captives formation: how and when charlie woodman, cpa svp, risk finance marsh cas ratemaking seminar...
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Captives Formation:Captives Formation: How and When How and When
Charlie Woodman, CPA
SVP, Risk FinanceMarsh
CAS Ratemaking Seminar
March 27, 2003
André Lefebvre, FCAS, MAAACredit & Market Risk Executive
Royal & SunAlliance
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Discussion PointsDiscussion Points
Risk and Risk Financing Perspectives
Single Parent Captive
Group Approach
Critical Considerations
Stop us at any time for questions
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Risk / Capital Risk / Capital RelationshipRelationship
Amount of loss
Expected
loss
Unexpected loss
Stress loss
Frequencyof loss
Operating Cash Flows /Strain on Working Capital
Buydown Debt/Reacquire EquityOpportunity
Capital Allocation /Budgeting / Revaluation
Capital / Resources At RiskCapital / Resources At Risk
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Universe of Risk Finance Universe of Risk Finance From the Insured’s From the Insured’s
PerspectivePerspective 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.
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Captive Insurance Captive Insurance Company - DefinedCompany - 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
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Insurance purchasingContract assessmentRely on brokerLimited Captive Use
Risk transferRisk assessmentStructural risk financing skil lsBasic AnalysisEmergence of ConsultantsGrowth of Captives as engines for risk assumption and tax planning
Risk transfer with limited risk assumption
Risk evaluationLarger risk sel f-assumptionTotal Cost of RiskPortfol io approachCapital markets methodEPS/P&L impactSel f-relevance and new consultingEmphasis on the captive as a flexible strategic platform.
Transfer/Retention/Capital Market structure
1960 1980 2000
Skill Sets
Where Captives Fit into Where Captives Fit into the Risk Finance the Risk Finance
EvolutionEvolution
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Captive Insurance Captive Insurance Company - FormsCompany - 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.
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Spectrum of Risk Spectrum of Risk FinanceFinance
Risk Transfer Risk Funding
Single ParentCaptives
Rent-a-Captive / Cell Facilities
Self-insuranceTrusts
First DollarRisk Transfer Guaranteed Cost
Group CaptivesPoolsRRGsReciprocal Exchanges
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Current Captive Current Captive Insurance Program Insurance Program
EmphasesEmphases Cost Savings
Risk Management Facilitation
Business Enhancement
Insurance / Risk Transfer Replication (Group Emphasis)
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Single Parent Captive Single Parent Captive RealityReality
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.
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Current Single Parent Current Single Parent Captive Insurance Captive Insurance
Program EmphasesProgram Emphases Cost Savings
Risk Management Facilitation
Business Enhancement
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Cost SavingsCost Savings
Long-term: “Seasoning” / Risk Management Point Facility
Short-term: “Business Case”
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SeasoningSeasoning
“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
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How (Re)insurers How (Re)insurers evaluate captives as evaluate captives as
Risk PartnersRisk Partners Where domiciled
How long in existence
Strength of captive’s financials
Who manages captive
Insurance program dynamics
Actuarial support
Owner proactivity and commitment
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Business CaseBusiness 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
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Tax RealityTax 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.
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Accelerated Tax Benefits Accelerated Tax Benefits - - Qualified InsurerQualified 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
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Tax Facts & Tax Facts & CircumstancesCircumstances
Third Party Writings Approach
Captive
Parent
Sub Sub Sub Sub Sub Sub
Deductible
Outside Business
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Tax Facts & Tax Facts & CircumstancesCircumstances
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Other Business Case Other Business Case ComponentsComponents
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
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Captive Operating CostsCaptive 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.
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Design Components and Design Components and IssuesIssues
Coverages
Structure
• Direct Writer
• Reinsurer Capitalization & Collateral
Domicile
• Cost
• Regulatory
• Other Premiums & Operating Expenses
Premium Taxation
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Program Evaluation or Program Evaluation or “Feasibility”“Feasibility”
Risk Assessment / Self-Assessment
Insurance Marketplace
Risk Quantification
Qualitative Issues
Pro Forma
Structure & Design
Time - Urgency versus Commitment
Capital
Cultural
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Capital Cost - A Capital Cost - A Sensitive IssueSensitive Issue
Captive After-tax Present Value Advantage/(Disadvantage)
CaptiveInvestment
Rate 5.50% 6.50% 7.50% 8.50% 9.50% 10.50% Break-even
5.50% $2,078,848 $137,561 ($1,527,474) ($2,956,416) ($4,183,296) ($5,236,996) 6.58%
6.50% $4,726,281 $2,448,695 $495,275 ($1,181,367) ($2,621,352) ($3,858,703) 7.80%
7.50% $7,719,697 $5,059,230 $2,777,535 $818,990 ($863,470) ($2,309,723) 8.99%
8.50% $11,098,256 $8,002,927 $5,348,452 $3,069,847 $1,112,158 ($571,154) 10.16%
9.50% $14,905,180 $11,317,045 $8,240,184 $5,598,999 $3,329,584 $1,377,843 **
10.50% $19,188,154 $15,042,678 $11,488,196 $8,437,089 $5,815,319 $3,560,238 **
Break-even * * 6.26% 7.09% 7.94% 8.79%
* Captive Investment Rate Break-even Value at the Specified Parent Time Value Money is Not Within The Scenario Range Selected.
