a direct writing captive, policies are issued directly to the insured Current carrier, broker, etc. relationships undisturbed Avoids expense of a traditional insurer (fronting fees, collateral, insurer�s profit) Downside issues: Not admitted in a state Has no financial rating May not satisfy contractual requirements for insurance Best used for specialized coverages, where certificates are not needed, or to insure deductibles/retentions

23. Captive as Ceding Insurer (Reinsurance Ceded)   

24. IV. Federal Income Taxation

25. Tax Treatment of Captives

26. Captive as Insurance Company for Federal Income Tax Purposes

27. Captives and Taxation: Federal Based on case law and IRS Revenue Rulings, there are three ways to be treated as an insurance company for IRS purposes: Brother-Sister subsidiary relationship (RevRuling 2002-90) Humana, HCA, Kidde Third-party business test (RevRuling 2002-89) Harper, Sears, Odeco, Amerco � + Employee Benefits Group captive of unrelated businesses (RevRuling 2002-91) OIL, AEGIS, MedMarc

28. Brother�Sister Structure - Risk Transfer and Risk Distribution

29. Third Party Test

30. Third Party Test Third-party business: Based on the Harper ruling, 30% unrelated business qualifies as a tax-deductible insurance company � RevRuling 2002-89 has a �bright line� test of 50% Sources of third-party business: Warranty plans, credit life, cargo/transit insurance, OCIP Marsh-sponsored reinsurance pools available: Green Island (WC, AL, GL � 1st $100K) $5M + SymmetRE (WC only � 1st $100K) $1M - $5M Employee benefits (IRS 92-93)

31. Employee Benefits in Captives U.S. Department of Labor (DOL) resisted captives for ERISA benefits until Columbia Energy (2000) and Archer Daniels Midland (2003) Precedents paved the way for similar programs to utilize expedited DOL approval process International Paper (group life), Swedish company SCA (life, ADD, LTD), Alcon Labs (life, LTD), Alcoa (life), Sun Microsystems (life � just approved) Requirements: US domicile Improvement in benefits to employees A-rated fronting insurer �Seasoned� captive

32. Value of Tax Efficiency Most beneficial in �long-tailed� types of exposures For a typical workers compensation or general liability exposure, may mean 3-7% NPV, after-tax benefit, after costs of the captive State income tax arbitrage on profits of captive could result in additional after-tax savings More than offsets costs of operation � threshold is +/- $6M of �longtail� risk premium Strategic uses of captive motivate the �smaller� parent company

33. Tax Benefits for Small Insurers IRS Section 831(b) Captive Can make election if premium income does not exceed $1,200,000 Taxed only on investment income (i.e., underwriting income is not taxable) Ideal for low frequency/high severity losses (e.g., products liability) Less ideal for WC (premiums approximate losses and, therefore, low or no underwriting profit) IRS Section 501(c)(15) Captive Gross receipts do not exceed $600,000 (more than 50% must be from premiums) Underwriting and investment income are not taxed

34. V. A Case Study

35. Evolution of a Captive � A Case Study 1995 � Captive formed to gain access to reinsurance market for products liability. Captive cedes 100% of the risk to other insurers. Net retained premium is $0. 1996 � Captive adds property, marine, crime (direct basis and reinsurance assumed basis). 1997 � Captive offers individual business units option to �buy down� large deductibles on WC, AL, GL. 2001 � Captive writes excess property and liability coverage on a direct basis and cedes most of risk to commercial reinsurers. 2003 - Captive writes stand-alone TRIA coverage. 2003 � Captive increases its property retention to $35MM. Catastrophic loss occurs! 2005 � Captive�s net retained premium has grown to $50MM annually. Captive increases retention on products liability from $0 to $30MM.

36. VI. Are You Ready? Feasibility &Implementation

37. Down To It! Three Steps to a Captive: Consultation, captive feasibility study Retain a captive manager � Marsh, of course! Implementation in chosen domicile � Utah, of course!

38. Down To It! Captive Feasibility Study $35 � 50K (see captiveguru.com = $50K) Actuarial analysis of loss history and projections of future liabilities (can analyze different retentions) Demonstrate financial impact on parent company Forecast of captive's pro-forma income statement, balance sheet, cash flows Forms the basis of domicile-required business plan Review and confirm domicile selection Transition to captive manager for license application and implementation

39. Down To It! Timing of Feasibility Study Collection of Data - Two to Three Weeks Preparation of Study - Four to Six Weeks Parent Review and Consideration - ???

40. Down To It! Implementation Timing: 45-90 days Captive manager ($5-15K) Finalize business plan Prepare license application Liaison with regulators Coordinate legal representation Facilitate banking relationships Liaison with accounting / actuarial firms Assistance with insurance program documentation, establishing policies & procedures, etc.

41. Down To It! Underwriting assistance Policy issuance Premium billing and collection Accounting and statistical analysis Preparation of accounting and financial reports Liaison with other service Cash management Actuarial analysis

42. Thank You!Questions?

57. Captives in UtahActuarial Involvement Little American Hotel Salt Lake City, Utah October 5, 2005 Presented by R. Glenn Taylor, ACAS, MAAA President, Taylor-Walker & Associates, Inc.

