Insurance Contracts for 831(b) Enterprise Risk Captives – Policies and Pooling Agreements

Jeffrey K. Simpson John R. Capasso Brian JohnsonGordon, Fournaris & Mammarella, P.A. Captive Planning Associates, LLC Bartlett Actuarial Group, Ltd.

Director President & CEO Managing Principal

Phone: (302) 652-2900 Phone: (888) 305-8889 Phone: (843) 377-0993

jsimpson@gfmlaw.com jcapasso@captiveplanning.com brianj@bartlettactuarialgroup.com

Tuesday, March 10, 2015 11:15 a.m.

Introduction

What will we discuss and why?

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Overview

Evolution of Enterprise Risk-Coverages

-Pricing

Policy Agreements

Pooling Arrangements

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ENTERPRISE ENTERPRISE

RISKRISK

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What is Enterprise Risk Management?Enterprise Risk Management (“ERM”) enables management to effectively deal with uncertainty and associated risk and opportunity, enhancing the capacity to build value.

Value is maximized when management sets strategy to strike an optimal balance between growth and return goals and related risks, and efficiently and effectively deploys resources in pursuit of the entity’s objectives. According to the Casualty Actuarial Society (“CAS”), ERM is defined as:

“The process by which organizations in all industries assess, control, exploit, finance and monitor risks from all sources for the purposes of increasing the organization’s short and long term value to its stakeholders.”

All entities face uncertainty. The challenge for management is to determine how much uncertainty to accept. Uncertainty presents both risk and opportunity, with the potential to erode or enhance value.

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Enterprise Risk ManagementFurthermore, CAS has enumerated the types of risk subject to ERM as Hazard, Financial, Operational and Strategic.Hazard risks – are those risks that have traditionally been addressed by insurers, including fire, theft, tornado, earthquake, windstorm, general liability, business interruption, pollution and health.Financial risks – cover potential losses due to changes in financial markets, including interest rates, foreign exchange rates, commodity prices, liquidity risks and credit risk.Operational risks – cover a wide variety of situations, including customer satisfaction, product development, product failure, trademark/copyright protection, corporate leadership, information technology, management fraud and information risk. Strategic risks – include such factors as completion, customer preferences, technological innovation and regulatory or political impediments.

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Enterprise Risk ManagementERM helps management ensure effective reporting and compliance with laws and regulations, and helps avoid damage to the entity’s reputation and associated consequences. The following capabilities inherent in ERM help management achieve the entity’s performance and profitability targets and prevent loss of resources:

•Aligning risk appetite and strategy – Management considers the entity’s risk appetite in evaluating strategic alternatives, setting related objectives, and developing mechanisms to manage related risks.

•Enhancing risk response decisions – ERM provides the objectivity to identify and select among alternative risk responses from; risk avoidance, reduction, sharing and acceptance.

•Reducing operational surprises and losses – Entities gain enhanced capability to identify potential events and establish responses, reducing surprises and associated costs or losses.

•Identifying and managing multiple and cross-enterprise risks – Every enterprise faces a myriad of risks affecting different parts of the organization, and ERM facilitates effective response to the interrelated impacts, and integrated responses to multiple risks.

•Seizing opportunities – By considering a full range of potential events, management is positioned to identify and proactively realize opportunities.

•Improving deployment of capital – Obtaining thorough risk information allows management to effectively assess overall capital needs and enhance capital allocation

In summary, ERM helps management get to where it wants to go and avoid pitfalls and surprises along the way. 7

Current Trends in ART• Property Risks:

Wind Flood Earthquake

• Cyber Risk

• Environmental / Pollution

• Workers’ Compensation

• Reputational / Brand Risk

• Representations & Warranties

• Supply Chain Interruption

• Intellectual Property

• Pandemic Risk

• Employee Benefits

Coverage Considerations

•Gain immediate control over a substantial business expense, which is designed to increase exponentially, with access to the reinsurance market

