Captives/RRGs 101-the Basics of Alternative Risk Transfer

Captives/RRGs 101-the Basics of Alternative Risk Transfer Sean Rider- Willis Captive Consulting Practice Jules Rousseau-Arent Fox LLP David Provost-State of Vermont Monday, March 14th - 1:30pm 3:00pm

Presentation Topics Introductions Captive Primer Captive Utilization The Feasibility Process Incorporation Ongoing Operations

Primer: the Basics What is a captive 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

Primer: the Basics HIGH Self-Insured Trust Complete assumption of risk with limited regulation Single Parent Captive Complete assumption of risk Subject to Regulatory Oversight Group Captive Pooling of Risk with Participants subject to Corporate Governance Deductible Policy 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 no deductible HIGH Financial Control

Primer: the Basics Captives have a long history, been around since the 1920 s In 2011 there are over 5,000 active captives globally with annual captive premium estimated around $60 billion The top 5 domiciles globally: Bermuda Cayman Vermont Guernsey British Virgin Islands 5

Primer: Benefits of a Captive Reduced long term costs Underwriting profit and investment income belongs to the captive Premiums are based on the loss experience of the captive, not on the expense needs of an insurance company Able to write off full premium while captive builds reserve Potential for lower overhead costs

Primer: Benefits of a Captive Reduced long term costs Aggregation of similar risk can reduce overall premiums Captive allows for direct access to reinsurance market and provides greater leverage for reinsurance Implementation of best practices in the captive lowers frequency and severity of loss which drives down cost of risk The captive facility provides accountability and auditing of risk management practices, ensuring improvements in loss costs

Primer: Benefits of a Captive Better Control Improved risk management provides benefit to captive owners Greater control over claims handling Captives allow businesses to be insulated from the market cycles of the insurance industry Alignment of interest redefines risk transfer discussions Improved Coverage Coverage can be tailored to meet the specific needs of the policy holders industry specific coverages Underwriting flexibility to provide coverage where it is unavailable or cost prohibitive Risks that are underwritten are exactly those of the company owner(s)

Primer: Types of Captives Single Parent Captives insure the risks of the owner or brother sister companies Group/Association Captives typically formed and owned by members of an industry or trade association to share the risks of the industry Agency Captives owned by insurance broker to insure client risks. Most established as rent-a-captives Risk Retention Group (RRG) members must be engaged in similar business activities, have homogenous risks and write only liability risks

Primer: Single Parent Captive Structure Shareholder Parent Company Premiums Insurance Policies Captive Investments

Primer: Group Structure Insured 1 Insured 2 Insured 3 Insured 4 Insured 5 Insured 6 1 Fronting Carrier 2 Captive Facility 4 3 Owner 1 Owner 2 Owner 3 Owner 4 Owner 5 Owner 6 1 2 3 4 Each individual insured purchases insurance from a common insurance company who has agreed to provide fronting to the captive transaction The fronting company cedes a certain amount of the risk and premium to a captive The captive s owners are the same organizations who bought the insurance in the first place The captive has internal rules which govern how risks are shared between members, when profits are dividended to shareholders, and how the captive is governed

Risk Considerations Type of Captive based upon risk philosophy: Group Captive limited control risk sharing elements Segregated Cell or Rent-a-captive limited control potential risk sharing elements RRG better control potential risk sharing elements Single Parent Captive optimal control for the long term

Primer: Types of Facilities Segregated Cell Captives each cell is risk sharing facility segregated by walls Rent-a-Captive licensed insurer formed by their owners to insure the risks of other organizations for a fee

Primer: Segregated Cell Captive Structure Segregated Captive Facility Facility Owner Cell 1 Insured 1 Beneficial Owner 1 Cell 2 Insured 2 Beneficial Owner 2

