Dr. James Kallman, ARM 8-1 Advanced PowerPoint Presentation ©2009 The National Underwriter Company

Dr. James Kallman, ARM 8-2 This Advanced PowerPoint Presentation accompanies the “Tools & Techniques of Risk Management & Insurance” textbook. Each of the 28 chapters in the textbook are presented here in the following sections:  Outline  Key concepts  Major sections  Chapter summary ©2009 The National Underwriter Company

Dr. James Kallman, ARM 8-3 Contents Techniques of Risk Management & Insurance Ch 1 Introduction to Traditional Risk Management……………1-5 Ch 2 Enterprise Risk Management…………………………….2-1 Ch 3 Risk Assessment: Identification…………………………..3-1 Ch 4 Risk Assessment: Quantification…………………………4-1 Ch 5 Overview of Risk Treatment Alternatives………………. 5-1 Ch 6 Non-insurance Transfer of Risk…………………………. 6-1 Ch 7 Insurance as a Risk Transfer Mechanism……………….7-1 Ch 8 Overview of Alternative Risk Transfer Techniques……..8-1 Ch 9 Global Risk Management…………………………………9-1 Ch 10 Loss Control Techniques……………………………… Ch 11 Emergency Response Planning……………………… Ch 12 Business Continuity Planning………………………… Ch 13 Claims Management…………………………………… Ch 14 Monitoring Claims for Financial Accuracy…………… Ch 15 Insurance Companies and Risk Management……… Ch 16 Working with an Agent or Broker……………………….16-1

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-4 Contents Tools of Risk Management & Insurance Ch 17 Commercial General Liability Insurance……………….17-1 Ch 18 The Workers’ Compensation System………………….18-1 Ch 19 Commercial Property Insurance……………………… Ch 20 Directors and Officers’ Liability Insurance…………… Ch 21 Employment-Related Practices Liability Insurance… Ch 22 Business Automobile Insurance……………………… Ch 23 Crime Insurance………………………………………….23-1 Ch 24 Capital Markets Risk Transfer Tools………………… Ch 25 Loss Control Tools……………………………………….25-1 Ch 26 The Certificate of Insurance…………………………….26-1 Ch 27 Surety Bonds…………………………………………… Ch 28 Claim Reviews……………………………………………28-1

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-5 Chapter 8 Overview of Alternative Risk Transfer Techniques Outline What is Alternative Risk Transfer (ART)? Step One: The Options Step Two: Funding Loss Retentions Step Three: Understanding Types of Captives Step Four: Choosing a Captive Domicile Step Five: Reviewing the Differences Advantages of a Group Captive Potential Disadvantages of a Captive Step Six: The Captive Feasibility Study Step Seven: Understanding Captive Tax Issues Other Alternative Risk Financing Techniques Chapter Summary

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-6 Chapter 8 Overview of Alternative Risk Transfer Techniques What is Alternative Risk Transfer (ART)? Defined: a collection of risk financing techniques The ART market is the set of products and services All ART techniques contain significant risk retention ART topics: ART retention types Funding loss retentions Captives Finite Risk contracts

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-7 Chapter 8 Overview of Alternative Risk Transfer Techniques Step One: The Options Risk retention connotes retention of risk, and the responsibility for managing risk ( loss control, claims mgmt, and reinsurance) Retention requires three characteristics: losses predictable in amount and frequency non-catastrophic losses insurance premiums are not a good value Non-insurance (being uninsured) is not a deliberate act

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-8 Chapter 8 Overview of Alternative Risk Transfer Techniques Step One: The Options Types of retention Per-loss (straight dollar) deductible – per occurrence Annual aggregate deductible – per year Percentage deductible – proportion of each loss Franchise deductible – per-loss that disappears at max Waiting period deductible – time deductible SIR – Insured pays first dollar losses up to retained limit (may be subject to deductible stacking) Qualified self-insurance – retention plan complying with state regulations

