INSURANCE
MANAGEMENT
SERVICES
kpmg
September 24, 2002
Captive Insurance Overview
Chad C. Wischmeyer, FCAS, MAAA, MMC Enterprise Risk
Bob Gagliardi, CPA, AIG Insurance Management Services
George Levine, FCAS, MAAA, KPMG LLP
Introduction
Introduction

Introduction of panel

Description of discussion format
– Introduction - Chad Wischmeyer
– Perspective of a Captive Manager - Bob Gagliardi
– Perspective of an Actuary - George Levine

Why are we here?
– captives are a hot topic
3
Topics of Discussion

What is a captive

Why companies form captives

Steps in forming a captive

Accounting and regulatory issues

Current developments

The role of the Actuary
4
The Evolution of Alternative Risk Financing

Distinctions Among the Various Options

Risk Retained versus Risk Transferred to a Third Party

Timing of the Cash Flows (Investment Income)

Tax Treatment of the Cash Flows

Legal Obligation to Bear the Risks
Guaranteed
Cost
Dividend
Plan
Retro
Rated
Plan
Deductible
Policies
Captive
SelfInsurance
5
Definition of a Captive

An insurance company that provides coverage to its owners
– A form of self-insurance

(From AICPA Audit and Accounting Guides)—Captive Insurance
Companies are WHOLLY OWNED SUBSIDARIES CREATED TO
PROVIDE INSURANCE TO THE PARENT COMPANIES
6
Characteristics of Captives

Licensed Insurance Company

Formed to insure or reinsure the risk of its owners or unrelated
parties of their choosing

Regulated under special legislation regulating captives
(regulated less stringently than state insurance laws which
govern fully admitted insurance companies)

Located offshore or onshore

Admitted only in its domicile and non-admitted in all other
jurisdictions.
7
Four Types of Captives

Single Parent (Pure) Captive

Wholly owned by one parent company

Formed primarily to insure or reinsure the risks of the corporate
parent or unrelated parties of their choosing

Group Captive

Owned by two or more companies, usually a trade association
or homogenous companies

Formed to insure or reinsure the risks of the group
8
Four Types of Captives (continued)


Rent-a-Captive (Cell Captive)
 Organized to insure or reinsure the risks of unrelated shareholders;
the insureds are "renting" capacity of the insurer capitalized by
outside sponsors
Risk Retention Group
 Operates similar to a group captive yet is regulated under federal
legislation
 Can operate in all fifty states yet only required to be licensed in its
state of domicile
 Insureds must be owners and owners must be insureds
 Can only write liability lines of risk
 The RRG cannot provide reinsurance
9
Captive Domiciles
Onshore Domiciles
–
–
–
–
–
–
–
–
Vermont
Hawaii
Colorado
Delaware
Tennessee
Illinois
New York
Maine
Offshore Domiciles
–
–
–
–
–
–
–
–
Bermuda
Barbados
Cayman Islands
Dublin IFSC
Luxembourg
Guernsey
Isle of Man
Singapore
10
Current Captive Growth
(from 5/01 and 5/02 Captive Insurance Company Reports)
Domicile
Bermuda
# of 1999
Captives
1,513
# of 2000
Captives
1,564
# of 2001
Captives
1,602
2001
Growth Rate
2.4%
Cayman Islands
469
517
545
5.4%
British Virgin Islands
140
181
262
44.8%
Guernsey
351
375
369
74
73
-1.4%
348
361
387
7.2%
2,879
3,072
3,238
5.4%
Hawaii
Vermont
TOTAL
58
Luxembourg
260
Ireland
163
Isle of Man
162
Barbados
199
-1.6%
11
Perspective of a Captive Manager
Why Captives are Formed

Reduce total cost of risk

Lack of available coverage

Premium stability

Creation of a new profit center

Control over claims process

Improve consolidated tax position
13
Successful Captives Have

A good spread of risk

Predictable losses

Long-term commitment from management
– Treasury support, loss control

Strong business partners
– Captive managers, claims handlers, etc.
14
Captive Formation Process

Feasibility study - Does a captive make sense for us?

