Let’s Get Started – Captives 101

Mike Meehan, CIC, CRM – Milliman, Inc.Anne Marie Towle, CPA – JLT Insurance Management

Krista Twesme, J.D. - Mortenson

Agenda / Format

• Captive Basics• Why captives are formed

• Some potential benefits

• Types / Utilization Models

• The Captive Formation Process• Concept to Implementation

• The Actuarial Feasibility Study

• Implementation / Next Steps

• Best Practices

Please ask questions throughout!

3

Captive Basics

WHAT IS A CAPTIVE?

✓ Vital financial tool

✓ A limited purpose, licensed insurance company, the main business

purpose of which is to insure the risks of the captive’s owners

✓ A risk assumption vehicle

✓ An insurance or reinsurance company

✓ Specifically established to insure or reinsure the risks of its parent or

associated third parties

4

Captive Basics

WHAT TYPES OF RISK ARE IN A CAPTIVE?

*SMALL SAMPLING OF TRADITIONAL COVERAGES ONLY

PROPERTY

GENERAL LIABILITY

WORKERS COMPENSATION

AUTO LIABILITY

PROFESSIONALLIABILITY

CYBER

WARRANTY / ESC’S

5

Captive BasicsWHAT TYPES OF RISK ARE IN A CAPTIVE? EXPANDING BEYOND TRADITIONAL RISKS

*SMALL SAMPLING OF EXPANDING COVERAGES ONLY

WAGE

&

HOUR

3RD PARTY PROGRAMS

(i.e. warranty, renters)

MEDICAL / EMPLOYEE BENEFITS

ENVIRONMENTAL

REGULATORY

EPLI

EXECUTIVE

RISK

6

Captive BasicsWHO CONSIDERS A CAPTIVE?

Organizations with:

√ Financial stability

√ Good spread of risk with predictable losses

√ Good claims history

√ Good risk management practices

√ The ability to finance exposure

√ Long-term commitment from senior management

√ Unusual or hard-to-place risks

√ Strong business partners

√ Purpose other than tax benefits

7

• The unwillingness/inability of insurers to provide cost effective insurance

• Global consistency

• The need for new capacity for certain risks

• Lack of confidence in the traditional markets ability to differentiate and provide stable protection

• The enhanced focus on loss prevention and intelligent claims handling

• The opportunity to see favorable risk management business outcomes

• The drive to recapture leakage in traditional risk transfer solutions

• The opportunity to take risk and profit positions in affiliate business

• The drive to control frictional and non-loss costs

BENEFITS BENEFITS

Captive BasicsWHAT FACTORS DRIVE CAPTIVE FORMATION?

8

Captive BasicsWHY DO ORGANIZATIONS ESTABLISH A CAPTIVE?

CapacityAccess to reinsurance

ControlManagement of claimsProgram design

CommercialAffinity programs

Extended warranties

CoverageFill coverage gaps

Exclusions for difficult risks

CaptiveStrategic enabler

CostLeverage the market

ComplianceLegal and tax certainty

Premium allocation

9

Captive Basics

HOW DO YOU DETERMINE YOUR TOTAL RISK TOLERANCE?

Measured as a % of :

√ Retained Earnings

√ EBITDA

√ Net Cash Flow

√ Unique Industry/Organization KPIs

The ultimate decision is tempered by individual company philosophy, risk

tolerance, business development goals, shareholder expectations, etc.

10

Captive BasicsWHEN IS IT MORE EFFICIENT TO RETAIN THE RISK?

11

Captive BasicsWHAT PITFALLS/CHALLENGES SHOULD YOU UNDERSTAND?

• Distributing profits

• Winding down program

• Restrictions on selling or transferring ownership

• Focus and commitment must be long term

• Overcoming the learning curve

• Incurring unexpectedly large losses

• Compliance issues

• Meeting and maintaining capital requirements

• Competing uses for available capital

• Accessing capital for competing needs

CHALLENGES CHALLENGES

12

UTILIZATION MODELS - WHAT TYPES OF CAPTIVE STRUCTURE?

