A Captive Primer: What they are and how they work Educate Evaluate Elevate 1 2018
Do It Right, Or Don t Do It At All At Elevate, we passionately believe in what we do. We are conservative and focus on insurance, risk financing, and risk management strategies to mitigate your risk over the long term. It s imperative you understand the captive strategy and how it works for your organization we do not believe in a one size fits all captive approach. This presentation is a summary only and not a replacement for a full captive feasibility study. Nothing contained in this presentation should be deemed an offer to sell insurance or offer legal or tax advice. 2
Elevate Captives Jerry has over 34 years experience in the insurance and alternative risk transfer industry and serves as CEO for Elevate Captives. In his position with Elevate, he is an approved captive manager in multiple jurisdictions, both onshore and off. Jerry is the Founding President of the Oklahoma Captive Insurance Association, member of the Captive Insurance Committee of the Self Insurance Institute of America (SIIA) and is an active speaker with industry trade groups. Jerry is an accredited Associate in Captive Insurance with ICCIE and an Adjunct Professor with Clear Law and Lawline. Ryan serves as Managing Director of Risk Management for Elevate Captives. Ryan performs the Elevate CORE Review for clients and his experience includes being the Director of Risk and creating captives for Boing, Whirlpool, and Koch Industries. Ryan has participated on many insurance and reinsurance company advisory boards and is a frequent speaker at RIMS (Risk & Insurance Management Society) and CICA (Captive Insurance Company Association), where he currently serves on the Board 3
What Are We Talking About Today? A Little About Elevate ü Create/manage captives to provide long-term solutions for enterprise risk management ü Domiciles: Arizona, Delaware, Hawaii, New York, Oklahoma, Texas ü Our goal is to provide the best captive administrative service in the industry and to do so with the highest integrity Captive Examples ü Single Parent with Mixed P/C and Employee Benefits ü Expense Profile A Lot About Captives ü History ü Types ü Structures ü What they re used for (and what they shouldn t be used for) ü Who makes a good captive candidate ü The captive formation process 4
Onshore/Offshore Captives as of 12.31.16 (Business Insurance) 7,006 CAPTIVES WORLDWIDE 5
Captive s Ranked by State as of 12.31.16 (Business Insurance) 6
Definition/History of Captives Definition by Captive.com: A captive insurer is generally defined as an insurance company that is owned and controlled by its insureds. Captives first used in 1700 s in Europe Lloyd s Café (the ship-owners meeting thereby creating Lloyd s of London) Apple ($99 AppleCare) Federal Express ( check the box ) Allstate (Sears) Three main markets that host captives: Europe (Isle of Man, Guernsey, Luxembourg, etc.) Offshore Financial Centers (OFC s Bermuda, Cayman, Nevis, etc.) USA (Vermont, Delaware, North Carolina, etc.) Over 7,000 captives worldwide and growing rapidly 30+ states currently have captive legislation: In US, first captive formed for captive coal mines named/owned by Fred Reiss, an insurance agent in Ohio in 1951 Delaware/Vermont have over 1,000+ each Most have specialties like series captives, medical stop-loss, XXX and AXXX 7
Mix and Match Types of Captives Small, fronted, protected cell, US-based, homogenous group captive 8
2 Most Common Captive Types Single Parent Captive: A single owner for whom the captive provides insurance protection. Also known as a Pure Captive representing over 60% of all captives. Can also be a protected cell or series captive insurance company. Group Captive: Formed by a group of individual companies that typically own the captive. A group captive can also be started/owned by an association (aka Sponsor ) and come in the form of a risk retention group (RRG), reciprocal group captive, or group reinsurance captive where a fronting company is involved. 9
The Large Captive Over $2.3m in Premium (The limit is indexed to inflation or $50,000, whichever is less) Historically, a large captive has been defined as anything over the limit within the 831b election (currently $2.3m). You typically see these as single parent (pure) captives owned by medium-to-large companies or some smaller-to-medium sized businesses. For example, a $150m company writing a large workers compensation deductible reimbursement policy or large healthcare systems writing medical malpractice and general liability. What are some of the benefits? The same as a Small Captive, plus: ü ü ü You tend to have greater flexibility in writing on a direct basis You can take advantage of a net-operating-loss carryforward All expenses, including administration, risk management, and any claims themselves, are deductible within the captive, thereby allowing for the potential of the premiums paid and all operating expense to be deductible 10
The Small Captive Under $2.3m in Premium A captive is a real insurance company the insured ultimately owns and controls. The small captive model can be used for low-frequency/ high severity risk. The captive also exists to cover gaps in commercial policies while protecting against risk where no coverage exists at all. It doesn t replace the commercial insurance program, it ENHANCES it. What are some of the benefits? ü It creates significant SAVINGS on commercial premiums ü Allows for GREATER protection using difference-in-conditions polices ü The underwriting profit is not taxed, thereby allowing an accelerated build-up of surplus. This allows you to take even more risk down the road. 11