** Parent Time Value Money Break-even Value at the Specified Captive Investment Rate is Not Within The Scenario Range Selected.
Parent Time Value Money
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UnderwritingUnderwriting
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?
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Estimated Operating Estimated Operating Expenses - Single ParentExpenses - Single Parent
Start-up costs - $50k
Annual Captive Management Fee - $50 - 75k
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
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Other ConsiderationsOther 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
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Group Captive RealityGroup 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.
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Quantification is CriticalQuantification 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$200,000
$400,000$400,000
$1,000,000$1,000,000
$25,000$25,000 Deductible
Aggregate Reinsurance
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Actuarial IssuesActuarial Issues
Retention Level
• Attachment Point
• Per Occurrence Limit
• Aggregate Limit Pricing
• Pure Premium
• Expenses
• Profit & Contingency Dynamic Financial Analysis
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Factors Influencing Factors Influencing Retention LevelRetention Level
Financial Wherewithal of the Insured
Financial Wherewithal of Insurers
Risk Philosophies
Insurance Market Conditions
Cost / Benefit Analysis
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Risk Transfer Savings
Risk
Current Program
Risk FinancingAlternatives
The Efficient Frontier 1
1The 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 The Risk Finance FrontierFrontier
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Retention Level Retention Level Decisions: Appetite Decisions: Appetite meets Opportunitymeets Opportunity
Property - Probability Distr ibution
0%
2%
4%
6%
8%
10%
12%
14%
Losses / (Gains)
Pro
bability
Unlimited $500K Retn $1MM Retn
$500,000 Retention
$1,000,000 Retention
Unlimited Retention
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Multi-Risk ComparisonMulti-Risk Comparison
Probability Distr ibutions - Individual Risks
0%
2%
4%
6%
8%
10%
12%
14%
Losses / (Gains)
Pro
bability
Prop. @1MM W.C. @1MM Prod. @1MM Auto @1MM
Auto Liability
Property
Workers Comp
Products Liab.
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““Portfolio Effect”Portfolio Effect”
Probability Distr ibutions - All Lines
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
Losses / (Gains)
Pro
bability
All Lines- Treated as Combined All Lines- Treated as Separate
Retained Risk @ 85th Percentile -
Risks Treated In Combination
Retained Risk @ 85th Percentile -
Risks Treated In Isolation
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$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 Common Characteristics of All Captivesof All Captives
$1MM/$3MM
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$1MM/$3MM
$MM Specific Excess/ $MM Aggregate
Excess / Risk Transfer
If available and / or affordable / reasonable
Common CharacteristicsCommon Characteristics
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Segregated cell captive with
individual excess coverage
$3MM/$18MM
$5MM/$8MM
$1MM/$3MM
$3MM/$16MM
$2MM/$9MM
Individual Limits
HG 1 HG 2 HG 3 HG 4 HG 5
Segregated Cell
AlternativesAlternatives
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$3MM/$18MM
$5MM/$8MM
$1MM/$3MM
$3MM/$16MM
$2MM/$9MM
HG 2 HG 3 HG 4 HG 5
Combined Limits
Group captive with shared
excess coverage
Group Pooling
Common CharacteristicsCommon Characteristics
HG 1
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Group CaptiveGroup Captive
Specific Reinsurance
Severity Fund
Frequency Fund
$200,000$200,000
$400,000$400,000
$1,000,000$1,000,000
$25,000$25,000Deductible
Aggregate Reinsurance
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Pricing IssuesPricing Issues
Similar to Pricing
• “High Deductible”
• “Excess Reinsurance”
Methodology
• Traditional methodso Aggregateo Frequency / Severity
• Monte Carlo simulation models
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Pricing Issues - Cont’dPricing Issues - Cont’d
Data
• Use insured own experience
• Supplement using “industry” datao Similar company/industryo 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)
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Dynamic Financial Dynamic Financial AnalysisAnalysis
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
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ConclusionConclusion
Questions
Thank you