The Feasibility Process

Moderator: Derek Freihaut – Principal and Consulting Actuary; Pinnacle Actuarial Resources

Panelists: Patrick Theriault – Managing Director; Strategic Risk Solutions

Michael Meehan – Consultant; Milliman

 

Agenda

• Refresher

• Captive Pre-Feasibility to Feasibility Study

• Actuarial Analysis

• Q & A

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What is Captive? – A Refresher Definition: A closely held insurance company that is owned and controlled by its insured(s)

• A licensed insurance company • Formed to insure or reinsure the risks of its owners or related parties of their choosing

• Regulated under special legislation regulating captives

• Located onshore or offshore • Generally licensed in only one domicile

–  non-admitted in all other jurisdictions

Ø  What a captive truly is: -  A formalized form of self insurance

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Characteristics

Why Captives are Formed

- Reduce Cost of Risk -  Underwriting Profits and Expense Reduction

- Increase Control -  Rates, coverage, policy wording, claims admn.

- Lack of Available Coverage - Entrepreneurial Opportunities (third party risk) - Industry Bias (medical malpractice, trucking, etc…) - Tax Liability Management

-  Acceleration vs. Permanent Deferral - Estate Planning and Wealth Transfer

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Captive Feasibility Process

The steps in considering and forming a captive are: 1.  Prefeasibility Discussion – Are goals realistic – any fundament issues? (Few

hours to a couple of weeks) 2.  Formal Feasibility – Does it make sense for us? (60 days to more than a year) 3.  Implementation – Making the concept a reality! (30-90 days) 4.  Begin Operations

The steps should be considered sequentially and estimated costs range from: Pure Group 1.  Prefeasibility Free – $ 5,000 Free – $10,000 2.  Feasibility Study $15 – 50,000 $25-100,000 3.  Implementation $10 – 30,000 $25- 100,000+ 4.  Ongoing Operation $80 – 200,000+ $100,000 ++

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Prefeasibility Discussion/Meeting

Many captives should not get past Step 1! –  Unrealistic client expectations/goals –  Traditional Insurance is a good deal –  Availability and cost of capital –  Bad tax fact pattern –  Need and “cost” of fronting –  Getting a decision or consensus

60% of prefeasibility calls/meetings result in decision not to proceed with feasibility study

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Key Feasibility Concepts •  Economic benefit provided through use of a captive. •  Focus on materiality of benefit from captive. •  Regulatory impact of captive – need to avoid subsidization and

maintain arms length approach. •  Access – direct or reinsurance and the implications of each

approach. •  Rating or other insurance requirements. •  Study combination of tax benefits, if any, and cost of allocated

risk capital and captive operating costs. •  Funding method impact on corporate budgets. •  Efficient use of funds – investment approaches, including loan-

backs, for captive assets and the impact on feasibility. •  Viability: study how captive facility will function under various loss

and investment scenarios.

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Common “Deal Breakers” •  Insufficient funding available or higher than expected

expense ratio •  Differential between parent’s rate of return on invested capital

(“hurdle rate”) and lower rate of return on captive’s investments

•  Change in focus at the parent level –  Change in personnel –  Not getting “buy-in” of senior management early in the

process •  Inability to achieve insurance tax status and premium

deductibility or creation of taxable transaction for tax exempt organizations

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Overall Feasibility Review – The Foundation

•  What risks is my organization facing? •  How best to manage my risks

–  Retain, Finance, Transfer

•  Best way to manage retained risks –  Pure self insurance, pure captive, group programs….

•  Captive solution review –  Financial results, capital, domicile, tax, etc…

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Retention Strategy

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IDENTIFY BOUNDARY

Loss Value ($)

SHOULD TRANSFER

CAN TRANSFER

MUST RETAIN

Prob

abili

ty o

f los

s

Markets won’t Insure or

will charge excessive premium

Earnings & Equity Capital are sensitive to losses in

this range

Earnings & working capital

can sustain losses in this

range

Equity holders may be willing

to chance a loss in this

range

Insurable Risk Tolerance Level

Insurable Risk Confidence Level

Risk Retention Strategy Risk Transfer Strategy

Consider Alternatives

How much to retain and what is the most efficient method of financing retained risk?

