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Reinventing Your Captive for Maximum Results Allan Harris, Risk Financing Superior Guaranty Insurance Co Mersini Keller, Tax Senior Manager KPMG LLP George Levine, Actuarial Director KPMG LLP Stan McKinley, Captive Owner and Moderator Superior Guaranty Insurance Co August 10, 2017 2017 VCIA; Speaker materials used by VCIA under license.

Agenda Introduction Business/Owner Perspective Tax Considerations Actuarial Observations Case Studies Traditional Insurance Coverage Advanced/New Insurance Coverage 3

Business/Owner Perspective 4

Captive Underwriting Committee Do you accept this mission? Management Liability Cyber Liability Reputation Risk 5

Captive Underwriting Committee Why are we considering this mission? Economic benefits Strengthen operational effectiveness and external relationships Formalize exposure assessment to better understand the risk Formalize loss data gathering and coverage assessment to bolster purchase of 3 rd -party risk transfer Capture risk in a regulated, audited entity 6

Captive Underwriting Committee Team mission: Captive, Risk Financing & Claims Managers + Tax, Accounting, Actuarial Exposure/Loss Information Decide coverages and exclusions Use of Reinsurance: attachment points and limits Reasonability Test: What are we missing? Sobriety Test: What could go wrong? 7

Tax Considerations 8

Tax Overview A closely held insurance company established primarily to insure the risks of its parent company and/or affiliated group A risk management technique where losses are financed by making payment to a captive insurance company Typically formed under regulations that are more relaxed than the regulations placed on commercial carriers Can be domiciled in U.S. or foreign jurisdiction 21 states and the District of Columbia Most common countries of domicile are Bermuda and Cayman Islands Most common states are AZ, DE, DC, HI, KY, MT, NC, NV, SC, UT, VT 9

The four required attributes of an insurance company 1. Presence of insurance risk IRS view: investment risk is not insurance risk; fortuity is required 2. Transfer of risk of economic loss IRS view: An arrangement whereby the insured pays for its own losses is not insurance 3. Risk Distribution-Operation of the Law of Large Numbers IRS historical view: the relevant unit of risk-bearing is the number of legal entities which bear a certain type of risk of loss 4. Insurance in its commonly accepted sense IRS view: regulation as insurance is not dispositive; historically accepted lines of business are generally commonly accepted 10

Fortuity of Risk RVI Case Facts RVI offered residual value contracts to lessors of commercial equipment Price based on the expected residual value of the equipment at end of lease Court s Focus Commonly Accepted Notions of Insurance How RVI s policies were insurance for nontax purposes: RVI was organized, operated, & regulated as insurance company by every state it operated in Insurance Risk Policies involved an insurance risk: RVI s loss could vary from zero to the full insured value Court rejects IRS pure risk standard Court rejects IRS analogy to put options on stock because lessors that RVI insures do not expect protected assets to appreciate; they expect assets to decline and they purchase policies to protect from large declines 11

Actuarial Observations 12

Insurance/Insurable Risk Understand the claims under the insurance policy Trigger of loss Financial loss can be determined from the contract Loss needs to be fortuitous Must be careful so that insured does not control the satisfaction of the claim s trigger 13

Actuarial Considerations Pricing: Discuss business needs for insurance coverage Obtain loss history (or near-loss history) if available Review and use exposure information Use industry data to extent company data is not credible or available 14

Case Study #1 Management Liability 15

Management Liability Proposal Captive policy: $5M deductible, $50M per occ / $100M basket agg. Premium $15 M. Reinsurance: attaches at $30M per occ, limit $25M per occ / $50M basket agg. Premium $5M. Covers: E&O, Fidelity Bond, D&O, EPL, Fiduciary Liability 16

Management Liability Proposal Issues: Volatility Length of tail Policy/contract interpretation Basis risk (covered by captive, not by reinsurers) 17

Live Content Slide When playing as a slideshow, this slide will display live content Poll: Do you accept the mission to write Management Liability in the captive? 18

Case Study #2 Cyber Liability 19

Cyber Liability Proposal Captive policy: Similar direct reinsured structure as the management liability program. Covers: Fraud losses, customer notification & restitution, credit monitoring, regulatory fines, mitigation, event forensics, clean-up Resulting from: Hacking, denial of service attack, confidential data breach, wrongful acts on social media, cyber extortion Not covered: Reputational damage (lost revenue, stock price decline), theft of trade secrets 20

Cyber Liability Proposal Issues: Limited loss data Difficulty determining / estimating covered loss Low spread of risk (centralized losses) Overlap w/ other coverages (bond, E&O, property) Extensive loss adjustment, extended loss emergence Cyber policies are often bought as much for the post-event services provided as the risk transfer the captive doesn t enhance this aspect 21

Live Content Slide When playing as a slideshow, this slide will display live content Poll: Do you accept the mission to write Cyber Coverage in the captive? 22

Case Study #3 Reputation Risk 23

Reputation Risk Proposal Captive provides say $20 million of coverage over a $10 million retention. Features/issues: Reputational losses may not be easily measured, e.g., revenue decline, but could be approximated using proxy indexes, e.g., employee turnover, customer visits, credit ratings Captives today tend to bear 100% of risk, i.e., not much in the way of commercial risk transfer Coverage could also include recovery costs, e.g., legal, consultants, PR, monitoring 24

Live Content Slide When playing as a slideshow, this slide will display live content Poll: Do you accept the mission to write Reputation Risk in the captive? 25

Q&A 26

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