Captive Governance: Cradle to Grave

Captive Governance: Cradle to Grave Ruth Fletcher, RAFletcher@spectraenergy.com, Spectra Energy Peter Joy, Peter.Joy@aon.com, Aon Risk Solutions Justin R. Peruski, jperuski@honigman.com, Honigman Tuesday, March 11, 2014, 2:30-3:30pm

Introductions: Spectra Energy A Fortune 500 company and is one of North America s premier pipeline and midstream companies Based in Houston, Texas with operations in the United States and Canada 22,000 miles of natural gas, natural gas liquids, and crude oil pipelines Approximately 305 billion cubic feet of natural gas storage, as well as natural gas gathering and processing, and local distribution operations 50% ownership in DCP Midstream, the largest producer of natural gas liquids and the largest natural gas processor in the US Serving North American customers and communities for more than a century

Introductions: Spectra Energy Connecting the largest diverse markets with growing supply Gas storage facility Gas processing plant Propane terminal NGL storage Shale gas formations Crude storage Major oil pipeline terminal

Introductions: Spectra Energy Compression Offshore Platform Storage

Captive Governance: Agenda Governance Overview Start-Up Feasibility / Organization Operational Growth / Maturity Wind-Down Closure

Captive Governance: Overview Governance is the framework for conducting business A captive insurance company is a separate legal entity which operates according to the requirements and/or expectations of: Regulatory and taxing authorities Owner(s), Board, management and consulting team Counterparties (includes, policyholders, carriers, banks, and their respective regulators)

Captive Governance: Overview Good Governance Involves effective policy and decision making Encourages teamwork and communication Focuses on sustainability Compliance and accountability Financial stability Identifying and mitigating risk Meeting owner s objectives Enhance long-term value Starts with organizers during feasibility and incorporation phases

Start-Up: Feasibility The feasibility study establishes the foundation of the captives business activities It will survive long after a captive is formed: It should be reviewed carefully by the parent It should be used to educate leadership Many components will be used to develop a business plan which will be reviewed in detail by the regulators It may be reviewed critically by the tax authorities A good feasibility clearly describes the business case for the captive and the reasons for program recommendations

Start-Up: Feasibility Essential elements include: Insurance fundamentals Anticipated coverage; policy terms; premium; limits Fronting needs and anticipated reinsurance arrangements Actuarial analysis Choice of domicile Structural and tax considerations Entity choice: corporation, LLC, series, protected cell Ownership and capitalization Tax treatment: premium deductibility, captive taxation Pro forma financials

Start-Up: Organization Key organizational documents include the Articles and Bylaws/Operating Agreement Articles/Certificate of Incorporation/Organization Depending on domicile, will be filed with secretary of state, corporations division, attorney general or registrar of companies Corporate charter and business purpose Authorized shares and statutory capital Director s limitation of liability and exceptions Breach of the duty of loyalty Gross negligence or willful neglect Improper personal benefit

Start-Up: Organization Bylaws/Operating Agreement Reserved owner powers Size of Board Director term limits Meeting requirements Quorum requirements Committees Executive, finance, underwriting, claims, audit Officer positions Indemnification Customized for owner and domicile

Start-Up: Organization Basic Duties of Directors and Management 1. Loyalty must act in good faith and reasonably believe action to be in the best interest of the captive Conflicts Fairness; independent advice 2. Due Care - must exercise judgment and care of an ordinarily prudent person under similar circumstances Time commitment Informed Inquiry

Start-Up: Organization The Board has a responsibility to make decisions collectively by resolution Board composition Board should include a multi-disciplinary team with the knowledge and experience to address strategic, operational and financial issues that face an insurance company Risk/claims management, legal, finance/treasury, executive leadership Character and fitness Each Director must complete a biographical affidavit for the regulators

Start-Up: Organization Board composition (cont.) Independent Director - increased transparency Someone without divided loyalties Outside of parent company s corporate culture Willingness to raise questions Expertise in insurance, helpful Insured group representation Pros and cons Resident Director, may be required Usually captive manager or legal counsel

Operational Board and Shareholder Meeting: Plan well in advance so that everyone can attend Have an agenda that educates & stimulates discussion Consider having the auditor present (for part of meeting) Consider having the actuary present (for part of meeting) Approve the actuarial study & audit Financial statement review Reassess and reappoint service providers Consider changing one director on a multi-year basis

Operational Orientation from the consulting team Define roles and responsibilities Explain differences of operating an insurance company Regulated; changes to Business Plan require approval Managed by outside company Seek direction from Board on corporate policies to adopt Conflicts Confidentiality Investment Dividend

Operational Role of the Manger Act as Principal Representative in Domicile Preparation of Financial Statements and Forecasts Statutory filings Treasury Service Activities Financial transactions (liaise with investment manager) Monitoring and processing cash and investment activities Assisting with collateral requirement: LOCs and trusts (captive manager, fiduciary, owner) Insurance services including policy documentation and endorsements Receive claim reports from TPA

Operational Review financial statements Cash flow statement Liquidity; reserve movement Break even operations? Income statement Premium flow; investment income; losses paid Balance sheet Cash and investments; losses recoverable; loss reserves

Operational Review and approve funding methodology Actuarial/Experience Rating Based on own experience, not industry (may not have sufficient data) Overhead is generally lower than market (may need to be adjusted) Premiums reflect more accurate cost of risk Discounting and confidence levels Market Rates (difficult to quote every year) Evidence arms length pricing generally higher premium (good for building surplus) Removes need for actuary (difficult to factor own experience) Other Techniques Hybrid

