Deconstructing the Value Proposition of Captives

Deconstructing the Value Proposition of Captives

Charlie Woodman, CPA, CGMA

Risk Finance & Analytics

Willis Construction Practice

Craig A. Ream

Program Administrator - CS Insurance Ltd.

Willis Captive Practice

20th Annual Willis Construction Risk Management Conference

Marriott Legacy Town Center – San Jacinto Room

Tuesday, September 16, 2014

Title of Presentation – edit in master | 2

Economics of Insurance: The Stage

Fixed (25%-35%)

Insurance CompanyOverhead, Taxes,Reinsurance Cost, Commissions

Profits & Investment Income

Underwriting Profit and Investment Income Accrued by Insurance Company

Profits & Losses55 -75%• Components of

Traditional Insurance:

Expected loss and ALAE

Taxes and regulatory fees

Overhead and administration

Insurer selling and distribution expense

Reinsurance and Intermediary charges

Risk Margins

Surplus charges

Risk Based Capital offsets

The Continuum of Risk Finance

HIGH

LOW

Pro

gra

m

Sop

his

ticati

on

HIGH

Assumption of Risk

Guaranteed Cost

Loss Sensitive or Retro Policy

Large Deductible Policy

• Complete transfer of risk• Commercial insurance with no deductible

• Assumption of limited risk in exchange for potential return premium

• Deferred “pay-in” premium

• Significant/complete risk assumption in exchange for deductible credit

Integrated Risk

Qualified Self Insurance w/ Risk Funding• State Qualified Self Insured• Insured is legal insurer

• Traditional Hazard lines (property, Casualty, EPL)

• Integrated layers at specified layers

Group Captives• Formed to insure member owners (shared

risks/assets)• Replication of insurance and group purchase of

excess

Program Selection Drivers are Risk Appetite

Financial Protection

Asset and Revenue Protection

Performance Certainty

Liquidity and Cash Certainty / Cost of Short-term Finance

Statutory or Counter-party Requirements

Revenue / Expense Matching

Safety & Loss Containment Services and Acquired Disciplines

Control

Negotiation & Leverage

Catastrophic Protection

Taxation

Market Opportunity


Captive Insurance Company - Defined An Insurance Company, typically owned by non-insurance parent(s), insuring the

risks or interests of its owner(s)

Incorporated, Regulated, Capitalized and Individually Accountable· May be fairly transparent

May or May not be a replacement for insurance. Depends on Form (ownership and insured relationship)

Emphasizes the ‘Insurance Transaction’

Insurance Company Operations:· Insurance Accounting and Financial Metrics· Must Always Maintain Positive Capital and Surplus (Unrestricted Net Worth I.e.,

Marketable Assets > Liabilities)

Typically administered by professional third-parties· Captive Mgt / Legal / Audit / Actuarial / etc.

Forms of Captives Single-owner or Pure

Group – Homogeneous or Heterogeneous

Association

Insurer Controlled

Agency / Sponsored

Rent-a-captive

Segregated account (cell) captives

Captive pools

Risk retention groups

Trusts

Special Purpose (Re)insurer

Etc…

6Feasibility Prerecorded

Lecture/ 6


Boil It Down – Two Real Types

Single Parent

Wholly-owned (and can include Rent-A-Captive “Cells” & Trusts)

Emphasis on Risk Funding and Cost / Funding Efficiencies

Underwrites ‘related’ risks to single economic interest as insureds are commonly parental operations

Will consolidate operating and financial position with publicly-held parent; may deconsolidate under certain circumstances in closely-held.

Group Owned

No common ownership among insured participants

Group, Association Captive, Risk Retention Group

Emphasis on Risk Transfer as an insurance market alternative

Will pool certain retention layers among participant insureds

Common services and emphasis on the health of the group as a whole.

Primary Focuses of Single Parent Captive Programs Cost Savings

· Long Term - “Seasoning” of a Property & Casualty Insurance Company:- Platform and enhance the placement of insurance coverage, terms and conditions- Access or contract with alternative markets or reinsurers- Effect optimal balance of risk retention and transfer, glean greater control over risk

process- Projected performance is difficult to quantify

· Short Term - “Business Case” / Cash Flow Efficiencies: Highly Quantitative / Heavy Tax

Risk Management / Program Facilitation· Provide rapid liquidity· Buy Down Deductibles of Subsidiaries or Operating units

- Stabilize or enable allocations and budgeting / contracting processes

Business Enhancement: “Profit Center”· Controlled Insurance Programs· Sub Contractor Default Insurance· Extended Warranty / Service Contracts

Asset Facilitation / Wealth Strategies – Closely-helds

8


Business Case: Assessment and Short-term ViabilityNPV - Short Term Business Case cost Savings

Accelerated Tax Benefits

State Tax Arbitrage

Operating Costs

WACC / Opportunity Cost of Capital

Other Quantitative & Qualitative

Capital Commitment / Operating Cost

Internal Costs & Resource Commitment

Recognitions and Materiality

Corporate Culture

Group Captive Value Proposition

Control over insurance “destiny”

Unbundled service providers

Retain underwriting profits and earn investment income

Disciplined loss funding in a tax favorable structure

Access to capacity and economies of scale

Reduce and stabilize costs

Improve risk management through accountability

Customized and focused loss control services

Improved long term premium stability

Best in class coverage

Captive benefits on shared platform – reduced expense

Group Captive Value Proposition

Unbundling the Insurance Transaction

Group Captives

How do they do it?