Study should
– identify potential risks of the captive (loss history)
– analyze the financial effects of the captive on its owners
– discuss the cash flow/ tax benefits
15
Captive Formation Process
Captive makes financial sense.
- Now What?
– Draft operations plan and financial projections
– Meet with regulators in chosen domicile
– Submit captive application to regulator
– Incorporate & capitalize company
16
Role of Captive Manager

Communicate with regulators and ensure compliance
with regulations

Prepare and maintain all accounting and financial
records

Act as liaison for parent company, attorney, auditor and
actuary

Coordinate / attend board meetings

Keep parent aware of industry developments
17
Regulatory Process

Domiciles
– Onshore vs. Offshore
– Tax considerations

Premium Tax

Income Tax
18
Domiciles

On-shore
– Vermont
– Hawaii

Off-shore
– Bermuda
– Cayman Islands

Differences becoming smaller as domiciles compete for business
19
Premium Taxes

Onshore domiciles
– Minimal premium taxes
– No state income taxes

Offshore
– Zero premium tax, but potential for other taxes (Federal Excise
Tax)
20
Income Taxes

Tax deductibility: self-insurance reserves are not deductible

Premium payments made to captive should be deductible if:
– Properly structured

Risk shifting and risk distribution
– Captive adequately capitalized

Problem - IRS does not define the term “insurance”
21
Accounting Issues

Risk Transfer - SFAS #113
– “Reasonable possibility of a significant loss”
– How to interpret this
– Deposit Accounting

NAIC Codification
– Minimal impact on most captives
22
Current Developments

Employee Benefits

Cell/ Sponsored Captives

Tax Developments
23
Employee Benefits

Department of Labor ruling allowing employee benefits in captives
– Accelerate tax deduction
– Cost control
– Unrelated risk - different definition for DOL and IRS

Express process once 2nd application is approved
24
Cell / Sponsored Captives

Sometimes called “rent-a-captives”
– Insures the risks of participants (cell owners/ renters)
– Assets of each cell are shielded from the other cells
– No capital requirements for renters

Existed offshore for a few years

1999 Vermont legislation limits ownership to insurance companies
25
Tax Developments

1977 CARNATION RULING: Premiums paid to offshore captive would
not be allowed as deductible for tax purposes unless significant
volume of insurance placed in non-related entities.

IRS has officially abandoned the “economic family theory”
26
Tax Developments (continued)

“Brother-Sister” subsidiary premiums stand up as deductible in TAM
on 12/10/01.
– Adequately capitalized
– No parental guarantees
– Arms length actuarially sound transactions
27
Actuarial Perspective
Scope of Actuarial Involvement
1)
Feasibility Study and Financial Planning
2)
Design of Alternative Risk Transfer Products
3)
Formation Process
4)
Certification of Reserves
29
1. The Captive Feasibility Process

Define Objectives
– Financial
– Business

Forecast Ultimate Retained Loss Costs

Perform NPV/Cash Flow Analysis of Alternatives

Develop Program Structure of Captive

Domicile Analysis

Determine Optimal Ownership Structure

Analyze Tax Issues
– Deductibility of Captive Premium
– Tax Treatment of Captive Income
30
2. Design of Alternative Risk Transfer Products