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-9 Chapter 8 Overview of Alternative Risk Transfer Techniques Step Two: Funding Loss Retentions Two main categories: Informal & Formal Informal loss funding techniques Current expensing Unfunded reserves Formal loss funding techniques Post-loss funding Borrowing, letters of credit, equity issues Pre-loss funding Funded reserves, trusts, captives

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-10 Chapter 8 Overview of Alternative Risk Transfer Techniques Step Three: Understanding Types of Captives Captives and Risk Retention Groups (RRG) Captive defined: a closely held and controlled company that accepts risk financing transfers from its principals rather than independently for the general public Characteristics Control over claims and reserving practices Control over investments Recapture of investment income and underwriting profits Potential tax advantages

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-11 Chapter 8 Overview of Alternative Risk Transfer Techniques Step Three: Understanding Types of Captives Captives goals reduce/stabilize costs provide risk management services provide tax opportunities assure risk financing markets Captive classifications Owned Rented Captive types Pure (single parent) Group (multiple parents)

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-12 Chapter 8 Overview of Alternative Risk Transfer Techniques Step Three: Understanding Types of Captives Captive classifications Owned: (policyholders own the capital) Pure: Single parent, single customer Group: Multiple parents, many customers Association: similar companies Agency: owned by a broker or agency RRG: permitted by the Risk Retention Act for specified exposures; with regulatory exemptions Supplement Single parent captives pure – captive’s only client is the parent broad – captive also sells to independent third parties third parties may deduct premiums paid to broad form

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-13 Chapter 8 Overview of Alternative Risk Transfer Techniques Step Three: Understanding Types of Captives Captive classifications Rented captives: (principals provide the capital) Rent-a-captive: Owners rent captive to others; contracts are separated to avoid risk sharing Protected cell: legislation provides firewalls between policyholders to avoid risk sharing

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-14 Chapter 8 Overview of Alternative Risk Transfer Techniques Step Three: Understanding Types of Captives History of captives late 1800’s: Factory Mutual System for fire insurance early 1900’s: Church Insurance Company, Ocean Marine P&I Clubs late 1900’s: market failures led to off-shore markets

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-15 Chapter 8 Overview of Alternative Risk Transfer Techniques Step Four: Choosing a Captive Domicile Captives subject to the domicile’s laws and regulations Minimum capital & surplus requirements Regulation’s purpose is to protect the consumer US domiciled captives are onshore captives Captives domiciled outside US are offshore captives

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-16 Chapter 8 Overview of Alternative Risk Transfer Techniques Step Four: Choosing a Captive Domicile Domicile Selection Criteria Friendly regulatory environment: applications & reporting Required capitalization: minimum assets & premium to surplus Local service infrastructure Low fees and taxes Permitted business: few restrictions on classes or third-party business Permissive Investment regulations: low relevant asset ratios Geographic convenience Onshore/offshore social perceptions and tax issues Political climate: stability of local governments & laws

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-17 Chapter 8 Overview of Alternative Risk Transfer Techniques Step Five: Reviewing the Differences Fronted versus Direct Captives State regulations & rating agency requirements may cause captives to not be Licensed and/or Admitted Captives use fronting companies - licensed, admitted insurers Insured pays premium to fronting insurer Insurer cedes % of risk and premium to insured’s captive Captive acts as a reinsurer for the fronting company The fronting company provides paper and claim service Direct-writing captives Insured pays premium to captive Captive may use other reinsurers Captive Owners (insureds) Fronting Carrier (Provides paper & services) Reinsurance Captive (invests funds, accumulates surplus) Captive Owners (insureds) Direct Captive Reinsurer