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RiskFinancing Options

Single Parent Captive

Sponsored/Rent-A-Captive/Group

Captive

Self-insurance

§ Long-term§ Control§ Ownership§ Separate legal entity

§ Turnkey operation§ No legal entity§ Ease of use§ Lack of control

§ Utilize working capital § Ease of use§ Can be capital efficient§ Exposure to volatility§ Collateral requirements

How muchrisk toretain

Based on:§ Financial Strength§ Market realities§ Long-term goals

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Actuarial Analysis “Formal Feasibility”

• Why is an Actuarial / Feasibility Study Necessary? • What Goes into / Comes out of a Study? • Evaluation of Results • Ongoing Captive Needs

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Why is an Actuarial / Feasibility Study Necessary?  •  Forms the basis for measuring the financial viability of the

proposed captive

•  Helps to identify potential advantages and the potential risks of operating a captive insurance company

» Risk Identification » Risk Quantification

•  May be required for licensing/application process

•  May be required for presenting to the reinsurance market

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What Goes into a Feasibility Study?

•  Basic Information –  Company specific

»  Goals »  Constraints

–  Operational »  Account background »  Management (claims and risk)

•  Loss Information –  Electronic –  Detailed claim run –  Large loss listing (outliers)

•  Exposures –  Historical and prospective (payroll, vehicles, sales, etc.) –  Descriptions/locations

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What Goes into a Feasibility Study?

•  Expense Analysis –  Will vary by

»  Type of program »  Domicile

•  Other Assumptions •  Challenges

–  Single Entity Versus Group Program

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Loss Analysis •  Review of Past Loss Experience •  Actuarial Adjustments •  Internal Factors (e.g. loss control) •  External Factors (e.g. laws) •  Loss Rate = Losses per unit of Exposure •  Expected Losses = Loss Rate x Expected Exposures •  Confidence Levels

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Loss Analysis - Example

LossAccident Incurred Development Ultimate Exposures Adjustment / Loss

Year Losses Factor Losses (in 00's) Trend Rate

2011 500,000 1.200 600,000 800,000 1.061 0.7962012 400,000 1.500 600,000 900,000 1.040 0.6932013 300,000 2.000 600,000 1,000,000 1.020 0.612

Total 1,200,000 1,800,000 2,700,000 0.694

Selected 0.700Projected Exposures 1,200,000

Expected Losses 840,000

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Expense Analysis •  Fronting Fees •  Reinsurance •  Claims Administration, Loss Prevention •  Commission & Brokerage •  Management Fees •  Legal, Audit, Actuarial, & Consulting •  Letter of Credit •  Other (Travel, Board Meeting, D&O) •  Taxes & Assessments

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Expense Analysis - Example

Expense Amount

Fronting Fees 10.0%Reinsurance 10.0%Claims Administration, Loss Prevention 5.0%Commission & Brokerage 5.0%Management Fees 50,000Legal, Audit, & Actuarial 40,000Letter of Credit 10,000Other (Travel, Board Meeting, D&O) 10,000Taxes and Assessments & Fees 6,000

Note: Expenses expressed in % form represent % of premium

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Other Assumptions  (for Pro Forma Financial Projections)

•  Premium Growth •  Capitalization - Amount and Form •  Rate of Return on Investments •  Loss Payout Pattern •  Income Taxes •  Adverse Scenario

What Comes Out of Feasibility Study

•  Loss Rates/Loss Ratios/Premiums –  Expected –  Adverse

•  Pro Forma Financial Statements –  Typically 5 Year –  Including loss payout projections

•  Evaluation of Results  

 

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Premium and Loss Ratios •  Required Premium = Losses + Expenses + Contingency Margin •  Actual Premium: Based on Rates and Rating Plans

•  Loss Ratio = Expected Losses  

  Estimated Premium

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Pro Formas • Financial Analysis

•  Various loss scenarios •  Various attachment points •  Various reinsurance structures

• Prospective pro forma financial statements •  5 year prospective financial statements including

income statement, balance sheet and cash flow •  Actuarially determined payout patterns •  Expected incorporation and ongoing expenses •  Investment modeling •  Surplus and capital contributions •  Reflect specific domicile(s)

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Pro Forma Financials – Income Statement

