AGC / CFMA Conference

Self Insurance with Sophistication

Are You Ready for a Captive?

October 23, 2008

Mark Ouimette, ARMmouimette@beechercarlson.com

What Is A Captive?

• A captive is a special purpose insurance company that insures the risk of its owners and sometimes related or affiliated third parties.

• A sophisticated way to self insure.

Date back to early 1960’s

• History of captives

Became more popular during insurance crisis periods

Today there are over 5,700

COST

TIME

PREMIUMS

1970 1975 1980 1985 1990 1995 2000 2005 2010

LOSSES

Market Cycle Impact: Premiums Compared to Losses

Growth of Captive Industry* 1970-2008

*Captive Insurance Company Reports Estimate

MarketCycle

1970 1975 1980 1985 1990 1995 2000 2005 2010

0

1000

2000

3000

4000

5000

Captive Growth

Captive Significance

• Comprise 20% of Worldwide Corporate P&C Spend

• Represents Between $55-$60BN Annual Premium

• U.S. Companies own 57% of the World’s Captives

• All 30 Companies Comprising the Dow Jones

Industrials

• Construction industry represents 6% of Global

Usage – $3.3/$3.6 BN Annual premium spend

Source: Marsh Survey Group

GENERIC TYPE A.K.A

1. Rent-a-Captives

2. Protected Cell Companies (PCCs) “Cell Captive”

3. Single Parent Captives “Pure Captive”

4. Industry Captives “Group Captive”

5. ASSOCIATION Captives “Group Captive”

6. Risk Retention Group Captives “RRGs”

7. Producer Owned Captives ”For Profit Agency Captive” or P.O.R.C.”

8. Program Business Captives “For Profit Group Captive”

Types of Captives and Their Range of Applications From the Simplest to Most

Complex

Changes in the Traditional Insurance Market

• Increase in policy exclusions

• Increase in coverage / definition restrictions

• Increase in deductible amounts

• Increase in liberalization by court interpretation

• Increase in settlement v. trial

Why an Alternative to Commercial Insurance?

• You want to control your destiny

• You know your risks better than any insurance company underwriter

• You do not want to be rated based on others and industry losses

• Certain aspects of “Off the shelf” insurance programs do not suit contractor specific circumstances

Captive Ownership

• The owners of the captive are its policyholders,

but also can be 3rd parties

• The policyholders have control over management, underwriting, claims, investments, etc.

• Overall decisions regarding captive operation rests in the hands of the Board of Directors elected by the captive owners.

Group Captives

• Owned by multiple, non-related organizations

• Designed to insure the risk of these owners

• Homogeneous – insuring only similar types of business risks

• Heterogeneous – insuring a wide range of risks

• Involves risk sharing with others – known and unknown

• Results in Dividends or Assessments

• Can be owned by members of a common trade or industry association

• Can be owned by the Association – Or in combination with members

• Shares the risks of that industry among its members

• Possibility of adverse selection

Association Captive

Why Captives Are Sophisticated?

• Coverage can be tailored to meet the specific needs of the policyholder(s)

• Underwriting flexibility to provide coverage where it is unavailable or overpriced in the commercial marketplace

• Premiums are based on the loss experience of the captive, not on the income and expense needs of an insurance company

• Premium funding flexibility based on actuarial loss projections via confidence intervals

Captive Sophistication continued

• Accumulated surplus can be used to reduce future premiums or be returned to the policyholders as dividends

• More incentives for safety programs & loss control

• Greater control over claim handling

• Opportunity for premium/loss reserve tax deductibility

• Insurance company accounting treatment - IBNR

• Underwriting profit & investment income belongs to the captive, not the insurance company

• Potential for lower overhead costs so a larger percentage of premium can be used for claim payments or dividends

• Direct access to the reinsurance marketplace

• Independence from the conventional insurance marketplace

• Flexibility – endorsements, cancellations, premiums

• Potential for tax advantages

• Access to U.S. Government’s coverage via TRIA

Captive Sophistication continued

Uses Of A Captive

• General Liability

- Completed Ops / Construction Defect

• Workers’ Compensation

• OCIP / CCIP

• Subcontractor Default (Surety / Performance Bond)

• Warranty

To Fund a Retained Working Loss Layer From $ 0 $ X

• Builders Risk-Earthquake / Windstorm

Uses Of A Captive Continued

• TRIA

• Excess or Buffer Layer - GL

• Specialty coverage (Mold etc.)