Assumption of a high level of risk Cost of risk transfer significantly reduced Insurance market volatility minimized

Proven risk sharing structure Reduces volatility in claims experience for participants Provides needed risk shifting and distribution

Volume purchase #61 on ENR top 400 - $900M in combined revenues Shock claims are diluted

Investment income

Enhanced loss prevention and claims management Avoid exposure to cat risks

Member selection - “Best in Class” controlled growth Assures health of program over time Reduces cost of risk transfer Enhances peer group best practices exchange

How do they do it?

Case Study

Construction Solutions


Contractors Group Captive Established in 2001

100% Member Owned and Controlled

Domiciled - Cayman Islands

Prospective Members: Moderate/High hazard contractors generating between $500,000

and $3,000,000 in combined WC, GL and Auto Standard Premium Contractors with a strong senior management commitment to safety Contractors with loss and incident rates superior to average for class Contractors with a formal loss control and safety program Contractors with solid financials


Common January 1st renewal date $136,000,000 of payroll insured 1,700 power units insured $10,000,000 in annualized captive premium Renewals presented in October and bound in November Strict loss control covenants and annual CORR analysis Bi-Annual Loss Control Meetings:

September 15, 2014 Dallas May, 2015 Pittsburgh

Bi-Annual Board & Shareholder Meetings: October 19-21, 2014 Toronto May 17-19, 2015 Cayman


Workers’ Compensation Statutory Coverage & 1M Employers Liability

General Liability 1M per occurrence 2M aggregate per project/per location aggregate

Automobile 1M Liability Physical Damage

Insured Coverage


Current Membership 2 Masonry Construction 2 Commercial Roofing & Sheet Metal Fabrication 1 Machinery Installation, Rigging, and Transportation 1 Road/Street Construction and Paving 1 Road/Street & Bridge Construction 2 Asphalt Distribution and Paving 1 Aggregates and Precast Concrete Products 1 Pipeline Construction


Current Members Peckham Industries – White Plains, NY The Hamlin Companies – Garner, NC Franco Associates – Pittsburgh, PA Cost Company – Pittsburgh, PA Energy Services of America (ESA) – Huntington, WV Valley Group – Fishersville, VA Suit-Kote – Cortland, NY Economy Paving – Cortland, NY Diamond Materials – Wilmington, DE Greenwood Industries – Millbury, MA LC Whitford – Waterville, NY


Internal Structure

Severity Fund B

$ 375,000 XS $ 125,000

One Time Capitalization: $ 30,000 Share Purchase

Experience Adjustment Assessment equal to one times A Fund

In a multi coverage occurrence the total clash retention is $ 500,000.

$ 1,000,000/Unlimited (WC)

$ 500,000

$ 125,000

General LiabilityWorkers

Compensation

Frequency Fund A

First Dollar to $ 125,000

Reinsurance – Arch

Excess of $ 500,000

Auto


Premium Distribution Example:

Captive Expenses $ 345,900

Loss Funding $ 654,100

Total Premium $1,000,000


Premium Distribution Example:

A Fund $ 490,575

B Fund $ 163,525

Loss Funding Allocation $ 654,100


Conceptual Annual Program PricingABC Construction

WC GL Auto Total

49.06% A Fund - $0 - $125,000 269,816$ 147,173$ 73,586$ 490,575$

16.35% B Fund - $125,000 - $500,000 89,939$ 49,058$ 24,529$ 163,525$

65.41% Total Loss Funds 359,755$ 196,230$ 98,115$ 654,100$

18.98% Excess & Aggregate Charge 104,390$ 56,940$ 28,470$ 189,800$

5.72% Front Administrative Charge 31,460$ 17,160$ 8,580$ 57,200$

3.50% Taxes/Boards & Bureaus Charge 19,250$ 10,500$ 5,250$ 35,000$

1.30% Loss Control Funding 7,150$ 3,900$ 1,950$ 13,000$

2.09% Claims Admin Funding 11,495$ 6,270$ 3,135$ 20,900$

3.00% Captive Expense Funding 16,500$ 9,000$ 4,500$ 30,000$

34.59% Subtotal 190,245$ 103,770$ 51,885$ 345,900$

Total Estimated Subject Premium 550,000$ 300,000$ 150,000$ 1,000,000$

Estimated Exposure 15,000,000$ 15,000,000$ 140

Estimated Composite Rate 3.67 2.00 1,071$

Share Purchase 30,000$ Retail Brokerage Fee TBDAssessment Exposure (A Fund) 490,575$ Collateral Required (2/3 A Fund) 326,723$