Small or Large - Key Ingredients Pay Claims (Formal TPA Process) Adequate Capital Legitimate Governance Must Have Transfer Legitimate Business Reason (Real Risk) What is a Captive Insurance Company? Legitimate Asset Investment Must Have Distribution Domicile Credibility Quality Reinsurance Credible Service Providers actuary, tax, audit, legal, captive manager CANNOT be just for Tax Benefit!! Conservative Parental Guarantees or Loan Backs(?) 12
The 831b Tax Election The IRS provides a special election for insurance companies collecting less than $2.3m in premium it s known as the 831b election. Any underwriting profit is not taxed (only taxed on investment income) Designed for low frequency/ high severity risk models Captive assets may be invested per regulatory guidelines It does have limitations: No NOL carry forward, no claim or operating expense deductions (except expenses related to investments) Effective May 1, 2017, certain captives and their owners that elect 831b tax treatment must disclose this interest as a Transaction of Interest and file Form 8886 This election is only considered after all aspects of the risk have been reviewed, not before In our opinion, the 831b election has been abused by certain promoters that exclusively push the tax benefits of the captive. They are not focused on the insurance and risk management aspects of the captive and they will not stand up to audit. 13
Benefits, Uses, and Coverage Educate Evaluate Elevate 14
What We Hear I keep paying premiums year-after-year and NEVER have any claims I know if I turn these small claims in, I ll be cancelled or they ll raise my premiums, so I just pay them out of my pocket On the one claim I did turn in, they denied it, so why pay for insurance The quote seemed really expensive and I don t typically have claims anyway, so 15
Who can benefit from a Captive? Those who have strong financial statements and wish to have ultimate control over their insurance and risk management programs Seller of Risk Those who have a clear understanding of their own risk & loss history: Sufficient operational exposures (employee benefits, fleets, property, business interruption, supply chain, etc.) Quality exposure and loss data (or shadow price ) demonstrating profit over time Strong financial statements showing sufficient net income Committed to risk management and cost containment programs Owners committed to paying appropriate premiums for multiple years: Captives are seldom short-term solutions How much is the minimum? About $400,000 captive premium due to the fixed expense ratio. Those wanting ultimate control over: - Consistent Premium - Underwriting Profit - Claims Management - Investment Return - Risk Management - Cost Containment Programs 16
How is a Captive Used? Deductible Reimbursement & Difference in Conditions (DIC): Raise deductibles and retentions to retain more profit & cut commercial insurance premiums DIC - covers exclusions, deductibles & excess protection with your commercial policies Risk that is too expensive, not available in the commercial market, or is currently uninsured (whether you know it or not): Medical Stop-loss Property, Hurricane (Named storm), Wind, Flood, DIC Key Contract/Key Employee (expense reimbursement) Business Litigation, Business Income (Interruption) Product Recall, Reputation, Crisis Management Employee Related Practice Liability/Directors & Officers Supply Chain Risk Enhance business planning (Enterprise Risk Management) 17
Risk Financing Continuum HIGH Program Control What happens to the premium as the retentions go up? Deductible Policy Group Captive Cell or Single Parent Captive Complete assumption of risk on primary layer Subject to Regulatory Oversight Pooling of Risk with Participants subject to Corporate Governance Significant/complete risk assumption in exchange for deductible credit Retro Policy Assumption of limited risk in exchange for potential return premium Deferred pay-in premium LOW Guaranteed Cost Complete transfer of risk Commercial insurance with little-to-no deductible Financial Control HIGH 18
The Captive Wrap Program Stand-alone and Difference-in-Conditions Policies 19
Coverage Examples Medical Stop-loss Professional Liability DIC* Coverage Contractual Liability Business Litigation DIC Environmental Liability/Excess Labor Strike Reimbursement Patent Infringement/Intellectual Property Property Management Professional Errors & Omissions Liability DIC Product Liability/Recall DIC Loss of Key Employee Wage & Hour Liability Credit Default Medical Malpractice/DIC Subcontractor Performance Reputational Risk Political Risk HIPAA/Billing Audit Liability Cyber Liability Business Interruption/DIC Employment Practices/DIC Employee Dishonesty General Liability DIC Professional Misconduct Administrative Actions Directors & Officers Liability Wind Deductibles on Property Inland Marine DIC Trade Credit Regulatory Change Fat Finger Insurance Adverse Party Legal Risk *Difference in Conditions 20
