Group Captive & Actuarial 101

Division Executive Vice President Chad Kunkel Artex Risk Solutions Division Executive Vice President

Pinnacle Actuarial Resources, Inc. Joe Herbers Pinnacle Actuarial Resources, Inc. Managing Principal

TC Leshikar KPMG Director, Tax

What is a Captive? A licensed insurance company formed to insure the risks of its owners Regulated by the Country or State the company is licensed in Captives are not all the same

Why form a Captive? Ability to retain underwriting profits Underwriting flexibility Lower insurance costs over the long term Control over claims Opportunity to receive investment income Direct access to reinsurance and carriers Incentives for loss control Tax advantages Insure coverage gaps

Types of Captives Single Parent Captives Rent-A-Captives Pure captives insuring only their own risks or affiliates Rent-A-Captives Agency Captives Association Captives RRG – Risk Retention Groups Group Captives

Single Parent Captive

Types of Captives Single Parent Captives Rent-A-Captives Captive “rents” its facility to an outside organization Agency Captives Insures risks of its customers Association Captives Group Captives

Rent-A-Captive or Cell Captive

Types of Captives Single Parent Captives Rent-A-Captives Agency Captives Association Captives Insures risk of the members of its association Group Captives Insures risk of its members or shareholders

Group Captive Group Captive Premiums Business 1 Business 5 Insurance Policies Business 2 Business 6 Business 3 Business 7 Business 4

Group Captive Considerations Reason for the Group Captive Need for Critical Mass Historical Data Capital and Carrier LOC requirements Retentions of the Captive Sharing Risk Captive Structure

Reason for forming a Group Captive Myth – taking risk does not always equal cheaper insurance Need for long term approach Hard and soft market cycle consideration

Critical Mass Important for viability of Group Premium volume typically equals lower costs Need for Reinsurance/Carrier support Law of large numbers Need to overcome start up costs

Historical Data Important to determine feasibility Historical Losses by Line of Coverage Historical Exposures Historical Premium information Projected Exposures Need for Carrier/Reinsurance Support Need for Actuarial Study

Capital Requirements Captive will need Capital in addition to Premium paid in If Fronted Program – Carrier Collateral considerations need to be contemplated

Captive Retentions Risk appetite of group needs to be contemplated High retentions could create concern for new insureds Low retentions could prevent carrier support Lower retentions can help with stability in early years Can increase retentions over time to assist in lower costs

Sharing Risk Number of ways to share risk Pooling or Quota Share Sharing occurs after premiums exhausted Layer Approach Reduces Sharing of Risk Holds Insureds more accountable

Captive Structure Stock or Mutual Company Ownership 1 Vote Per Insured Based on Premium or Capital Return of Premium Considerations Tax

Captive Process

Captive Feasibitliy Studies - Outline What is a Captive Feasibility Study What are Actuaries? Actuarial Involvement in Captive Feasibility Study Dealing with Uncertainty Predicting the Future

Captive Feasibitliy Studies Data Analysis Loss Estimates Capitalization Requirements Domicile Tax Issues Coverage, Retentions, Limits Expenses Reinsurance Costs Regulatory Issues Pro forma Financials

Actuaries & Captive Feasibitliy Studies Projecting the future in regards to: Premiums Losses Loss Adjustment Expenses Captive expenses Acquisition, general, taxes Reinsurance costs Capitalization Requirements Investment Returns

What is an Actuary? Insurance professional skilled in measuring and quantifying risk Typically a math or statistics major in college Schooled in all aspects of insurance operations Claims - Accounting Underwriting - Ratemaking Marketing - Reinsurance Legal - Systems/IT

What does an Actuary do? Quite simply – Predict the Future Ratemaking – Figure out what premiums to charge for a variety of coverages, limits and deductibles Loss Funding Studies – Projecting future costs so insurer or self – insured entity can budget costs Loss and loss adjustment expense reserve accruals for financial reporting purposes Retention Level Analysis Exposure Modeling (CAT) Risk Transfer in Reinsurance

Essential Background Information Business Plan Historical premium, losses, claim counts & exposures for entity being considered Domicile, Service Providers being considered

Captive Business Plan Key management of enterprise Owner(s), officers, roles Nature of underlying business being insured Coverages Retentions – both per occurrence and aggregate Limits Services Providers

