Captives Formation: How and When Charlie Woodman, CPA SVP, Risk Finance Marsh CAS Ratemaking Seminar March 27, 2003 André Lefebvre, FCAS, MAAA Credit & Market Risk Executive Royal & SunAlliance

1 Discussion Points  Risk and Risk Financing Perspectives  Single Parent Captive  Group Approach  Critical Considerations  Stop us at any time for questions

2 Risk / Capital Relationship Amount of loss  Expected loss  Unexpected loss  Stress loss Frequency of loss Operating Cash Flows / Strain on Working Capital Buydown Debt/ Reacquire Equity Opportunity Capital Allocation / Budgeting / Revaluation Capital / Resources At Risk

3 Universe of Risk Finance From the Insured’s Perspective  Risk Transfer Becomes someone else’s risk  Risk Funding Efficiencies Our risk, our balance sheet, more cost and timing efficient  Off-Balance Sheet Our risk, someone else’s balance sheet  “Planet Killer” Protection Our risk, our balance sheet, save our lives.

4 Captive Insurance Company - Defined  An Insurance Company, typically owned by non-insurance parent(s), insuring the risks or interests of its owner(s)  Incorporated, Regulated, Capitalized and Accountable  May or May not be a replacement for insurance. Depends on Form (ownership and insured relationship) Emphasizes the ‘Insurance Transaction’ Insurance Company Operations

5 Where Captives Fit into the Risk Finance Evolution

6 Captive Insurance Company - Forms  Single Parent - Non Risk Pooling Wholly-owned, Rent-A-Captive, Trusts Emphasis on Risk Funding and Cost / Funding Efficiencies  Group Owned- Risk Sharing / Risk Pooling Group, Association Captive, Risk Retention Group Emphasis on Risk Transfer replacement / Alternative “insurance”  This distinction is critical in assessing the merits of a program.

7 Spectrum of Risk Finance Risk Transfer Risk Funding Single Parent Captives Rent-a-Captive / Cell Facilities Self-insurance Trusts First Dollar Risk Transfer Guaranteed Cost Group Captives Pools RRGs Reciprocal Exchanges

8 Current Captive Insurance Program Emphases  Cost Savings  Risk Management Facilitation  Business Enhancement  Insurance / Risk Transfer Replication (Group Emphasis)

9 Single Parent Captive Reality  Individual Reporting Concern and a Consolidated Entity  A Single-Parent Captive Insurance Subsidiary, insuring the risks of the parent and affiliated operating brother- sister concerns, is only self-insurance in its most sophisticated form. Risk Retention Levels and Captive Utilization are two different considerations. If a concern cannot afford to increase its risk retention levels without a captive, then they certainly cannot afford to assume more risk with one.  No one needs a captive insurance subsidiary.

10 Current Single Parent Captive Insurance Program Emphases  Cost Savings  Risk Management Facilitation  Business Enhancement

11 Cost Savings  Long-term: “Seasoning” / Risk Management Point Facility  Short-term: “Business Case”

12 Seasoning  “Seasoning” / Risk Management Point Facility  Extends the Corporate Risk Management “Commitment” to It’s Own Risks  Engages in Insurance under the Insurance Industry’s Mechanisms and Measurements  Regulated and “Grounded”  Reinforces Relationships with (Re)insurance Markets  Hard to quantify

13 How (Re)insurers evaluate captives as Risk Partners  Where domiciled  How long in existence  Strength of captive’s financials  Who manages captive  Insurance program dynamics  Actuarial support  Owner proactivity and commitment

14 Business Case  NPV of Cash Flows - Short Term Business Case cost Savings Accelerated Tax Benefits - Qualified Insurer State (& International) Tax Arbitrage Operating Costs Opportunity Cost of Capital  Other Quantitative & Qualitative

15 Tax Reality  The underlying issues which define whether an insurance transaction has occurred or whether a transaction is self- funding are: “Insurance Risk” - Insurer must assume a reasonable possibility of incurring significant loss. Notions of Risk - Form Risk Transfer / Risk Distribution - Risk of loss must be legally transferred from one legal entity to another, which pools the risk among other risks so as to increase predictability, and reduce adverse loss uncertainty.

16 Accelerated Tax Benefits - Qualified Insurer  Insurance Premiums are Deductible over the policy term  “Casualty” losses are subject to “Economic Performance” for tax  Accounts and “set-asides” are not economic performance  Incurred Basis (incl. IBNR) vs. Paid Basis SubChapter L of the IRC  Accelerated Recognition, not an accelerated realization i.e. Already recognized for financial reporting No “above the line” accounting benefit Consolidated Cash Flow Benefit Note: Basis of tax benefit is actual premium deduction from insured to Group Captive

17 Tax Facts & Circumstances

18 Tax Facts & Circumstances

19 Other Business Case Components  State (& International) Tax Arbitrage  Operating Costs  WACC / Opportunity Cost of Capital Capitalization Losses as Premiums Discount rate on enhanced cash flows  Other Quantitative & Qualitative (Re)insurance Internal Costs & Resource Commitment Recognitions and Materiality Corporate Culture

20 Captive Operating Costs  Start-up  Fronting, if applicable.  Management  Measurement: Audit & Actuarial  Legal & Regulatory  (Re)insurance  Pools and Participations  Premium-based Taxes Direct / Reinsurance Federal Excise Taxes Self-procurement / Direct placement.