Single Parent Sponsored Cell Captive Association/Group Captive Risk Retention Group

SCALE >$1M in premium Any minimum premium levelTypically a min. of $250k in

premium, no maximumAny premium volume

FEATURES

▪ Larger account solutions

▪ Unilateral control of captive (subject to regulator)

▪ No risk sharing, unless pooling arrangement is deployed

▪ Typically established by a 3rd party sponsor

▪ Insured can “rent” the captive space

▪ Typically lower operating costs

▪ Could be a protected cell or incorporated cell structure

▪ No risk sharing

▪ Sharing risk is required

▪ Access to profitability of insurance program

▪ Considerably greater control as compared to guaranteed cost insurance

▪ Lack of unilateral control of services and risk

▪ Communal risk management

▪ Sharing risk is required

▪ Policy holders are share holders

▪ Formed in a state/domicile and ability to write in all 50 states

▪ Liability insurance only

▪ Typical Industries: Healthcare, transportation, governments and professional services

Captive Basics

13

CAPTIVE BASICSQUALIFICATION FOR TAX DEDUCTIBILITY

Parent

SubsidiaryCaptive

This arrangement must contain:

• Presence of insurance or insurable risk

• Risk shifting

• Risk distribution

• Commonly accepted notions of insurance

Scenario 1

100% Internal Risk

Parent

SubsidiaryCaptive

Scenario 2

Greater than 30% of premium must be 3rd party

3rd Party

Premium

Must meet one of the scenarios

14

Parent

Captive1

SubsidiarySubsidiary

SubsidiarySubsidiary

Subsidiary

Reinsurance/Excess

2

Single Parent Direct Written Program workflow

1. Subsidiaries submit exposures to captive

2. The captive may purchase reinsurance or stop-loss for excess protection

SINGLE PARENT CAPTIVE EXAMPLE

CAPTIVE BASICS

15

CELL STRUCTURE EXAMPLE

Owner

PCC Facility

Managementcompany

SeveralS/H

SingleS/H

Cell1

Cell2

Cell3

CAPTIVE BASICS

16

UTILIZATION MODELS

BUSINESS PURPOSE FOR CAPTIVE UTILIZATION MODELS

Retained Risk Finance Risk Transfer Rate Arbitrage Access to Capacity 3rd Party Utilizations

Bu

sin

ess

Pu

rpo

se

▪ Governance around retained risks

▪ Enhancing risk management efforts

▪ Better use of capital to retain risk than transfer

▪ Harmonization of risks across global portfolios

▪ Accelerating of tax deductible premiums

▪ Reducing cost of risk transfer

▪ Reinsurance market cost of risk transfer is less than retail equivalent

▪ Managing TCOR

▪ Recapturing Ceding Commission

▪ Transferring risk to alternative forms of capacity, which may not be otherwise accessible in commercial retail market

▪ Accessing profitability imbedded in insurances sold to affiliates / consumers/ partners

▪ Creating ‘stickiness’ for core product offerings

▪ Further penetration into consumer / partner / affiliate wallets

Exam

ple

s

▪ Deductible buy-down

▪ Participation in excess programs

▪ Fronted global programs

▪ Multinational benefit pooling

▪ Reinsurance pass through

▪ Excess Re placements

▪ Integrated risk programs

▪ Multinational benefit pooling

▪ Credit Risk Transfer

▪ ART Solutions

▪ Cat Bonds

▪ Integrated Aggregates

▪ Parametric Triggers

▪ Terrorism Pools

▪ Consumer facing insurance programs

▪ Forced Placed Insurances

▪ Affiliate business

▪ Agency captives

Capital Efficiency:

▪ Bringing together correlated and non-correlated risk to benefit from severity risk diversification effect

▪ Capital Efficiency: Harmonizing and aggregating global and individual risk programs to maximize risk transfer market leverage and diversify market concentration in risk portfolios

17

The Captive Formation ProcessCAPTIVE DEVELOPMENT PROCESS

ReviewCurrent

Insurance Program and Risk Appetite

Formal Feasibility

Study

Decision to Proceed

Business Plan Development

Captive Application,

License, Incorporation

and Capitalization

Commence Operations

18

The Captive Formation Process

WHAT IS A FEASIBILITY STUDY?