Stop Loss Insurance Funding Medical Stop Loss Captive Layer Self-Insured Retention How it Works Medical( Stop(Loss(in( Captive 5315%( Savings Medical stop loss may be funded in a captive as a direct reimbursement policy, or as reinsurance behind a regular carrier ( fronted ) The captive layer typically sits above a self-insured retention of $25 - $100K Specific and aggregate stop loss may be purchased above the captive layer to cap losses Captive layers are often funded at 125% of expected losses, based on an actuarial calculation Employer may fund the captive layer with their own funds and avoid complicated ERISA issues (by using employee funds, but not applicable in Hawaii) Purchasing stop loss from a captive insurer is functionally the same as from a commercial insurer and can be structured to have no impact on plan participants Employers with smaller populations can participate in a group medical stop loss captive Subject to regulatory approval, medical stop loss policies may be funded in existing P&C captives 21
What Do the Structures Look Like? Educate Evaluate Elevate 22
International Risk Insurance Company (IRIC) Delaware-domiciled Series Captive Insurance Company (SCIC) Contractual Relationship IRIC Administrative Core Series Captive A Min $100k Capital Series Captive B Min $100k Capital Series Captive C Min $100k Capital Own FEIN Own Board Own Assets 23
Single Parent (Pure) Structure Ownership of Holding Company will typically mirror that of Insured Holding Company Insurance Company Why a holding company? 1. Not regulated, so no NAIC bio or D&O issues 2. Flexible ownership changes 3. Used in Golden Handcuff structure 4. Some cash flow benefits Insured 24
Group Captive with Fronting Company Funding Model Insured A Capital Loan Repayments or Dividends Three Funding Phases: 1. Feasibility 2. Statutory Capital 3. Growth Capital Insured B Capital Loans or Investments Holding Company Insured C 100% Capitalization Surplus Note Premium Fronting Company Group Captive (Insurance Company) 25
Captive Examples and Expense Examples Educate Evaluate Elevate 26
Single Parent Captive Example (Mixed P&C Stop Loss) Commercial renewal in 2013 (without a captive): $840,000 premium $250k SIR on commercial policy Fully-insured on health plan Multiple gaps/exclusions Commercial renewal in 2017 (with a captive): $515,000 premium $500,000 SIR on commercial policy $30,000 Spec Ded ($10,000 excess $20,000 in captive) $1m DIC limit with Zero SIR in captive $5.3m in captive assets $4.3m in premium deductions $325,000 in annual premium savings, $1.6m total so far Holding Company Captive with $250,000 in Statutory Capital Loss of Key Contract Coverage Examples Hedge Fund E&O DIC Fat Finger Endorsement EPLI/D&O Business Litigation Reputational Risk Loss of Key Employee Network/Cyber Liability Crisis Management Business Interruption 27
Reinsurance - Why you might need or want it Ground-up Quota-share Purpose Protect captive against significant loss Preserve capital Risk transfer Risk distribution Structure Quota-share 49/51% Ratio 2.5% Cost 51% of Premium/Risk Your Captive Reinsurance 49% of prem. kept in the Captive 51% of prem. for 51% of Limit 1M Limit Quota-share Captive Participants Captive Participants Captive Participants 28
5-year Financial Overview Pure Captive with Reinsurance Expense ratio should be much lower than commercial at 35%+ Reduction in commercial premium due to retentions (10-20%+) Claims are paid to owner (they do not come out of your cash flow) Highly efficient regardless of tax election Loss Ratio Paid Claims Available Captive Assets 5% 486,500 10,028,386 25% 2,342,500 7,917,147 50% 4,685,000 5,278,098 80% 7,496,000 2,111,239 This table reflects a 35% loss ratio, 2% ROI, WITH reinsurance: Year 1 Year 2 Year 3 Year 4 Year 5 Total Premium 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000 10,000,000 Admin/Operational (est.) 75,000 75,000 75,000 75,000 75,000 375,000 Reinsurance 51,000 51,000 51,000 51,000 51,000 255,000 Paid Claims 655,900 655,900 655,900 655,900 655,900 3,279,500 EBITDA 1,218,100 1,218,100 1,218,100 1,218,100 1,218,100 6,090,500 Investment Inc (net of tax) 48,724 99,397 152,097 206,905 263,905 771,027 Net Profit 1,266,824 1,317,497 1,370,197 1,425,005 1,482,005 6,861,527 Available Captive Assets 1,266,824 2,584,321 3,954,518 5,379,523 6,861,527 29
Actual Claim Examples Wage & Hour: $480,000 due to allegations the insured didn t follow strict guidelines on breaks, lunchtimes, and overtime rules. Excluded from commercial EPLI/D&O policy. Trade Credit: $260,000 due to large client (of the insured) filing bankruptcy and continuing to use security services. Insured s IT system failed to flag nonpayment s. Commercial policy declined claim due to prior acts date on policy. Reputational Risk (Headline): $63,000 due to homicide investigation of elder death. Nurse falsified medical records. Hiring of PR firm not covered under General Liability policy and claim denied due to actual or alleged wording in commercial policy. Sexual Abuse Allegation: $140,000 due to defense of Owner by previous employee alleging sexual abuse. Commercial carrier declined due to retro-date. Defense verdict and insured fully reimbursed. 30
Risk and Insurance Review Process & Foundations Educate Evaluate Elevate 31
Elevate CORE Review Coordinated Overview of Risk and Exposure 32
The Captive Creation Process Step I: CORE Process Step II: Regulatory Filing Step III: Funding & COA Insurance review Actuarial rates Captive lines of insurance Loss projections Domicile and Service provider Go/no go Regulator discussion Corporate structure creation Bank accounts Investment plan Business plan File Receipt of Cert of Authority Capitalize Fund Premium Policy Issuance Implement investment plan Governance plan 30 Days 15 Days 30 Days 33
Questions and Answers Our family is blessed to do what we do, and we love doing it. Thank you for allowing us to visit with you today. Jerry D. Messick, ACI CEO Elevate Captives M: 405.550.2651 jm@elevatecaptives.com 34