Primer: Types of Risks

Types of Captive Utilization Retained Risk Finance Infrastructure for providing transparency, validation, and rationalization of retained risk positions Enhancing risk management efforts Accelerating tax treatment of deductible liabilities Risk Transfer Rate Arbitrage Reinsurance market cost of risk transfer is less than commercial retail cost of risk transfer Better use of capital to retain risk than transfer it Managing total cost of risk Access to Capacity Federal programs (TRIA) Reinsurance capacity, which may not be otherwise accessible in commercial retail market (trade credit risk, +10 yr pollutions risks) Entrepreneurial Utilizations Franchisee programs Consumer facing insurance programs (warranty, service contract, point of sale insurances, etc) Affiliate business (vendors, VAPs, distributors, etc) Agency captives 3 rd party business

Utilization: Retained Risk Finance There are generally two models for managing retained risks in captives: Deductible Reimbursement Programs, and Catastrophe Excess Programs Each have different motivators, benefits, and challenges Deductible Reimb Workers compensation General liability Auto liability Product or service extended warranty Construction exposures Environmental liability Property and business interruption Equipment maintenance Managed care errors and omissions EE Benefits Self-insured medical stoploss (non-erisa) Reputation/brand/loss of income risks Intellectual property (patent, trademark, copyright) Product recall coverage Medicare fraud and abuse insurance Punitive damages coverage International kidnapping protection Trade credit risk Professional and products liability Cyber-risk Cat Excess Director and Officer liability Employment practices liability

Utilization: Deductible Reimbursement Programs Financing retained risk positions under existing commercial deductible programs An infrastructure for transparency, validation, rationalization of retained risk positions; Bring senior management visibility to risk management efforts and the real cost of risk; Funding loss control, risk management, claims incentive programs; Enhancing risk management and safety outcomes by aligning business center leadership to risk management outcomes; Accelerating tax treatment of deductible liabilities. Key Characteristics: frequency driven, long tail, high volume liabilities Deductible Reimb Workers compensation General liability Auto liability Product or service extended warranty Construction exposures Environmental liability Property and business interruption Equipment maintenance Managed care errors and omissions EE Benefits Self-insured medical stoploss (non-erisa)

Utilization: Deductible Reimbursement Programs How do they Work? The insured continues to purchase deductible insurance programs form the commercial market; The insured then purchases a deductible reimbursement program form their captive, paying a premium equivalent to their loss picks under the commercial deductible program; In the commercial deductible program, the insured will be required to post a security instrument of some sort, it is possible, upon negotiating with the carrier, that the premiums that the insured pays to the captive be used to secure the insured s liabilities under the commercial deductible program Risk Transfer Program (Excess Insurance over Deductible) Insured s Deductible Fits into the deductible layer Deductible Reimbursement Program (provided by the Captive) (Aggregate Stop Loss)

Utilization: Catastrophe Risk Excess Programs Financing retained risk positions in the excess layers where commercial capacity is not available An infrastructure for transparency, validation, rationalization of retained risk positions; Bring senior management visibility to risk management efforts and the real cost of risk; Possibility to access reinsurance markets capacity where retail market capacity is insufficient; Does not translate into risk transfer, in most cases Challenged to achieve accelerated tax treatment of retained liabilities. Key Characteristics: low frequency, high severity, board attention, limited capacity, need to show consideration of exposure (ERM, S&P) Reputation/brand/loss of income risks Intellectual property (patent, trademark, copyright) Product recall coverage Medicare fraud and abuse insurance Punitive damages coverage International kidnapping protection Trade credit risk Professional and products liability Cyber-risk Cat Excess Director and Officer liability Employment practices liability

Utilization: Reinsurance (Rate Arbitrage & Capacity) Accessing risk transfer cost or capacity in the reinsurance market which is otherwise unavailable in the commercial retail market Opportunity to reduce total cost of risk transfer when there is a significant differential between the retail and the reinsurance markets for similarly valued limits Opportunity to access capacity which is only available on a reinsurance basis Opportunity to access federal programs (like TRIA) for which an insurance company infrastructure is a prerequisite Key Characteristics: challenging retail insurance coverages, limited capacity, differential in reinsurance costs, terms or conditions from commercial retail market, tends to be high excess large capacity covers. Terrorism (TRIA) Shipping coverage Title and private mortgage insurance Cyber-risk Reinsurance Professional and products liability Self-insured medical stoploss (non-erisa) Director and Officer liability Employment practices liability Product recall coverage Punitive damages coverage

