A Captive Primer:What they are and how they work

Educate – Evaluate – Elevate

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At Elevate, we passionately believe in what we do. We are conservative and focus on insurance, risk financing, and risk management strategies to mitigate your risk over the long term.

It’s imperative you understand the captive strategy and how it works for your organization – we do not believe in a “one size fits all” captive approach.

This presentation is a summary only and not a replacement for a full captive feasibility study. Nothing contained in this presentation should be deemed an offer to sell insurance or offer legal or tax advice.

Do It Right, Or Don’t Do It At All

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Elevate Captives

Jerry has over 34 years experience in the insurance and alternative risk transferindustry and serves as CEO for Elevate Captives. In his position with Elevate, heis an approved captive manager in multiple jurisdictions, both onshore and off.

Jerry is the Founding President of the Oklahoma Captive Insurance Association,member of the Captive Insurance Committee of the Self Insurance Institute ofAmerica (SIIA) and is an active speaker with industry trade groups. Jerry is anaccredited Associate in Captive Insurance with ICCIE and an Adjunct Professorwith Clear Law and Lawline.

Ryan serves as Managing Director of Risk Management for Elevate Captives.Ryan performs the Elevate “CORE™ Review” for clients and his experienceincludes being the Director of Risk and creating captives for Boing, Whirlpool,and Koch Industries.

Ryan has participated on many insurance and reinsurance company advisoryboards and is a frequent speaker at RIMS (Risk & Insurance ManagementSociety) and CICA (Captive Insurance Company Association), where he currentlyserves on the Board

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What Are We Talking About Today?

A Little About Elevateü Create/manage captives to provide

long-term solutions for enterprise risk management

ü Domiciles: Arizona, Delaware, Hawaii, New York, Oklahoma, Texas

ü Our goal is to provide the best captive administrative service in the industry and to do so with the highest integrity

A Lot About Captivesü Historyü Typesü Structuresü What they’re used for (and what

they shouldn’t be used for)ü Who makes a good captive

candidateü The captive formation process

Captive Examplesü Single Parent with Mixed P/C

and Employee Benefitsü Expense Profile

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Onshore/Offshore Captivesas of 12.31.16 (Business Insurance)

7,006 CAPTIVES

WORLDWIDE

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Captive’s Ranked by Stateas of 12.31.16 (Business Insurance)

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Definition/History of Captives

Definition by Captive.com: A captive insurer is generally defined as an insurance company that is owned and controlled by its insureds.

Captives first used in 1700’s in EuropeØ Lloyd’s Café (the ship-owners meeting…thereby creating Lloyd’s of London)Ø Apple ($99 AppleCare)Ø Federal Express (”check the box”)Ø Allstate (Sears)

Three main markets that host captives:Ø Europe (Isle of Man, Guernsey, Luxembourg, etc.)Ø Offshore Financial Centers (OFC’s – Bermuda, Cayman, Nevis, etc.)Ø USA (Vermont, Delaware, North Carolina, etc.)Ø Over 7,000 captives worldwide and growing rapidly

30+ states currently have captive legislation:Ø In US, first captive formed for “captive” coal mines named/owned by Fred Reiss, an

insurance agent in Ohio in 1951Ø Delaware/Vermont have over 1,000+ eachØ Most have specialties like series captives, medical stop-loss, XXX and AXXX

Mix and Match Types of Captives“Small, fronted, protected cell, US-based, homogenous group captive”

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2 Most Common Captive Types

• Single Parent Captive: A single owner for whom the captive provides insurance protection. Also known as a “Pure Captive” representing over 60% of all captives. Can also be a protected cell or series captive insurance company.

• Group Captive: Formed by a group of individual companies that typically own the captive. A group captive can also be started/owned by an association (aka “Sponsor”) and come in the form of a risk retention group (RRG), reciprocal group captive, or group reinsurance captive where a fronting company is involved.

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The Large CaptiveOver $2.3m in Premium

(The limit is indexed to inflation or $50,000, whichever is less)

Historically, a “large captive” has been defined as anything over the limit within the 831b election (currently $2.3m). You typically see these as single parent (pure) captives owned by medium-to-large companies or some smaller-to-medium sized businesses. For example, a $150m company writing a large workers compensation deductible reimbursement policy or large healthcare systems writing medical malpractice and general liability.

What are some of the benefits? The same as a Small Captive, plus:

ü You tend to have greater flexibility in writing on a direct basisü You can take advantage of a net-operating-loss carryforwardü All expenses, including administration, risk management, and any

claims themselves, are deductible within the captive, thereby allowing for the potential of the premiums paid and all operating expense to be deductible

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The Small CaptiveUnder $2.3m in Premium

A captive is a real insurance company the insured ultimately owns and controls. The

small captive model can be used for low-frequency/ high severity risk.

The captive also exists to cover gaps in commercial policies while protecting against

risk where no coverage exists at all. It doesn’t replace the commercial insurance program, it ENHANCES it.

What are some of the benefits?ü It creates significant SAVINGS on commercial premiums

ü Allows for GREATER protection using difference-in-conditions polices

ü The underwriting profit is not taxed, thereby allowing an accelerated

build-up of surplus. This allows you to take even more risk down the

road.

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What is a Captive

Insurance Company?

Legitimate Business Reason

(Real Risk)

Must Have Distribution

CANNOT be just for

Tax Benefit!!

Must Have Transfer

Legitimate Asset InvestmentPay Claims (Formal TPA Process)

Legitimate GovernanceQuality Reinsurance

Credible Service Providers –actuary, tax, audit, legal,

captive manager

Conservative Parental Guarantees or Loan Backs(?)