Financing Retained Risk through a Wholly Owned Captive ...
A Financial Example
– Assumptions
– Annual Expected Ultimate Retained Losses = $10 million
– Cash Flows are Discounted at 7.50%
– Federal Tax Rate Imposed = 35.00%
– Insured is a US Based Corporation
31
Tax Treatment of Captives
Cash Flows under Self Insured Arrangement
Cash Flow Payout Per
Year
Year
Losses
Payments
Year 1
Year 2
Year 3
Year 4
Year 5
18.00%
25.00%
23.00%
18.00%
16.00%
$1,800,000
2,500,000
2,300,000
1,800,000
1,600,000
Total
100.00%
$10,000,000
Value of Tax
Deduction
$630,000
875,000
805,000
630,000
560,000
Present Value of Tax Deduction = $2,958,077
32
Tax Treatment of Captives
Cash Flows under Captive Arrangement
Cash Flow Payout Per
Year
Year
Losses
Payments
Year 1
Year 2
Year 3
Year 4
Year 5
18.00%
25.00%
23.00%
18.00%
16.00%
$1,800,000
2,500,000
2,300,000
1,800,000
1,600,000
Total
100.00%
$10,000,000
Premium Paid to
Captive
$10,000,000
Value of Tax
Deduction
$3,500,000
Present Value of Tax Deduction = $3,500,000!
33
3. The Captive Formation Process

Business Plan
– Forecasts of Annual Expected Losses
– Program Structure (Premiums, Limits, Capitalization)
– Proforma Captive Financial Statements
34
3. The Captive Formation Process (continued)

Financial Impact to Parent
– Cash Flow Requirements to Pre-Fund Premium
– Capitalization of Captive - Cash or LOC
– Cost of Capital Eliminated through Intercompany Loans from
Captive to Parent
– Accrual of Liabilities (Case Reserves and IBNR)
35
4. Certification of Reserves
10 ITEMS to Request
1) Legal name of entity and domicile address
2) For single parent captives, legal name of owner and address
3) Name and contact information for coordination with captive owner
4) Name of captive management firm, address and contact
information
5) Captive background information (including date of incorporation,
date operations commenced, coverages written, limits of liability,
deductibles, retentions, reinsurance coverages). This should
include a history of changes to any of these items.
36
4. Certification of Reserves
10 ITEMS to Request (continued)
6) Copy of draft balance sheet and income statement.
7) Copy of Schedule P Type Loss Triangles
8) Copies of any workpapers that document loss reserve, unearned
premium reserve or reinsurance calculations.
9) December 31st loss run showing paid losses, incurred losses and
allocated loss adjustment expense information by coverage and
year.
10) Representation as to presence or absence of asbestos,
environmental impairment liability or terrorist related claims.
37
The Actuarial Reserving Process

Information Available
– Losses


From Third Party Administrator, Client’s Parent, or Captive
Manager
Timing—What Valuation to Use
– Premiums
– Exposure Data
– Financial Statements

Unaudited Statements

Audited Statements (internal)
38
The Actuarial Reserving Process

Some Generally Accepted Loss Methodologies
– Chain-Ladder Methods
– Use of Industry Data
– Bornhuetter-Ferguson Methods
– Loss Limitations: Large Losses
– Berquist-Sherman Type Adjustments
39
The Actuarial Reserving Process

Actuarial Deliverables
– Depend Upon Domicile’s Requirements!
– Statement of Actuarial Opinion

Vermont Requirement—With audited financial statements,
six months after fiscal year end
– Actuarial Report
– Actuarial Workpapers
40
Actuarial Opinion Requirements
by Domicile

Bermuda
– Actuarial Opinion from Loss Reserve Specialist

Cayman Islands
– No formal Opinion Requirement, unless Authority Requests a
Review, then Report

Vermont
– Actuarial Opinion and Workpapers on Site of Company
41
The Actuarial Reserving Process
Limitations of Captive Reviews

Timing of Reviews - At Year End or Before Year End

Range of Reserves - Where to Carry Reserves

Gross or Net of Insurance?
42
The Actuarial Reserving Process
Unique Risks of Captives

Availability of Data

Quality of Data

Reconciliation of Paid Data for Timing Differences

Small Size of Organization

Solvency of Reinsurer or Fronting Insurer

Complex Programs
43
Conclusion

Questions
44