Entrepreneurial Utilizations Participating in the profitability of insurance programs offered to 3 rd parties Opportunity to build new profit centers Opportunities to access further monetize commercial relationships Examples include: Franchisee insurance programs Consumer facing insurance programs sold in tandem with core products at point of sale Forced insurance products required of those in credit relationships Key Characteristics: profitable business, mutually enhances commercial relationship, portfolio size exceeds $3-5m. Entrepreneurial Package, workers comp, auto liab, personal insurances to franchisees Warranty / service contract programs to consumers Forced placed insurance programs to credit customers Credit life insurance to finance consumers Title and private mortgage insurance

Captive Feasibility & Formation Process Compile data Consult with experts Commission feasibility project Select domicile Seek and select risk and service partners Implement captive Ongoing operations

Costs and Timeline Costs Equity Captive Cell in Seg Facility Timeline (w eeks) Low High Low High Phase One: Feasibility Study Phase One: Feasibility Study short long Actuarial Study 10,000 25,000 10,000 25,000 Actuarial Study - 6 Legal and Tax advice 10,000 20,000 5,000 15,000 Legal and Tax advice 2 6 Coordination and General Consulting 35,000 45,000 15,000 20,000 Coordination and General Consulting 4 10 55,000 90,000 30,000 60,000 Overall 5 12 Phase Tw o: Captive Impplementation Phase Tw o: Captive Implementation Domicile License and Registration Fees 1,500 7,000 1,500 2,250 Develop Business Plan 2 3 Law yers Fees for Incorporation 10,000 20,000 Complete Application 2 4 Management Fee for incorporation 7,500 10,000 5,000 10,000 Develop Legal Documents 2 4 Other Disbursements 2,000 3,000 2,000 3,000 Incorporate Company 1 1 21,000 40,000 8,500 15,250 Capitalize Company 1 2 Phase Three: Ongoing Operations Seek Insurance License 3 6 Annual Government Fees 5,000 15,000 Complete all contracts 2 2 Law yers, Secretarial and Directors Fees 6,000 10,000 6,000 10,000 Overall 6 16 Audit Fee 15,000 45,000-20,000 Actuarial Fees 10,000 25,000-25,000 Management Fee 45,000 125,000 35,000 100,000 Initial Capitalization Miscellaneous 4,000 6,000 4,000 6,000 Single Parent 120,000 1,000,000 85,000 226,000 45,000 161,000 (In the timeline many distinct items happen simultaneously the tasks above are not started and finished sequentially, allow ing for an abbreviated overall timeline relative to the tasks involved and their specific timelines)

Feasibility Project A Feasibility Project typically has four main components: General Framework Actuarial Analysis Tax and Legal Analysis Pro Forma Financial Statements

Feasibility Project: General Framework Captive Basics Risk Taking Structural Options and Scenarios Domicile Decision making Financing Options Coverage Requirements Marketing Initiatives / Options Additional Ancillary Uses

Feasibility Project: Domicile Domicile decision metrics: Capitalization and surplus requirements Receptiveness of regulatory environment Quality of local infrastructure Availability of expertise Stability of regulatory environment Flexibility as respect investment portfolio Ease of doing business in a suitably regulated environment Experience in business under consideration including Employee Benefits Efficient financial outcomes: tax, wealth, investment etc.