58. INTRODUCTION

59. Overview Definition of Actuary Actuarial functions - General Actuarial functions � Captives Captive formation Following licensure

60. Definition Actuary A place where they keep birds A place where they bury dead actors What you get when you cross a computer with a gypsy fortune teller An accountant without the personality A person who can pursue a straight line from an unwarranted assumption to a foregone conclusion

61. Definition Actuary One trained in evaluating the current financial implications of future contingent events A mathematician dealing with probabilities in the insurance business

62. Actuarial functions - General Reserving Pricing Reinsurance analysis

63. Actuarial functions � Captives Captive Formation Reserving Pricing Following licensure Reserving Pricing

64. Captive formation Feasibility process How can the actuary help? Actuarial study Considerations Existence of prior actuarial studies Data and information Availability Credibility

65. Actuarial Study Considerations (Continued) Potential types of captive Potential types of coverage Long vs. short tail Workers Compensation Non-typical P&C coverages Portfolio transfers

66. Actuarial Study Considerations (Continued) Potential coverage layers Underlying deductibles / self-insured retentions Captive retention levels Excess coverage vs. reinsurance Specific excess of loss Aggregate excess of loss Quota share

67. Actuarial Study Considerations (Continued) Loss development Trend Underwriting expenses Capitalization Regulatory Requirements Regulatory Ratios

68. Actuarial Study Results of actuarial study Projected loss costs / incurred losses and LAE Projected premium rates Loss ratios Cash flows Claim payout patterns Discounting Reserves Confidence levels Capitalization

69. Actuarial Study Incorporation into pro-forma financial statements Incorporation into feasibility study

70. Feasibility Study Decisions Application completed and submitted Application review process Respond to questions

71. Following licensure Pricing Underlying Exposure Trend Retention Reinsurance

72. Following licensure Reserving Reserve opinion Reserve study Initial reserve study serves as a base

73. CONCLUSION

74. QUESTIONS?

75. www.taylor-walker.com gtaylor@taylor-walker.com rross@taylor-walker.com lspann@taylor-walker.com Phone (801) 562-5748 Contact information

76. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Utah Requirements for Forming Captives �How To� Steps and Procedures

77. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Basic Process: Self assessment Retain advisory services Assess feasibility Discuss plans with Utah Insurance Department (UID) Apply for Certificate of Authority as Captive

78. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Self Assessment: There are a myriad of things to consider in determining whether a captive is right for any organization. As a result, there are no hard and fast rules. However, the following questions should be helpful in determining if it is right for you. While the following questions are not comprehensive, they should provide some initial sense about the feasibility of a captive.

79. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Self Assessment: How does your claims experience compare to the average pool of insureds covered in the traditional market? Is your current claims experience consistent and predictable? How well do you know your insurable risks and which risks would you like to move from the traditional market? How much do you currently pay in premiums? What are the demographics of your risks (i.e. international, national, or Utah only)? What is the financial stability of the parent organization? Is the parent willing to commit to the captive concept?

80. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Retain Advisory Services (Captive Manager): Due to the complexities involved, it is best to retain a captive manager. This is particularly important early in the process to ensure time and resources are used in an effective manner. Since captive managers are familiar with captive concepts and the licensing process, they will help ensure that key considerations have been made and the licensing process will run smoothly.

81. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Retain Advisory Services (Captive Manager): The UID requires that you choose a captive manager from our approved listing. Captive managers can get on our approved listing by submitting a UID Captive Management Firm Application. To obtain an application, contact Steve Fry, Captive Director, via email at sgfry@utah.gov Please be advised that the UID does not warrant the quality of each captive management firm. It is the responsibility of each individual applicant to screen each captive manager and choose according to their needs.

82. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures  Assess Feasibility: Your captive manager will help you conduct a feasibility study, which will be provide a more definitive conclusion as to whether a captive insurer makes sense based on an applicant�s specific circumstances. A feasibility study will generally look at both the quantitative and qualitative factors.

83. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Feasibility Study (Quantitative Factors): Coverage & program structure Loss analysis and rate development Capital & surplus Claims projections & pro forma statements Reserve requirements Fronting & reinsurance Investment income Taxes

84. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Feasibility Study (Qualitative Factors): Ownership structures Governance Domicile (Utah) Management

85. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Discuss Plans with Utah Insurance Department: Before spending time with application forms, the Department requires that you meet with the UID. The captive manager and the applicant should be involved in these meetings.

86. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Discuss Plans with Utah Insurance Department: We don�t want to see application forms until we have met with you personally. There are several reason for this approach. We don�t want you to waste time on forms until we feel there is a chance for success. It gives us a chance to give guidance and insights to help ensure a smooth licensing process. We want to meet applicants personally so we know who we are dealing with during the application process.

87. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Discuss Plans with Utah Insurance Department: While the UID has a regulatory role over licensed captives, we are interested in the success of the captive market. Use us as a resource. We will assist where we can appropriately do so. Meetings will be conducted with Steve Fry, Captive Director, and Neal Gooch, Deputy Insurance Commissioner. Contact Steve Fry at (801) 538-3811 to set up an appointment.

88. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Make Application: Application forms will be provided by the UID once we have met with the applicant and are comfortable that the proposed plan is feasible. Assuming a complete and accurate application is received, the review process should take about 30 days.

89. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Applicant forms are as follows: UID Captive Insurer Application UID Biographical Affidavit UID Captive Reinsurance Exhibit UID Approved Letter of Credit Form UID Statement of Economic Benefit UID Appointment of Service of Process Form

90. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Service Provider Applications: UID Captive Management Firm Application UID Captive Actuary Application UID Authorized CPA Application

91. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures UID Captive Insurer Application (Main Application): General Information Name, parent, contact info, captive type, organization type, location of principal office, name and address of registered agent, location of books and records, name of board members and officers Financial Information Form and amount of capitalization, name and address of beneficial owners, and relationship of beneficial owners to captive.

92. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures UID Captive Insurer Application (Main Application): Service Providers Management firm, attorney, claims administrator, CPA, actuary, broker, etc. Miscellaneous Information Explanation of insurance coverage/limits/reinsurance, incorporation documents, feasibility study, parent company financials and historical information, detailed business plan, etc.

93. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures UID Captive Insurer Application (Main Application): Detailed business plan should include the following: Summary of risks to be insured Use of fronting arrangements Expected annual premiums Retention limits (per loss and aggregate) Rating program Reinsurance program Organization and responsibility for loss prevention Loss experience for past three years and projections for the next three years Org chart Financial projections on an expected and worst claims scenario

94. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures UID Biographical Affidavits: Biographical affidavits are required to be filed for all officers and directors of the captive as well as beneficial owners having more than 10 percent ownership in the captive. Biographical affidavits should include (but not be limited to): Personal information, educational history, employment history, past residences, and other relevant information. All information is kept confidential.

95. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures UID Captive Reinsurance Exhibit: This form is where applicants indicate the type of insurance they intend to write on either a direct basis or through reinsurance using a fronting carrier. The form also requires other specifics such as per claim and aggregate limits, whether policies are assessable, whether there are guarantees by the parent, or whether there will be loans back to the parent.

96. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures UID Approved Letter of Credit Form: The statutes allow for capitalization to come in the form of a Letter of Credit (LOC). If this is the form of capitalization chosen by the applicant, the LOC must come in the form stipulated and approved by the Department.

97. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures UID Statement of Economic Benefit: The Statement of Economic Benefit is used to determine the economic impact the applicant captive may have on the State of Utah. In order to establish a captive entity with the Division of Corporations, the statutes require articles of incorporation approved by the UID and a Certificate of Public Good. The UID issues the Certificate of Public Good based on information provided in the Statement of Economic Benefit and the rest of the application.

98. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Appointment of Service of Process: Captive insurers must appoint a resident registered agent for service of process. They must also appoint the commissioner to receive service of process in the event the resident registered agent cannot be located.

99. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Other Considerations: The Department may retain an outside review firm to conduct a review of the application and make recommendations to the UID on licensure. If an outside review firm is retained, the applicant will be responsible for paying the actual cost of that review. Costs are estimated at approximately $3,600 dollars.

100. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Other Considerations: Captive insurers are required to: Hold an annual Board of Directors meeting in Utah. Maintain a principal place of business in Utah. Appoint a local registered agent to accept service of process. Form with no less than 3 incorporators of which two must be Utah residents. Appoint at least one Utah resident to be on the Board of Directors.

101. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Capitalization Requirements: Pure Captive $250,000 Association Captive (stock/mutual) $750,000 Industrial Insured (stock/mutual) $500,000 Sponsored Captive $1,000,000 Any Captive as Reciprocal $1,000,000

102. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Reporting Requirements: Each Captive must: Have an annual audit by approved CPA (June 30th) Obtain certification of loss reserves and loss expense reserves from approved actuary (June 30th) File an annual report with UID (March 1st) Be subject to examination by UID once every 3 years. Reporting should be on GAAP basis unless SAP approved.

103. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Investment Restrictions: Association Captives, Sponsored Captives, and Industrial Insured Groups must comply with U.C.A. 31A-18-105 and 106. Pure Captives and Industrial Insured Captives have no limitations, but investment policy must be followed as on file with commissioner. Only pure captive may make loans to the parent or affiliates. Such loans may not exceed 50 percent of total assets.

104. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Applicable Taxes and Fees: Initial filing of license application $202 Initial issuance of license $5,000 Annual renewal of license $5,000 No taxes based on premium volumes.

105. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures Types of Insurance Allowed: ALL lines of insurance are allowed EXCEPT the following: Workers compensation (on direct basis but allowed through reinsurance) Personal motor vehicle or homeowners insurance

106. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures

107. October 2005 Utah Requirements for Forming Captives, �how to� steps and procedures QUESTION & ANSWER