ABC Construction

All Lines to include General Liability, Auto Liability and Workers CompensationPolicy Term $0 - $125,000 $125,001 - $500,000 $500,001+ Total Incurred

2013 200,000$ -$ -$ 200,000$ 2012 650,000$ -$ -$ 650,000$ 2011 325,000$ 100,000$ -$ 425,000$ 2010 325,000$ 300,000$ -$ 625,000$ 2009 325,000$ 375,000$ 500,000$ 1,200,000$ 2008 125,000$ 375,000$ 1,500,000$ 2,000,000$

TOTALS 1,950,000$ 1,150,000$ 2,000,000$ 5,100,000$


ABC Construction

2013 2012 2011 2010 2009 2008 Total

Gross Subject Premium 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$ 6,000,000$ Losses Incurred (Paid+Reserved) 200,000$ 650,000$ 425,000$ 625,000$ 700,000$ 500,000$ 3,100,000$ Losses Excess of $500,000 Reinsured: -$ -$ -$ -$ 500,000$ 1,500,000$ 2,000,000$

A FUND Net Premium 490,575$ 490,575$ 490,575$ 490,575$ 490,575$ 490,575$ 2,943,450$ Losses Incurred (Paid+Reserved) 200,000$ 650,000$ 325,000$ 325,000$ 325,000$ 125,000$ 1,950,000$

Profit/(Loss) 290,575$ (159,425)$ 165,575$ 165,575$ 165,575$ 365,575$ 993,450$ Transfer to B -$ -$ -$ (136,475)$ (165,575)$ (211,475)$ (513,525)$ A Fund Assessment -$ 159,425$ -$ -$ -$ -$ 159,425$

Sub-Total: 290,575$ -$ 165,575$ 29,100$ -$ 154,100$ 639,350$ Deficit Reallocation (Risk Share) -$ -$ -$ -$ -$ -$ -$

Final A Fund Balance 290,575$ -$ 165,575$ 29,100$ -$ 154,100$ 639,350$

B FUNDNet Premium 163,525$ 163,525$ 163,525$ 163,525$ 163,525$ 163,525$ 981,150$ Losses Incurred (Paid+Reserved) -$ -$ 100,000$ 300,000$ 375,000$ 375,000$ 1,150,000$

Profit/(Loss) 163,525$ 163,525$ 63,525$ (136,475)$ (211,475)$ (211,475)$ (168,850)$ Transfer from A -$ -$ -$ 136,475$ 165,575$ 211,475$ 513,525$ Deficit Reallocation (Risk Share) -$ -$ -$ -$ 45,900$ -$ 45,900$

Final B Fund Balance 163,525$ 163,525$ 63,525$ -$ -$ -$ 390,575$

Loss Equity Balance*: 454,100$ 163,525$ 229,100$ 29,100$ -$ 154,100$ 1,029,925$

45.4% 16.4% 22.9% 2.9% 0.0% 15.4% 17.2%


Maximum Cost: $ 1,482,510Premium + Assessment

Minimum: $ 356,654 Captive “Fixed” ExpensesLess - Investment IncomePlus - Shared Losses


(Assume A Fund $482,510 Each Year)

1st Year 2/3 of A Fund = $321,673

2nd Year 2/3 of A Fund = $321,673 $643,346 combined

3rd Year 2/3 of A Fund = $ 321,673 $965,019 combined

No Additional Collateral required at 4th renewal!!

4th Year Caps at 2/3 of 3 Year Total = $965,019

Hypothetical Collateral Requirements


Service Providers

Front and Reinsurance - Arch Insurance Program Administration – Willis Onshore Legal Counsel – Kerr, Russell & Weber, LLP Captive Manager – SRS (Cayman) Investment Manager – PRP Performa Ltd. Auditor – KPMG Actuarial – Milliman Claims Administration – Gallagher Bassett Loss Control – Willis


Insured

CS INSURANCE LTD.

Captive Flow

CS Retail Broker

Arch Insurance Company

Willis, SRS, KR&W, Milliman, KPMG, GB

Underwriting Profits!

Policy Issuance

Financial Protection

Specific and Aggregate Excess Coverage

Statutory Coverage

Meets Legal Regulatory and Customer Requirements

Underwriting Expertise

Loss Control Resources

Claims Administration – Gallagher Bassett


Construction specific focus – coverage and services

Size of program

Enhanced input and control of captive operations

Active peer group - culture of constant improvement

High average member premium size - $885,000

Low average risk sharing – 3.5%

Minimal assessments

Why Construction Solutions?

Why Construction Solutions?

Enhanced and focused risk control

Exceptional historical results – loss ratio 33%

$81 MM Premium - $22 MM paid & $3.5 MM reserves

Program Structure – flexible retention, ALAE, clash, aggregate

No automatic close-out policy

Excellent distribution history

$10 MM in distributions to date

Policy years closed – net cost was 70% of original premium

Questions?


Documents

Deconstructing the Value Proposition of Captives