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-18 Chapter 8 Overview of Alternative Risk Transfer Techniques Advantages of a Group Captive Reduced operating cost – compared to insurer overhead Lower/stable pricing – free from hard market increases Investment income & underwriting profit – retained by owners Broader coverage – due to fewer regulations Equitable premium rating - reflects actual losses Coverage availability/stability – free from market swings Direct reinsurer access – lowers commissions, better pricing, access to reinsurer pools Improved service – better understanding of captive’s risks Reduction in long-term cost of risk Enhanced risk management perspective – increased visibility of risk management, optimal retention levels, better allocation of costs, investment income offsets cost of risk Fewer regulatory restrictions – allows self-funding and better rates

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-19 Chapter 8 Overview of Alternative Risk Transfer Techniques Potential Disadvantages of a Captive Internal administrative costs – more time than insurance program Capitalization and commitment – substantial initial costs Dependent upon service providers – must outsource many services Inadequate loss reserves and potential losses – variation in losses may deplete reserves and necessitate additional capitalization Increased cost and reduced availability of other insurance – loss of account pricing discounts from packaging policies

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-20 Chapter 8 Overview of Alternative Risk Transfer Techniques Step Six: The Captive Feasibility Study Feasibility study factors: Unbiased perspective – study by an independent party Cost – expensive to perform a good study Qualified professional – hire a competent analyst Introduction: Goals, sources, executive summary Candidate overview: current insurance, loss history, actuarial report Captive basics: risk/reward, minimums, structure, rented/owned, domicile Financial analysis: loss calculations, discounts, proformas Tax issues: premium deductibility, captive taxes Legal issues: SEC, domicile requirements Incorporation: expenses, business plan, service providers Timeline Captive Feasibility Study Basic Elements

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-21 Chapter 8 Overview of Alternative Risk Transfer Techniques Step Seven: Understanding Captive Tax Issues Tax deductibility – Is the premium paid to the captive deductible? Tax timing – When must the captive pay taxes on earnings? Supplement Seek appropriate tax advice from a qualified tax consultant tax issues are complex tax rules are subject to change

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-22 Chapter 8 Overview of Alternative Risk Transfer Techniques Other Alternative Risk Financing Techniques Finite risk reinsurance Not dependent on the spread of risk useful for high severity, high frequency risks: product recalls, warranty programs, environmental impairment programs, commodity price fluctuations, credit risk Fully funded programs – the risk is in the timing of payments Uses investment earnings and the time value of money Multi-period policy term with policy aggregates Supplement Additional risk-financing techniques include catastrophe bonds, insurance derivatives, securitization, and contingent capital arrangements

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-23 Chapter 8 Overview of Alternative Risk Transfer Techniques Other Alternative Risk Financing Techniques How a finite risk program works Risks identified Reinsurer establishes premium and experience account Reinsurer sets preset interest rate (keeps excess) Losses paid from experience account Any surplus returned to insured Reinsurer charges fees for service Risk transfer in finite risk contracts Pure finite risk contracts have no risk transfer Blended programs contain a layer of risk transfer

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-24 Chapter 8 Overview of Alternative Risk Transfer Techniques Other Alternative Risk Financing Techniques Types of finite risk contracts Loss portfolio transfers (LPT) – transfer unknown liabilities off balance sheet for known expense Prospective aggregate contracts – funds unknown prospective losses Retrospective aggregate contracts – funds known prior losses Calculating a finite risk reinsurance premium Net present value of future cash flows + fees The potential accounting effects of finite risk reinsurance Get the advice of a competent tax counsel

©2009 The National Underwriter Company Dr. James Kallman, ARM 8-25 Chapter 8 Overview of Alternative Risk Transfer Techniques Chapter Summary What is Alternative Risk Transfer (ART)? Step One: The Options - types of retention Step Two: Funding Loss Retentions Step Three: Understanding Types of Captives Step Four: Choosing a Captive Domicile Step Five: Reviewing the Differences Advantages of a Group Captive Potential Disadvantages of a Captive Step Six: The Captive Feasibility Study Step Seven: Understanding Captive Tax Issues Other Alternative Risk Financing Techniques – finite risk