Establishing Core Objectives

Program Design

Data Collection

DomicileSelection

Regulatory, Tax & Legal Analysis

ActuarialAnalysis

FEASIBILITY ANALYSIS

Timeline is typically a minimum of 8-12 weeks

Actuarial Feasibility Study – Why is it Necessary?

Measures Financial Viability

Risk Identification/Quantification

Required by Regulators

Reinsurance Negotiations

Actuarial Feasibility Study – What is Typically Included?

Loss Rates/Premiums/Loss Ratios

• Expected

• Adverse

Pro Forma Financial Statements

• Includes:

• Income Statement

• Balance Sheet

• Statement of Cash Flows

• Typically 5 Year

• Based on Expected and Adverse Scenarios

Actuarial Feasibility Study - Data Collection

Background

• Company Specific

• Goals

• Constraints

• Operational

• Account Background

• Management

• Claims

• Risk

Loss Data

• Historical

• Annual Evaluations

• Detailed claim run

• Large loss listing

Exposures

• Historical

• Will vary by LOB

• Payroll

• Sales

• Vehicles

• Prospective

• Descriptions

• Locations

Other

• Expenses (will vary)

• Type of Captive

• Domicile

• Other Assumptions

• Growth

• Rate of Return

• Single parent versus group program

Actuarial Analysis – Estimate Ultimate Losses

Review Past Experience

Actuarial Adjustments

Internal Factors

External Factors

Selected Loss Rate

Estimated Ultimate Loss

Actuarial Analysis – Estimate Ultimate Losses

Loss

Accident Incurred Development Ultimate Exposures Adjustment / Loss

Year Losses Factor Losses (in 00's) Trend Rate

2013 750,000 1.200 900,000 1,000,000 1.061 0.955

2014 600,000 1.500 900,000 1,100,000 1.040 0.851

2015 450,000 2.000 900,000 1,200,000 1.020 0.765

Total 1,800,000 2,700,000 3,300,000 0.851

Selected 0.850

Projected Exposures 1,200,000

Expected Losses 1,020,000

Actuarial Analysis – Pro Forma Financial Projections

• Fixed – Management, Legal, Audit, Actuarial, Other

• Variable – Reinsurance, Claims Handling, Commission and Brokerage

Expenses

• Growth – Exposure, Premium

• Rate of Return on Investments

• Loss Payout Pattern

• Domicile Specific (ie. Taxes)

Other Assumptions

• Can Reflect Various Attachment Points, Reinsurance Structures

• Expected and AdverseScenarios

Pro Forma Financial Projections – Estimated Expenses

Expense Amount

Fronting Fees 10.0%

Reinsurance 10.0%

Claims Administration, Loss Prevention 5.0%

Commission & Brokerage 5.0%

Management Fees 50,000

Legal, Audit, & Actuarial 40,000

Letter of Credit 10,000

Other (Travel, Board Meeting, D&O) 10,000

Taxes and Assessments & Fees 5,000

Note: Expenses expressed in % form represent % of premium

Actuarial Analysis – What is Typically Included?

Loss Rates/Loss Ratios/Premiums

Pro Forma Financial

Statements

Evaluation of Results

What is best for your

organization?

Expected & Adverse

Scenarios

Typically 5 years

Pro Forma Financials – Income Statement1/1/2018- 1/1/2019- 1/1/2020- 1/1/2021- 1/1/2022-