• Ability to segregate funds and build surplus to stabilize annual cost incurred

•Create a new corporate profit center and increase rate of return

•Establish and benefit from “best practice” risk management procedures

•Reduce current business costs over a predictable term of years and avoid artificial market adjustments

•Create flexible claims payment structure

•Provides coverage for uninsured or hard-to-insure risks

•Create an insurance infrastructure that provides flexibility for unknown market changes (whether politically or financially mandated)

•Potential to build up underwriting profits of the captive exempt from federal income tax – when premiums are less than $1.2 million

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Enterprise Risk ManagementRisk Evaluation and Transfer

Understand the organizations’ risk exposures

Know the organizations’ risk tolerance

Be aware of loss history

Know the insurance marketplace

Understand the organizations’ risk requirements and how they may change, and

Determine the organizations’ corporate risk limits and expectations

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Risk Management and UnderwritingReducing the Net Cost of Risk

•Almost any form of self-insurance can be less expensive than risk transferred to the commercial marketplace (due to adverse selection to support external losses)

•Carefully analyze risk exposure (strategic underwriting)

•Transfer unacceptable levels of risk to others (commercial insurers, reinsurers)

•Best-in-class claims administration

•Proactive risk mitigation program (employee education/training)

•Expert captive management

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PRICINGPRICING

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POLICY POLICY

AGREEMENTSAGREEMENTS

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Advantages & Benefits to ControlControl over policy drafting and administration

is one of the key advantages of a captive

Opportunity to tailor coverage to insured’s unique exposures Address specific gaps in insured’s commercial insurance program Flexibility in interpreting policy provisions Ability to endorse after the fact to confirm intentions

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Administrative/Practical Concerns

Captive plays a dual role – insurer of related party risks and reinsurer of pooled, unrelated party risks Customized and / or diverse policies create uncertainty for the insurer Also less efficient for the captive manager to administer claims, since every policy can have different definitions / claim triggers / methods of valuation / exclusions

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Administrative/Practical Concerns

Presence of unrelated exposures can lead to tensions between captives in the pool• Captives may not want their manager to interpret policies

liberally• Because pooling arrangements can put as much as 75% of

a claim into the pool, an insured has an incentive to aggressively contest a denied claim.

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Administrative/Practical Concerns

There are also external pressures from the desire to have the captive be treated as an insurance company for tax purposes.• Case law emphasizes the need for reasonable pricing that

is actuarially determined• This necessarily requires some level of coordination

between policy terms and premium pricing analysis• Vague policy language could arguably expand coverage

beyond what the actuary contemplated, perhaps even into business risks, as opposed to insurable risks

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Goals of Policy Drafting

Establish and meet the expectations of the insured with respect to scope of coverage, the responsibilities of the insurer and insured. Coordinate with feasibility study and business planPrevent claim disputes

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Policy Forms, Limits, and Exclusions

Master Policy” vs. Individual policies• Master policy can be unwieldy• Difficult to make master policy internally coherent

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Policy Forms, Limits, and Exclusions

Claims made or occurrence based?• The term “Claims made” is ubiquitous – not always

applicable

• What event creates liability for the insurer: – The event itself?– A Claim against the insured from an injured third-

party?– Loss (e.g. expense) actually incurred by the

insured?

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Policy Forms, Limits, and Exclusions

Policy Limits

• Do you permit or prohibit stacking (e.g. an occurrence triggers liability under multiple captive policies)?

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Policy Forms, Limits, and Exclusions

Policy Exclusions:

• Making sure that the exclusions are applicable to the types of coverage

• Balance between providing DIC coverage and permitting policy to cover moral hazards, uninsurable risks

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Adjudication of Claims

Exhaustion of Liability for the Insurer

• Must the bad act or property damage occur during the policy period or can it occur prior?