Data Analytsis Projecting Ultimate Losses Project Ultimate Loss Ratio Start with current reported incurred losses Adjust for retentions Adjust for expected future loss development Adjust for future trend Adjust for changes in statutory benefit levels (WC) Use multiple methods to project ultimate losses Rely on a point estimate or reasonable range of ultimate losses Project Ultimate Loss Ratio

Lags Property/Casualty insurance business is characterized by lags (which give rise to need for IBNR)

Uncertainty in Projecting Ultimate Losses Changes in rate of claim payments Changes in case reserving practices Changes in mix of exposure Changes in retention limits Changes in claim reporting procedures

Data Analysis Projecting Expenses Commissions/Brokerage Fronting Taxes, Licenses & Fees General (audit, actuarial, legal) Claims Handling Reinsurance Loss Control Federal Excise Tax Usually stated as % of either WP or EP

Data Analysis Underwriting Profit Investment Returns FIT Dividends Investment Income Mix of investments by type (stocks, bonds, cash, other) Expected returns by type Realized Capital Gains/Losses FIT Dividends

Pro Forma Financials Run Pessimistic, Base and Optimistic scenarios Underwriting Exhibit Projected premiums (direct / ceded / net) Projected losses (premium x loss ratio) Projected expenses Dividends Underwriting profit (by subtraction) Balance Sheet Assets, Liabilities & Surplus

Pro Forma Financials Run Pessimistic, Base and Optimistic scenarios Income Statement Underwriting Income, Investment Income, Other Income Changes in Surplus Beginning Surplus Capital Paid In Net Income Change in unrealized gains Stockholder dividends Cash Flow Statement Beginning Cash Inflows (premiums, investment income, paid-in capital) Outflows (losses, expenses, taxes, dividends)

Consideration of Uncertainty Reliance on actual data versus benchmarks and/or external data – less uncertainty in we have reliable data for entity being studied Nature of historical data (# of years, consistency between years) Examine reasonable range versus point estimate

Predicting the Future We know our projections will not be absolutely correct Objective is to have projections “in the right neighborhood” close to reality Systematic pessimism or optimism in not good With feasibility studies, we provide a range from pessimistic to optimistic

TAX From the insured’s perspective From the owners’ perspective - Are the Premiums Deductible? - Are there any Premium Taxes? Domicile, U.S. Federal Excise Tax, State Premium Taxes etc. From the owners’ perspective If Non-U.S. domiciled, are the owners subject to tax annually or only when distributions are made? Is there any “unrelated business taxable income” for the tax-exempt owners

TAX From the captive’s perspective Is it considered an “insurance” company for U.S. tax purposes (i.e. can it deduct loss reserves, are the premiums paid by the insureds deductible)? If Non-U.S., is it a controlled foreign corporation (“CFC”)? If Non-U.S., is it eligible to make the Section 953(d) election to be taxed as a U.S. Corporation? Is it eligible to make the Section 831(b) election? If Non-U.S., are there withholding taxes on its income? If Non-U.S., does it intend to “conduct a U.S. trade or business”?

TAX Items to Consider Taxable and tax-exempt organizations may have different tax motivations Some uncertainty in the area of U.S. Tax of Captives. Should be part of Owners/insureds’ risk tolerance assessment Determine upfront, how the Captive will be treated for U.S. Tax purposes. Make sure all stakeholders’ tax advisors are involved at formation and all on same page Document the business reasons for captive formation as support in case of future audit Include tax calculations in proformas and projections

Formation Process Creation of Business Plan Identification of Services Providers Insurance Manager forwards Business Plan to CIMA Meeting with CIMA License Application submitted to CIMA Pro forma Projections, Actuarial projections, Business Plan, Identification of service providers along with director applications “Approval-In-Principle received – 6 Weeks Company incorporated and capital put in place License Issued

Get Started Board of Directors Appointment of Officers Appoint and Engage Service Providers Insurance Arrangements Creation and approve operating budget Creation of Committees You are up and running!

On Going Board Meetting Shareholder/Member Involvement Committees Determine how often Shareholder/Member Involvement Committees Signing Authority Financial Statement Review Investment Policy Review of Goals/Establish new ones

Long Term Retention of Membership Long Term Approach Adequate pricing and capitalization Risk Management Return of Premiums/Dividends Monitor Service Providers Review of Structure/Retentions

Questions & Answers