12/31/2018 12/31/2019 12/31/2020 12/31/2021 12/31/2022

UNDERWRITING INCOME

Gross Written Premium 1,700,000 1,734,000 1,768,680 1,804,054 1,840,135

Net Earned Premium 1,530,000 1,560,600 1,591,812 1,623,649 1,656,121

UNDERWRITING DEDUCTIONS

Loss and Loss Expense Incurred 1,020,000 1,040,400 1,061,208 1,082,432 1,104,081

Expenses 456,000 468,100 480,601 493,519 506,871

Total Underwriting Deductions 1,476,000 1,508,500 1,541,809 1,575,951 1,610,952

Net Underwriting Income 54,000 52,100 50,003 47,698 45,169

INVESTMENT INCOME

Net Investment Income 23,265 46,456 60,675 70,942 79,420

Profit (Loss) Before Tax 77,265 98,556 110,678 118,640 124,589

Federal Income Tax (including deferred) 26,270 33,509 37,631 40,337 42,360

Net Income 50,995 65,047 73,047 78,303 82,229

SURPLUS

Opening Surplus 1,000,000 1,050,995 1,116,042 1,189,089 1,267,392

Income for Period 50,995 65,047 73,047 78,303 82,229

Capital Contributions 0 0 0 0 0

Ending Surplus 1,050,995 1,116,042 1,189,089 1,267,392 1,349,621

Net written premium/Surplus 1.456 1.398 1.339 1.281 1.227

Reserves/Surplus 0.738 1.108 1.276 1.358 1.392

Pro Forma Financials – Balance SheetBALANCE SHEET

1/1/2018- 1/1/2019- 1/1/2020- 1/1/2021- 1/1/2022-

12/31/2018 12/31/2019 12/31/2020 12/31/2021 12/31/2022

ASSETS

Cash and Short-term Investments 1,102,705 1,598,304 1,929,474 2,195,269 2,422,488

Letter of Credit 750,000 750,000 750,000 750,000 750,000

Deferred Federal Income Taxes 37,317 64,910 84,077 98,365 109,274

TOTAL ASSETS 1,890,022 2,413,214 2,763,551 3,043,634 3,281,762

LIABILITIES

Outstanding Loss and Loss Expense Reserve 775,440 1,236,070 1,517,664 1,721,617 1,878,872

Federal Income Taxes Payable 63,587 61,102 56,798 54,625 53,269

Unearned Premium Reserve 0 0 0 0 0

TOTAL LIABILITIES 839,027 1,297,172 1,574,462 1,776,242 1,932,141

CAPITAL

Initial Capital 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000

Capital Paid In 0 0 0 0 0

Income Earned 50,995 116,042 189,089 267,392 349,621

TOTAL CAPITAL 1,050,995 1,116,042 1,189,089 1,267,392 1,349,621

TOTAL LIABILITIES AND CAPITAL 1,890,022 2,413,214 2,763,551 3,043,634 3,281,762

Actuarial Analysis – Evaluate Results

Evaluate Results

Lines of Business

Limits / Retentions

Minimum Number of Participants

(Group Program)

Solvency Measurements

Capital Requirements

Actuarial Analysis – Determine Initial Capital

How is Initial Capital

Determined?

Type of Risk

Insured

Limits / Retentions

Variability in Loss

Projections

Are Policies Assessable?

Financial Strength of Parent

Collateral Requirements

(Fronted Program)

Regulation and/or

Regulator

31

Captive Formation – Next StepsHOW DO I SELECT A DOMICILE?

OnshoreOffshore

√ Capitalization and surplus requirements

√ Receptiveness of regulatory environment

√ Quality of local infrastructure

√ Availability of expertise

√ Stability of regulatory environment

√ Flexibility as respects investment portfolio

√ Ease of doing business – in a suitably regulated

environment

√ Experience in business under consideration

√ Efficient financial outcomes: tax, wealth,

investment etc.

32

The Captive Formation Process

ReviewCurrent

Insurance Program and Risk Appetite

Formal Feasibility

Study

Decision to Proceed

Business Plan Development

Captive Application,

License, Incorporation

and Capitalization

Commence Operations

33

Captive Operations - ResponsibilitiesCAPTIVE DEVELOPMENT PROCESS

Shareholders• Elects directors

• Appoints Auditors

Board of Directors

• Elects officers

• Establishes policies

• Manages business

• Oversees Committees

• Engages service providers

34

Captive Operations - Committees

Captive Committees

Executive

Finance / Investment

Underwriting

AuditRisk

Management

Claims

Marketing

35

Captive Operations – Service Providers

CaptiveManager

Legal

Carriers

Actuary

TPA

Auditor

Investment

Risk Management

Regulator

Closing Thoughts – Some Best Practices to Consider

Corporate governance and culture starts at the top

Engage experts who can guide you through the process

Running an insurance is likely much different that the business that you are in. Treat it as such. Stay involved.

Ask questions on anything and everything you don’t understand

Communication with service providers is critical

Plan early for the future (sharing of dividends, assessments; closing)