Feasibility Project: Domicile Onshore: (over 30 States!) Vermont Hawaii South Carolina New York District of Columbia Arizona Nevada Utah Montana Puerto Rico U.S. Virgin Islands Offshore: Bermuda Cayman Islands British Virgin Islands Barbados Turks & Caicos Channel Islands (Guernsey/Jersey) Ireland Gibraltar Isle of Man Malta

Feasibility Project: Tax and Legal Tax Issues Premium Deductibility Captive Taxation Premium / Surplus Lines Taxes Shareholder Taxation Ownership Structure Direct Ownership Holding Companies Family Wealth Planning Compliance Issues Doing business in subject business jurisdictions Corporate Structure Mutual Reciprocal Stock Company Segregated Facilities

LEGAL ASPECTS of CAPTIVE FORMATION Tax Deductibility of Premium Payments Use of Premium and Capital by Captive Licensing and Regulation of Captives and RRGs Legal Effects of Owning an Independent Insurer Interesting Alternative Risk Transfer Options Jule Rousseau, Arent Fox

Tax Deductibility of Premium Payments Requirements for Risk-Shifting and Risk-Distributing 50% Underwriting of Third Party Risks Eleven or More Subsidiaries Standard Insurance Terms, Costs, and Risk of Loss Jule Rousseau, Arent Fox

Use of Premium and Capital by Captive Minimum Capital and Surplus Requirements Investments of Capital and Reserves Generation Skipping Benefits Structure of Ownership of Captive Jule Rousseau, Arent Fox

Licensing and Regulation by Captives, RRGs Domicile and State Where Captive is Doing Business Effects of Licensing Special Rules for RRGs Under the Federal Risk Retention Act Requirements of Surplus Lines and Premium Taxes Supervision by State Insurance Departments - Pro s and Con s Jule Rousseau, Arent Fox

Legal Effects of Owning an Independent Insurer State Laws will Apply Relationship with Claimants Relationship with Insurers/Reinsurers Insolvency Jule Rousseau, Arent Fox

Interesting Alternative Risk Transfer Options Goal: To provide worldwide coverage through single policy Goal: To provide defense costs for expected types of litigation Goal: Wealth transfer Goal: Provide option in hard market for difficult to place risk - TRIA Goal: Design a program for profit 35 Jule Rousseau, Arent Fox

Feasibility Project: Actuarial Analysis Loss Forecasts Rate Making Working with regulators towards approval

Feasibility Project: Pro Formas Financial Analysis Various loss scenarios Various attachment points Various reinsurance structures Prospective pro forma financial statements 5 year prospective financial statements Actuarially determined payout patterns Expected incorporation and ongoing expenses Investment modeling Surplus and capital contributions

Incorporation of the Captive Initial approvals and selection of service providers Draft operations plan and financial projections Meet with domicile regulators Submit captive application to regulator Incorporation Certificate of Authority ( COA ) Capitalize Underwriting/Operations begin Other activities/steps subsequent to COA

Operations Captive Manager responsible for: Bookkeeping Financial statements Regulatory reporting Annual meeting coordination Actuarial coordination Policy renewal coordination Liason between all captive services professionals Audit coordination

Regulation after Formation Changes in Plan of Operation Investment restrictions Directors Meetings/Conflict of Interest Policy Filing Requirements Examinations Monitoring of financial performance/parent Company information 40

Operations: Risk Philosophy What is the ultimate goal for the program? defend to the end? resolve where appropriate? financial goals? just culture and equitable resolutions?

Operations: Risk Program Identify chosen philosophy Outline strategic plan identify resources set goals/timelines establish measurements Implement plan Educate insureds Report out on findings Set expectations on follow up

Operations: Finding Resources Once need identified ask could it/should it be done in house? what are the costs of resources? what are the benefits of externalizing? what are the benefits of internalizing? what best meets goals of ultimate?

Operations: Evaluating Service Providers Compared to the strategic plan are providers in line with goals? do providers know parameters of accountability? are goals being achieved? would the same choice be made?

Operations: Recommendations Annual review of strategic plan Still applicable? Consistent with practice? Annual evaluation of coverages- Where are gaps? duplication? Is desired outcome achieved? Financially? Operationally?

Who should consider a captive? Good risk management Long term commitment Financially sound Driven by an interest in financing assumed risk positions Reasonably predictable insurance risk Savvy financial planning