• EPLI

• Professional Liability

• Difference of Conditions

• Employee Benefits

Captive Utilization By Industry

Source: Marsh Survey Group

Manufacturing10%

Financial Institutions20%

Construction6%

Chemicals3%

Aviation and Aerospace

2%

Other7% Automotive

2%

Health Care11%

Life Sciences3%

Mining, Metals and Minerals

3%

Power & Utilities8%

Real Estate3%

Retails and Consumer Products

10%

Technology & Telecom

6%

Transportation6%

Utilizing a Captive Takes Place of:

• Traditional Risk Transfer

• Funded Reserve

- Set aside

• Unfunded Reserve

- Current expense

• Balance sheet accrual

How Are Captive Insurance Policies Written?

• Deductible or SIR Reimbursement Policy Most Common Same coverage as the policy above it No certificate issues

• Direct Write Policy Common for certain circumstances Manuscript Form Possible certificate issues – No “A” Rating

• Reinsurance To A Fronting Company Less Common in Today’s Market (popular in 1990’s) No Certificate issues Collateral Intensive - Stacking

Hypothetical SIR/Deductible Structure

Captive

ContractorInsured

Excess Insurance

Policy

$0

$1M SIR

$9M

Pays

Premium

Issues Policy

Issues Policy

Common Ownershi

p

Pays Prem

ium

Contractor Insured Captive Reinsurer

Common Ownership

Policy(s) Issued

May Purchase Coverage

Hypothetical Direct Write Structure

Pays Premium

Fronting

• A licensed insurance company utilized by a captive when the type of coverage or entity requires a licensed carrier or an AM Best “A” rated carrier

• The captive reinsures the fronting carrier for the risk it assumes by having funds ceded it to the captive

• Fee is usually a percentage of gross premium

• Collateral requirements

Insured Contractor

“A” Rated Ins. Co “Front”

Captive Reinsurer

IssuesPolicy

Acts as Reinsur

er

Common Ownership

Hypothetical Fronted Structure

Pays Premium

Cedes Premium

Less Front Fee

May Purchase Coverage

Domiciles

• Owners select the jurisdiction where they want

the captive to be based – called a “domicile”

“On-Shore” = within the U.S.

“Off-shore” = outside the U.S.

• Captive must adhere to the laws and regulations of their domicile

Domicile Comparison

• Capitalization

• Registration & incorporation expenses

• Premium Taxes

• Investment restrictions

• Resident Agent requirements

• Reporting requirements

Domicile Chart

Source: Marsh Survey Group

Bermuda, 25%

Cayman Islands,

12%

Guernsey, 6%

Ireland, 5%

Isle of Man, 3%

Luxembourg, 12%

Singapore, 3%

U.S. - Hawaii, 5%

Sweden, 3%

U.S. - Vermont,

15%

Other (U.S), 6%

Other, 5%

Who Should Consider a Captive

• A large general contractor or group of GC’s or Subcontractors with sufficient insurance premium to achieve savings

• Track record of low loss ratios/safety/loss control

• Disproportionate premium to policy limits

• Uninsurable exposures

• Allocation or Profit Center Opportunity/ CCIP

• Ability to capitalize Usually 3:1 premium to capital

Taxes and Issues Affecting Captive

• Consider tax treatment

Controlled Foreign Corporation IRC 951-964 United States Taxpayer IRC 953(d) Small Insurance Company IRC 831(b)

• Arrange for professional tax assistance

• Avoid adverse tax consequence

Meeting the Definition of “Insurance”

• Rev. Rul. 2001-31: economic family theory n/a

• 12 subs (Rev. Rul. 2005-40)

• 8 Subs are enough (Malone & Hyde, 1993)

• 4 Subs might suffice (FSA 199945009)

• 1 Sub not enough for risk pool (FSA 200202002)

• 30% third party risk required – Harper Group (CA 9, 1992)

• 50% third party risk (Rev. Rul. 2002-89)

• Homogeneity? (FSA 200202002)

• Risk Measured by written premium received

Brother – sister captive

Parent

Sub 1 Sub 2 Sub 3 Sub 4

Captive Captive

Parent

Parent-subsidiary captive

3rd

Party3rd

Party3rd

Party

Who Will Run the Captive?

• Independent captive management companies

• International brokers/agencies – captive management arm

• Reinsurers captive management arms

Captive Management

• Captive Managers have sufficient resources to perform insurance, accounting, underwriting, and claims functions. This can involve the following:

Annual reports and filings for regulators

Bind coverage and issue insurance or reinsurance contracts

Perform banking and investment functions

Rate and underwrite risk exposure

Issue Policies

Captive Management continued

• Captive Managers have sufficient resources to perform insurance, accounting, underwriting, and claims functions. This can involve the following:

Allocate premiums, losses and dividends as needed

Adjust claims

Typical Structure

Captive Insurance CompanyIssues Policies, Collects Premiums,

Disburses Funds to TPA, States, and Feds

Insured(s)

Domicile Regulator

Captive Manager

Corporate Legal

Counsel

Auditor &Tax

Bank & Investme

nt

TPA Claims

Board of Directors

Actuary