Captive Insurance: Risk & Financial Implications

1. Captive Insurance:Risk & Financial Implications Ryan Erickson McGriff, Seibels & Williams, Inc. Trey Tasker, ACAS, MAAA McGriff, Seibels & Williams, Inc. Geoff Welsher Marsh, Fleet Solutions Kevin Doyle Artex Risk Solutions

2. Agenda • 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

3. Unfunded------------------- Retain Pre-Loss Funding --------- Post-Loss Funding -------- Group Captive Share Risk Retention Group Group Dividend Program Non-Insurance Contracts - Transfer Insurance ------------------- Derivatives ----------------- Overview - Risk Financing Options Self-Insurance Deductible Programs Captive Insurance Company Limited Risk Programs Line of Credit Contingent Capital Risk Financing Options Indemnification Agreements Hold-Harmless Agreements Guaranteed Cost Loss-Sensitive Programs Futures and Forwards Options

4. Insurance Pricing Continuum Less Information More Information Guaranteed Cost Self-insurance Underwriting Schedule Rating Small Deductible Large Deductible Fronted Program Experience Rating Classification Rating What happens when the retention grows? This is when captives can be useful.

5. Captives vs. Commercial Insurance • 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

6. The Benefits of Commercial InsuranceBasic View Risk Transfer Catastrophic Hazard Events Uncontrollable Hazard Events Protect Dir & Ofc Cost Reductions Efficiency of Diversification Accelerated Tax Deduction Documented Expense External Demands Debt-Related Covenants Regulatory Requirements Customer Expectations Service Expertise Assessment of Hazard Risks Prevention of Hazard Losses Handling of Hazard Claims

7. The Benefits of Commercial InsuranceBasic View Risk Transfer Catastrophic Hazard Events Uncontrollable Hazard Events Protect Dir & Ofc Cost Reductions Efficiency of Diversification Accelerated Tax Deduction Documented Expense External Demands Debt-Related Covenants Regulatory Requirements Customer Expectations Service Expertise Assessment of Hazard Risks Prevention of Hazard Losses Handling of Hazard Claims • This perspective is very Hazard-focused.

8. The Benefits of Commercial InsuranceBasic View Risk Transfer Catastrophic Hazard Events Uncontrollable Hazard Events Protect Dir & Ofc Cost Reductions Efficiency of Diversification Accelerated Tax Deduction Documented Expense External Demands Debt-Related Covenants Regulatory Requirements Customer Expectations Service Expertise Assessment of Hazard Risks Prevention of Hazard Losses Handling of Hazard Claims A case study of large companies suggested that they could easily replace all but two of these benefits.

9. The Benefits of Commercial InsuranceBasic View Risk Transfer Catastrophic Hazard Events Uncontrollable Hazard Events Protect Dir & Ofc Cost Reductions Efficiency of Diversification Accelerated Tax Deduction Documented Expense External Demands Debt-Related Covenants Regulatory Requirements Customer Expectations Service Expertise Assessment of Hazard Risks Prevention of Hazard Losses Handling of Hazard Claims 3. These items are valuable. How do we replace these items?

10. The Benefits of Captive InsuranceBasic View Risk Transfer Frequency of Hazard Events Uncontrollable Hazard Events Cost Reductions Better Local Knowledge Accelerated Tax Deduction Documented Expense External Demands Customer Expectations Service Expertise These items are among the benefits of captives.

11. Benefits Overlap Commercial Insurance Expertise in risk Frequency of hazard risks Regulatory requirements Captive Insurance (Single-Parent) Debt-related covenants Severity of hazard risks Better local knowledge Customer Expectations Protect Dir & Ofc Documents full expense Restores full tax deduction

12. “Advertised” Benefits of CaptivesFinancial and Non-Financial

13. “Advertised” Benefits of CaptivesFinancial and Non-Financial

14. “Real” 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 marketingto 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.

15. Agenda • 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

16. Unfunded ------------------- Retain Pre-Loss Funding --------- Post-Loss Funding -------- Group Captive Share Risk Retention Group Group Dividend Program Non-Insurance Contracts - Transfer Insurance ------------------- Derivatives ----------------- Overview - Risk Financing Options Self-Insurance Deductible Programs Captive Insurance Company Limited Risk Programs Line of Credit Contingent Capital Risk Financing Options Indemnification Agreements Hold-Harmless Agreements Guaranteed Cost Loss-Sensitive Programs Futures and Forwards Options

17. Impact of Self-InsuranceRisk-Taker • 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

18. Impact of Self-InsuranceInsurer • 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

19. Insurance Flow of Funds Self-Insured Risk Guaranteed Cost Insurance Program Large Deductible Insurance Program Client Client Client Premium Payment Promise Premium Promise Paper Carrier Carrier Demand Payment Claimant Demand Payment Demand Payment Claimant Claimant

20. Insurance Flow of Funds Large Deductible Insurance Program Client Premium Payment Promise Paper Promise Carrier Reinsurer Premium Demand Payment Claimant

21. Captive Insurance CompanyDefined “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)

22. Captive Flow of Funds “A” Large Deductible Insurance Program Promise Client Captive Premium Insuring Agreement Premium Promise Paper Payment Indemnity Agreement Promise Carrier Reinsurer Premium Demand Payment Claimant Captive indemnifies the deductible.

23. Captive Flow of Funds “B” Reinsurer Client Premium Premium Promise Promise Promise Captive Excess Carrier Premium Demand Payment Claimant Captive directly insures, with support.

24. Captive Flow of Funds “C” Reinsurer Client Premium Premium Promise Promise Promise Captive Reinsurer Fronting Carrier Premium Demand Payment Claimant Captive reinsures the direct insurer.

25. Captive Insurance CompanyDrivers of Growth • 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

26. Captive Insurance CompanyTypes • 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.

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

28. Captive Prospect ProfilePure Captives • 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

29. Captive Prospect ProfileSponsored 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

30. Captive Challenges • 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

31. Captive Players (Cash Flow “C”) Insured Consultant/Broker Third-Party Admin Premium Claims Fronting Insurer Insurance Market Insurance Broker Premium Claims Captive Reinsurer Manager/Sponsor Reinsurance Broker Premium Claims Reinsurance Market Reinsurer

32. Captive Planning Issues • 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 • Incorporation and Operating Costs: The formation and operation of a captive entails various expenses including: Start-Up Costs Annual Operating Costs

33. Unfunded ------------------- Retain Pre-Loss Funding --------- Post-Loss Funding -------- Group Captive Share Risk Retention Group Group Dividend Program Non-Insurance Contracts - Transfer Insurance ------------------- Derivatives ----------------- Overview - Risk Financing Options Self-Insurance Deductible Programs Captive Insurance Company Limited Risk Programs Line of Credit Contingent Capital Risk Financing Options Indemnification Agreements Hold-Harmless Agreements Guaranteed Cost Loss-Sensitive Programs Futures and Forwards Options

34. 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

35. 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.

36. 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

37. 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

38. 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

39. 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

40. 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.

41. Benefits Overlap Commercial Insurance Expertise in risk Frequency of hazard risks Captive Insurance (Group Owned) Regulatory requirements Debt-related covenants Severity of hazard risks Better local knowledge Customer Expectations Protect Dir & Ofc Documents full expense Restores full tax deduction

42. Compare and Contrast

43. Agenda • 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