Operational Review and approve insurance policies Policyholders and insureds Coverage and exclusions Premium and limits Retroactive dates Claims reporting requirements

Operational Review significant claims Vitally important part of captive Must show arms-length negotiation Use an outside adjuster for large claims Important if reinsurers are involved Licensure requirements to adjust claims in state of claim In-house personnel can still make ultimate settlement decision Consider who is responsible for this decision

Operational Review and approve investment policy Typically, new captives restrict their equities /alternative investments until their portfolio grows Generally less than 20% in early years More mature captives sometimes invest up to 40% in equities/alternative investments and otherwise have a more diversified portfolio Captive investment portfolio generally reviewed and monitored in conjunction with captive shareholder s investments If captive funding is on a discounted basis, projected investment returns should be taken into account in determining discount rate Consider benchmarking against other captives, e.g., AM Best survey of captives

Operational Audit Considerations Evidence Board / management understand the business What are the captive s objectives? What coverage is provided? What are the operating procedures? Who is responsible for what? What controls exist? Evidence Board / management understand the risk Financial reporting risks and objectives What could go wrong? Financial statement level

Operational Audit Best Practices Adopt parent company s best practices Treat the captive as a significant subsidiary Involve the right people in the captive s operations Have dedicated personnel in the key areas (risk management, finance, tax, legal, etc.) If available, utilize internal audit department Have a documented system of internal controls Should address the captive s unique risks Make key controls auditable Review controls at Board meetings and keep updated Develop a Procedures & Operations Manual

Operational. CONTENTS 1 INTRODUCTION Purpose of Manual 4 Role of ESM Reinsurance Limited 4 Queries or Unusual Circumstances 6 Manual Pages Filing Instructions 7 2 GENERAL CORPORATE DATA Company Information 8 Registered Office and Details of Incorporation 9 List of Current Directors 10 List of Current Officers 11 Legal Counsel 11 Auditors 11 Agents 11 Committees & Members 12 Risk Management Consultant 12 Investment Managers 12 Investment Custodians 13 Banking Information 13 TPA Details 13 Letter of Credit Issuer 14 3 POLICY SUMMARIES (Examples) Primary Property Damage / Business Interruption Policy 15 Primary General Liability Reinsurance Policy 21 Transit Risks Policy 24 - Page No. CONTENTS CONTINUED 4 RESPONSIBILITIES Purpose 26 Chair 26 Manager 26 Claims Committee 28 Underwriting Committee 29 Investment Committee 31 5 UNDERWRITING PROCEDURES Purpose 32 6 INTERNAL CLAIMS PROCEDURES Purpose 33 Notification of claims 34 7 FINANCIAL REPORTING PROCEDURES Purpose 40 Responsibilities 40 Processing of Premium Cessions 40 Collection of Cash for Premium Cessions 40 Processing of Reinsurance Policies 41 Payment of Reinsurance Premiums 41 Reporting and Paying Claims 42 Day to Day Operations of Financial Services 40 Reporting Financial Results to ESM Reinsurance Limited. 43 Page No. -

Operational: Growth/Maturity Anticipate and prepare for change Possible internal changes Owner-insured s business / industry Corporate structure M&A activity Possible external changes Insurance market and carriers Service providers Captive domicile or owner-insured s state law Federal and state tax laws

Operational: Growth/Maturity Best Practices to keep leadership informed Interpretation of actuarial and financial data Compliance with domicile and tax filing requirements Trends in the insurance market Changes in domicile law Tax and accounting changes Investment performance and strategy Succession Planning Identify key personnel and possible successors Ensures continuity and transfer of knowledge Minimizes disruption

Operational: Growth/Maturity Strategic Planning, update assumptions from Feasibility Study: Insurance, actuarial; structural and tax; domicile and financial considerations SWOT analysis Consider and rank enterprise risks Review of effectiveness of service providers and Board effectiveness Does the captive continue to achieve business objectives? Are there other opportunities?

Operational: Growth/Maturity Strategic Planning should include: Internal owner-insured subject matter experts Risk management Tax, accounting, finance, operations Outside captive and insurance consulting team members Actuary Manager Broker Tax/Legal counsel Claims handler Investment advisors

Wind-down: Closure Reasons a captive will reach the end of life-cycle Change in parent s business Economic considerations Exit of non-core business lines Softening insurance market or availability of specialized coverage Loss of champion in a single-parent captive or a key member of a group captive Legislative and regulatory changes M&A of parent

Wind-down: Closure Options for discharging captive liabilities Merger Run-off and voluntary dissolution If short tail, then this is easy to do If long tail, this can take time, consider Internal resources or external resources? Existing or more aggressive approach to claims resolution? Downsizing by transferring to a cell Novation / Reinsurance Third party consent? Willing to pay additional cost to transfer liability? Confidence in reinsurer? Sale of Captive Consider post-closing contingent liabilities

Wind-down: Closure Run-Off Strategic Considerations Value of the Claims Control of claim settlement process Cost of continuing to operate captive Incentivize team to manage efficiently Other uses of capital and surplus Possibility of downsizing to a cell Timing of Capital Release Reduction of surplus requirements

Wind-down: Closure Governance Considerations Keep regulator informed of developments Board continuity during the closure phase is important from a regulator s standpoint Ability to pay claims and solvency of captive Economic capital report Greater sensitivity to all stakeholders as captive is discharging liabilities and insurance obligations Explore all options to extinguish liabilities Confirmation liabilities discharged for liquidation and dissolution