Cayman Captive ForumPresentation 2013

Captive / Actuarial 101

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Joseph A. HerbersManaging Principal

Fiona J. MoseleyPresident & Director

Julie E. RobertsonPartner

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" Everything you wanted to know and were afraid to ask… An introductory session to cover practical guidelines on legal, actuarial and regulatory matters during the formation and operational stages of a new captive."

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What is a Captive?• The most simple definition: a licensed insurance company

formed to insure the risks of its owners

But the world is more complicated- RRGs; cell companies (SPCs), agency captives, rent-a-captives, micro captives,

branch captives, reciprocals, series LLCs, portfolio insurance companies (PICs)

• If you’ve seen one captive . . . you’ve only seen one captive!

• Array of models provides flexibility, but creates the need for expertise and evaluation of the options in formation

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What is a Captive?

• A licensed insurance company

• Regulated in a state or country (domicile) that has unique laws for captives

− They typically vest a great deal of authority in the regulator and are less stringent than laws regulating commercial carriers

• Owners/insureds involved in governance

• Often have no employees but are managed by contracted service providers

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Why form a Captive?

Coverage isn’t available commercially Coverage is unaffordable

Flexibility Tax advantages

Access to reinsurance markets Desire to provide coverage to third parties

Need for stable source of coverage Need for uniform program across borders

Generate profits Beat the market

Control of claims Heightened focus on loss prevention

Keep investment income on premiums Eliminate coverage gaps

Design coverage to meet insurance needs Drive organizational change

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Captive Feasibility Studies - Outline

• What is a Captive Feasibility Study• What are Actuaries?• Actuarial Involvement in Captive Feasibility Study• Dealing with Uncertainty• Predicting the Future

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Captive Feasibility Studies

• Data Analysis• Loss Estimates• Capitalization Requirements• Domicile• Tax Issues• Coverages, Retentions, Limits• Expenses• Reinsurance Costs• Regulatory Issues• Pro forma Financials

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Actuaries & Captive Feasibility Studies

• Projecting the future as regards:– Premiums– Losses– Loss Adjustment Expenses– Captive expenses

• Acquisition, general, taxes• Reinsurance costs

• Capitalization Requirements• Investment Returns

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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

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What does an Actuary do?

• Quite simply – Predict the Future• Ratemaking – Figure out what premiums to charge for 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

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Essential Background Information

• Business Plan• Historical premium, losses, claim counts & exposures

for entity being considered• Domicile, Service Providers being considered

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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• Service Providers

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Data Analysis

• Projecting Ultimate Losses– 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

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Lags

• Projecting Ultimate Losses– 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

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

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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

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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

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Data Analysis

• Underwriting Profit• Investment Returns– Investment Income

• Mix of investments by type (stocks, bonds, cash, other)• Expected returns by type

– Realized Capital Gains/Losses• FIT• Dividends

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Pro Forma FinancialsRun 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

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Pro Forma FinancialsRun Pessimistic, Base and Optimistic scenarios

• Income Statement– Underwriting Income, Investment Income, Other Income– Change 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)

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Consideration of Uncertainty

• Reliance on actual data versus benchmarks and/or external data – less uncertainty if we have reliable data for entity being studied

• Nature of historical data (# of years, consistency between years)

• Examine reasonable range versus point estimate

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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 is not good• With feasibility studies, we provide a range from

pessimistic to optimistic

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Captive ModelsSingle Parent CaptiveWholly owned insurance company established to insure/reinsure the risks of the single parent and/or its affiliates.

SINGLE PARENT NO AFFILIATES:

COMPANY X

CAPTIVE

Insurance

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Captive Models

SINGLE PARENT CAPTIVE SERVING AFFILIATES:

COMPANY X

CAPTIVE

COMPANY XSubsidiary 1

COMPANY XSubsidiary 3

COMPANY XSubsidiary 2

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Captive ModelsGroup CaptiveTwo or more owners form an insurance company to insure/reinsure risks of its owners (or their affiliates)

GROUP CAPTIVE:

COMPANY X COMPANY ZCOMPANY Y

CAPTIVE

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Captive Models

Cell Captive (aka Segregated Cell Captive, Sponsored Captive, Segregated Portfolio Company)

One insurance company with separate “cells,” each cell with a separate insurance program and possibly a shareholder.

CAPTIVECell X Cell ZCell Y

Ownership of Voting Stock ofthe Captive, Appoints BoardPreferred X Shares

Preferred Z SharesPreferred Y Shares

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Captive ModelsRisk Retention GroupSimilar in structure to a group captive, but formed in a U.S. state under authority of Liability Risk Retention Act. All insureds must be owners, and all owners must be insureds – only authorized to write liability risk.