21 Design Components and Issues  Coverages  Structure Direct Writer Reinsurer  Capitalization & Collateral  Domicile Cost Regulatory Other  Premiums & Operating Expenses  Premium Taxation

22 Program Evaluation or “Feasibility”  Risk Assessment / Self-Assessment  Insurance Marketplace  Risk Quantification  Qualitative Issues  Pro Forma  Structure & Design  Time - Urgency versus Commitment  Capital  Cultural

23 Capital Cost - A Sensitive Issue

24 Underwriting  Traditional risk Professional Liability/Medical Malpractice Workers compensation, auto and general liability Products/completed operations, errors & omissions, environmental D&O, Surety, Property? Employee Benefits: Voluntary LTD, Optional Life, Health coverages?

25 Estimated Operating Expenses - Single Parent  Start-up costs - $50k  Annual Captive Management Fee - $ k  Annual Assurance Audit - $15k Actuarial - $25k  Legal & Regulatory - $15k  Premium Tax (if applicable) US Federal Excise Tax - Avoided under IRC Sec. 953(d) ‘domesticating election’  Other (I.e. Annual General Meetings, travel, etc.) - $10k

26 Other Considerations  Operational Directors & Officers Committees Meeting Structure & Timing  Financial Timing, Distribution & Format Investments  Structural for Group Emphasis Fronted / Reinsurance Retro rated Capitalization  Administrative  Consensus, Agreement, Voice, Relevance, Commitment

27 Group Captive Reality  A Group Captive is dependent on its members and its advisors. Risks of the few may become the risks of the many. The Assets of the many may become the assets of the few.  The goal is the replication and replacement of insurance and a group purchase of excess coverages / reinsurance Can be a problem to insurers, due to risk concentration.  Works best when the ‘motivation’ is high. Industry abandonment or extreme over-pricing. Commitment to changing industry risk practices. Creating a group “voice.” Communication and consensus already exists or a centralizing entity coordinates the efforts.

28 Quantification is Critical  Especially in the Group Captive In any transaction, if Garbage In, then Garbage Out.  Assessment and Quantification Counter-party risk will exist in a group environment  Will form the bulk of premium determination and payment terms  Will dictate design and risk layers  Will define flexibilities Specific Reinsurance Severity Fund Frequency Fund $200,000 $400,000 $1,000,000 $25,000 Deductible Aggregate Reinsurance

29 Actuarial Issues  Retention Level Attachment Point Per Occurrence Limit Aggregate Limit  Pricing Pure Premium Expenses Profit & Contingency  Dynamic Financial Analysis

30 Factors Influencing Retention Level  Financial Wherewithal of the Insured  Financial Wherewithal of Insurers  Risk Philosophies  Insurance Market Conditions  Cost / Benefit Analysis

31 Risk Transfer Savings Risk Current Program Risk Financing Alternatives The Efficient Frontier 1 1 The efficient frontier is the point at which there is no greater expected reward for a given level of risk, and vice versa The Risk Finance Frontier

32 Retention Level Decisions: Appetite meets Opportunity $500,000 Retention $1,000,000 Retention Unlimited Retention

33 Multi-Risk Comparison Auto Liability Property Workers Comp Products Liab.

34 “Portfolio Effect” Retained 85th Percentile - Risks Treated In Combination Retained 85th Percentile - Risks Treated In Isolation

35 $1MM per loss $3MM per year - Aggregate Losses Retained Defined amount of losses to be retained and funded through the captive The Retention Common Characteristics of All Captives $1MM/$3MM

36 $1MM/$3MM $MM Specific Excess/ $MM Aggregate Excess / Risk Transfer If available and / or affordable / reasonable Common Characteristics

37 Segregated cell captive with individual excess coverage $3MM/ $18MM $5MM/ $8MM $1MM/ $3MM $3MM/ $16MM $2MM/ $9MM Individual Limits HG 1HG 2HG 3HG 4HG 5 Segregated Cell Alternatives

38 $3MM/ $18MM $5MM/ $8MM $1MM/ $3MM $3MM/ $16MM $2MM/ $9MM HG 2HG 3HG 4HG 5 Combined Limits Group captive with shared excess coverage Group Pooling Common Characteristics HG 1

39 Group Captive Specific Reinsurance Severity Fund Frequency Fund $200,000 $400,000 $1,000,000 $25,000 Deductible Aggregate Reinsurance

40 Pricing Issues  Similar to Pricing “High Deductible” “Excess Reinsurance”  Methodology Traditional methods o Aggregate o Frequency / Severity Monte Carlo simulation models

41 Pricing Issues - Cont’d  Data Use insured own experience Supplement using “industry” data o Similar company/industry o Bureau  Correlation of Risks  Risk Loads Captives which only insure the risks of the parent and affiliates / subsidiaries are only self-insurance in its most sophisticated form (i.e., no real risk transfer)

42 Dynamic Financial Analysis  DFA’s goal is to provide management with: solid information about the interaction of decisions from all areas of company operations; a quantitative look at the risk-and-return trade-offs inherent in emerging strategic opportunities; and a structured process for evaluating alternative operating plans.  Captive insurance companies are well-suited for DFA application

43 Conclusion  Questions Thank you