1/1/2014- 1/1/2015- 1/1/2016- 1/1/2017- 1/1/2018-12/31/2014 12/31/2015 12/30/2016 12/30/2017 12/31/2018

UNDERWRITING INCOMEGross Written Premium 1,400,000 1,428,000 1,456,560 1,485,691 1,515,405Net Earned Premium 1,260,000 1,285,200 1,310,904 1,337,122 1,363,864

UNDERWRITING DEDUCTIONSLoss and Loss Expense Incurred 840,000 856,800 873,936 891,415 909,243Expenses 396,000 406,900 418,177 429,847 441,924

Total Underwriting Deductions 1,236,000 1,263,700 1,292,113 1,321,262 1,351,167

Net Underwriting Income 24,000 21,500 18,791 15,860 12,697

INVESTMENT INCOMENet Investment Income 20,345 38,866 50,069 57,983 64,388Profit (Loss) Before Tax 44,345 60,366 68,860 73,843 77,085

Federal Income Tax (including deferred) 15,077 20,525 23,413 25,107 26,209

Net Income 29,268 39,841 45,447 48,736 50,876

SURPLUSOpening Surplus 1,000,000 1,029,268 1,069,109 1,114,556 1,163,292Income for Period 29,268 39,841 45,447 48,736 50,876Capital Contributions 0 0 0 0 0Ending Surplus 1,029,268 1,069,109 1,114,556 1,163,292 1,214,167

Net written premium/Surplus 1.224 1.202 1.176 1.149 1.123Reserves/Surplus 0.620 0.952 1.121 1.219 1.274

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Pro Forma Financials Balance Sheet

1/1/2014- 1/1/2015- 1/1/2016- 1/1/2017- 1/1/2018-12/31/2014 12/31/2015 12/30/2016 12/30/2017 12/31/2018

ASSETSCash and Short-term Investments 932,943 1,326,842 1,584,355 1,786,962 1,956,678Letter of Credit 750,000 750,000 750,000 750,000 750,000Deferred Federal Income Taxes 30,732 53,455 69,239 81,005 89,988TOTAL ASSETS 1,713,675 2,130,297 2,403,594 2,617,967 2,796,666

LIABILITIESOutstanding Loss and Loss Expense Reserve 638,598 1,017,940 1,249,841 1,417,802 1,547,306Federal Income Taxes Payable 45,809 43,248 39,197 36,873 35,192Unearned Premium Reserve 0 0 0 0 0TOTAL LIABILITIES 684,407 1,061,188 1,289,038 1,454,675 1,582,499

CAPITALInitial Capital 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000Capital Paid In 0 0 0 0 0Income Earned 29,268 69,109 114,556 163,292 214,167TOTAL CAPITAL 1,029,268 1,069,109 1,114,556 1,163,292 1,214,167

TOTAL LIABILITIES AND CAPITAL 1,713,675 2,130,297 2,403,594 2,617,967 2,796,666

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Evaluation of Results

•  Adequacy of Capital •  Adequacy of Reserves (for LPT) •  Adequacy of Premium •  Minimum Number of Participants •  Solvency Measurements

–  Premium / Surplus –  Reserves / Surplus

How Much Start-Up Capital Is Needed? Will Be a Function of: • Type of risk insured and limits provided • Loss projections credibility • Confidence funding level selected • Collateral needs (fronted programs) • Whether policies are assessable • Access to additional capital funding sources (i.e. who is the captive’s parent) • Investment philosophy

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Domicile Selection Consideration

•  Domicile Reputation and Political Stability •  Domicile Regulatory and Service Provider Infrastructure •  Type of Risk Insured •  Tax and Accounting Consideration •  Cost of Operation – Tax, Fees, Other •  Location and Ease of Access •  Relationship of Service Providers With Domicile

Regulators

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Ongoing Captive Issues

•  Annual Loss Reserve Opinion •  Change in Business Plan •  Updated Premium Projections •  New Coverage Analyses •  Loss Layers / Reinsurance Analysis •  Capital Analysis •  Cost Allocation / Dividend Analysis

Questions?

Patrick Theriault, CPA, CPCU, AIAF Mike Meehan, CIC, CRM Managing Director Consultant Strategic Risk Solutions Milliman, Inc. Email: patrick.theriault@strategicrisks.com Email: mike.meehan@milliman.com

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Thank You!

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