COMPANY X COMPANY ZCOMPANY Y

RISK RETENTION GROUP

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Domicile Selection

• Driving factors– Structure/Coverage Needs– Regulatory environment;

history– Tax considerations

• Onshore and offshore• Premium taxes

• Other factors– Capital/surplus requirements– Operating costs– Political stability– Infrastructure– Domicile meeting requirements– Local director requirements– Operating costs– Ease of travel– Perception, particularly for nonprofits– Availability of home state as a

domicile– Unique characteristics of the domicile

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Tax

• From the insured’s perspective− Is the premium deductible?− What are the premium taxes?

• Domicile, US federal excise tax, state premium taxes

• From the owners’ perspective− If offshore, are the owners subject to tax annually or only

when distributions are made?− If offshore, is there “unrelated business taxable income”

for the tax-exempt owners

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Tax

• From the captive’s perspective− Is it an insurance company for US tax purposes (ie, can deduct its

loss reserves)?− If offshore, is it eligible to elect to be a US corporation for tax

purposes (a 953(d) election)?− Is it eligible for a small company election (an 831(b) election)?− If offshore, are there withholding taxes on its income?− If offshore, controlled foreign corporation or not?− If offshore, does it intend to “conduct a U.S. trade or business”?− Are there opportunities for the captive to be a tax-exempt entity?

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Tax

What’s most important:− Understand that taxable and tax-exempt organizations may have

different tax motivations− Recognize that there is not certainty in this area and determine

owners/insureds’ risk tolerance− Determine tax positions up front, not when returns are prepared− Make sure all stakeholders’ tax advisors are involved at the

beginning− Document the business reasons for captive formation as support in

case of future audit− Include tax calculations in pro formas and projections

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Direct Write or Fronted Program?

• A captive typically is not licensed/approved/admitted in the jurisdiction in which the insureds are located and is treated as an “unauthorized insurer”

• Can the captive write coverage directly or does it need a “front”?− State legal and regulatory requirements− Contractual requirements of insureds− Patient compensation funds

• Does the captive intend to attract new insureds/have a desire to market the program?

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Formation• Legal documents for formation:

− US: Articles of Incorporation/Bylaws− Cayman: Memorandum of Association/Articles of Association

• Other legal documents:− Shareholders agreement for group captives− Information circular/offering documents for group captives− Subscription agreement

• License Application: − Pro formas− Actuarial projections− Business plan− Identification of service providers− Applications of directors and officers

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Initial Operations

• Approval in principle sparks a flurry of activity• Put in place operational guidelines• Board of Directors guidance• Front Company and Reinsurance• Insurance Manager• Committees• Regulatory

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Approval in Principle Sparks a Flurry of Activity

• Incorporation• Subscribers Meeting• First Directors Meeting• Open Bank Account• License issued

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Put in Place Operational Guidelines

• Board of Directors• Front company• Reinsurers• Insurance Manager• Committees

− Claims Management, Audit and actuarial, investment etc.

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Getting Up and Running

• Approve insurance arrangements• Engage service providers

− Actuary, auditor, lawyer, investment manager, banker, insurance manager

• Adopt operating budget• Approve investment policy• Other policies: claims payment, expense

reimbursement

Congratulations: You’re running an insurance company!

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Board of Directors Guidance• Frequency of meetings, circulation of contact details and

agreement of approval mechanism• Understand business plan and laws of operation• Mind and Management discussion

– who is driving the bus and from where?

• Discuss and declare any conflicts and process around future conflicts

• Appointment of Secretary and define role• Mandates for Committees• Signing Authority

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Corporate Governance

• Role of the Shareholders• Role of the Directors• Role of the Officers• Directors Duties

− Fiduciary− Duty of care and skill− Minutes− Meetings− Engagement and oversight of service providers

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Front Company and Reinsurance

• Review and sign agreements• Confirm logistics and reporting

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Insurance Manager

• Confirm responsibilities and expectations• Reporting deadlines• Information exchange• Financial Statement prep, Actuarial and Audit• Who is driving the bus?

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Committees

• Define make-up• Adopt the mandate• Review the business plan

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Regulatory

• 6 month check up• Financial Statement submission• Conformity to Business Plan• What if something go wrong?

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Success Factors

• Taking the long view• Management commitment• Adequate funding and capitalization• Group captives: documentation and fairness• Focus on risk management and mitigation• Conservatism in the early years

Q & A

Thank you for your attention