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Adjudication of Claims

Valuation of Claims

• How are business interruption losses calculated?• Projection income that “would have been earned” but for

the event• Meaningful comparison of pre-loss and post-loss

experience• Valuing the loss of a contract or a key employee

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POOLINGPOOLING

ARRANGEMENTSARRANGEMENTS

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Key FeaturesLayer vs. First Dollar

Layer:• Protects Against Abusive & Nuisance Claims• Participants Feel Less Vulnerable• Very Few Shared Claims

First Dollar:• Every Claim is Shared• Increases Loss Frequency• Easier to Defend?

Struggle for Balance 27

Key FeaturesFront or Reinsurance

Pool as Direct Writer:• Facilitates High Volume Programs• Easier to Standardize and Issue Policies

• Beware of Multi-State Issues

Pool as Reinsurer:• Easier for Pool (Simple Reinsurance)• May Add a Transaction (Reinsurance and Retrocession)

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Key FeaturesEntity or Contract

Entity:• Direct regulation and frictional costs• May give participants more comfort• May be necessary if pool intends to retain risk

Contract:• Ease of entry and documentation• Can reduce administrative expenses• Who holds the money?• How do you pay claims?

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Key FeaturesTerm – Retrospective or Prospective

Several Pool Philosophies:• Fixed start date for current year• Rolling admission• Fixed future start date

Retrospective:– Mid or late year entry can force retrospective policy

issuance– Might not be insurance

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Key FeaturesPremium Allocation

Consider how much premium is being pooled (typically in %):• Safe Harbor• Greater than 50%• But what if your quota share of pool includes your own

risk?

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Key FeaturesPremium Allocation

Consider how the % is determined:• Often arbitrary or little actuarial support for

reasonableness• Easier to get comfortable in first dollar?• More difficult in layered or hybrid designs

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Key FeaturesMaximum Exposure (Stop Loss)

Always get asked:• Some pools have stop loss provisions• Some pools buy stop loss coverage• Some pools ignore or don’t think they need stop loss

May be important in open pools or pools with high limit exposuresCarefully circumscribed pools may not need itParticipant program or policy aggregates can operate as a virtual stop loss provision

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Key FeaturesCollateral

Natural Tension:• Captive owner wants his money in the captive• Pool needs to know the funds are available to pay claims

Common Methods:• Funds withheld• Pledged account• Controlled operating account or other set aside

•Can be very messy if pool must collect from each participant to pay claims 34

Practical ConsiderationsOpen or Closed

Open:• Can increase participants quickly• Broad diversity (risk, industry, geography)• Helpful in extraordinary situations

Closed:• More certainty regarding risks and vetting of participants• Enough participants?• Easier in and out

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Practical ConsiderationsClaims

Magnitude and Frequency:• Pool’s history?• “Never had a claim!”• How much is enough?

Management:• Who adjusts claims and how?• What if there is a committee of participants?• Written record important

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Practical ConsiderationsTransparency

How much do you need or want?• All participants known to one another?• All claims and claimants identified?

Should it work like a member-owned group?

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Practical ConsiderationsStandardization – Underwriting/Rating

Several different pool underwriting approaches?• All participants must be underwritten through pool’s

program• Pool must review and approve underwriting• Pool doesn’t consider underwriting

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Practical ConsiderationsStandardization – Underwriting/Rating

Does it matter for participant:• Subjectivity in rates• Not reviewing at all could be too laissez-faire?• Otherwise, maybe more about confidence of the pool

provider

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Practical ConsiderationsStandardization – Coverages

Coverage selections may be more important than rating method because:• Affect frequency and severity• Different appetites for different exposures• First party vs third party control

Homogeneity:• What does it mean?• Is it required?

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Practical ConsiderationsReaction to Experience

The most important factor of all?How do you act like an insurance company?• What happens at renewal time?• Is there annual re-rating of underlying coverage?• Is there annual re-consideration of reasonableness of

premium allocation?

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QUESTIONS AND ANSWERSQUESTIONS AND ANSWERS

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