Adequate Capital

Domicile Credibility

Small or Large - Key Ingredients

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The 831b Tax Election

The IRS provides a special election for insurance companies collecting less than $2.3m in premium…it’s known as the 831b

election.

Ø Any underwriting profit is not taxed (only taxed on investment income)Ø Designed for low frequency/ high severity risk modelsØ Captive assets may be invested per regulatory guidelinesØ It does have limitations: No NOL carry forward, no claim or operating expense

deductions (except expenses related to investments)Ø Effective May 1, 2017, certain captives and their owners that elect 831b tax treatment

must disclose this interest as a Transaction of Interest and file Form 8886Ø This election is only considered after all aspects of the risk have been reviewed, not

before

In our opinion, the 831b election has been abused by certain promoters that exclusively push the tax benefits of the captive. They are not focused on the insurance and risk management aspects of the captive and they will not stand up to audit.

Benefits, Uses, and Coverage

Educate – Evaluate – Elevate

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I keep paying premiums year-after-year and NEVER have any claims…

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What We Hear…

I know if I turn these small claims in, I’ll be cancelled or they’ll raise my premiums, so I just pay them out of my

pocket…

On the one claim I did turn in, they denied it, so why pay for insurance…

The quote seemed really expensive and I don’t typically have claims anyway, so…

Who can benefit from a Captive?

Those who have strong financial statements and wish to have ultimate control over their insurance and risk management programs – “Seller of Risk”

Those who have a clear understanding of their own risk & loss history:Ø Sufficient operational exposures (employee benefits, fleets, property, business interruption,

supply chain, etc.)Ø Quality exposure and loss data (or ”shadow price”) demonstrating profit over timeØ Strong financial statements showing sufficient net incomeØ Committed to risk management and cost containment programs

Owners committed to paying appropriate premiums for multiple years:Ø Captives are seldom short-term solutionsØ How much is the minimum? About $400,000 captive premium due to the fixed expense ratio.

Those wanting ultimate control over:- Consistent Premium - Underwriting Profit - Claims Management - Investment Return- Risk Management - Cost Containment Programs

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How is a Captive Used?

Deductible Reimbursement & Difference in Conditions (DIC):Ø Raise deductibles and retentions to retain more profit & cut commercial insurance

premiumsØ DIC - covers exclusions, deductibles & excess protection with your commercial

policies

Risk that is too expensive, not available in the commercial market, or is currently uninsured (whether you know it or not):

Ø Medical Stop-lossØ Property, Hurricane (Named storm), Wind, Flood, DICØ Key Contract/Key Employee (expense reimbursement)Ø Business Litigation, Business Income (Interruption)Ø Product Recall, Reputation, Crisis ManagementØ Employee Related Practice Liability/Directors & OfficersØ Supply Chain Risk

Enhance business planning (Enterprise Risk Management)

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Risk Financing Continuum

HIGH

LOW

Prog

ram

Con

trol

HIGH

Financial Control

Guaranteed Cost

Retro Policy

Deductible Policy

• Complete transfer of risk• Commercial insurance with little-to-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

Group Captive• Pooling of Risk with Participants subject

to Corporate Governance

Cell or Single Parent Captive• Complete assumption of risk on

primary layer• Subject to Regulatory Oversight

What happens to the premium as the retentions go up?

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The Captive Wrap Program™Stand-alone and Difference-in-Conditions Policies

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Coverage Examples

Medical Stop-loss Political RiskProfessional Liability DIC* Coverage HIPAA/Billing Audit Liability Contractual Liability Cyber Liability Business Litigation DIC Business Interruption/DICEnvironmental Liability/Excess Employment Practices/DICLabor Strike Reimbursement Employee Dishonesty Patent Infringement/Intellectual Property General Liability DIC Property Management Professional Professional Misconduct Errors & Omissions Liability DIC Administrative Actions Product Liability/Recall DIC Directors & Officers Liability Loss of Key Employee Wind Deductibles on PropertyWage & Hour Liability Inland Marine DICCredit Default Trade CreditMedical Malpractice/DIC Regulatory ChangeSubcontractor Performance “Fat Finger” InsuranceReputational Risk Adverse Party Legal Risk

*Difference in Conditions

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How it Works

Ø Medical stop loss may be funded in a captive as a direct reimbursement policy, or as reinsurance behind a regular carrier (“fronted”)

Ø The captive layer typically sits above a self-insured retention of $25 - $100KØ Specific and aggregate stop loss may be purchased above the captive layer to cap lossesØ Captive layers are often funded at 125% of expected losses, based on an actuarial calculationØ Employer may fund the captive layer with their own funds and avoid complicated ERISA issues

(by using employee funds, but not applicable in Hawaii)Ø Purchasing stop loss from a captive insurer is functionally the same as from a commercial

insurer and can be structured to have no impact on plan participantsØ Employers with smaller populations can participate in a group medical stop loss captiveØ Subject to regulatory approval, medical stop loss policies may be funded in existing P&C

captives

Funding Medical Stop Loss

Medical(Stop(Loss(in(Captive

5315%(Savings

Self-InsuredRetention

Captive Layer

Stop Loss Insurance

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What Do the Structures Look Like?

Educate – Evaluate – Elevate

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IRIC“Administrative Core”

Series Captive “A”Min $100k Capital

International Risk Insurance Company (IRIC)Delaware-domiciled Series Captive Insurance Company (SCIC)

Contractual Relationship

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Series Captive “B”Min $100k Capital

Series Captive “C”Min $100k Capital

Own FEINOwn BoardOwn Assets

Single Parent (Pure) Structure

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HoldingCompany

InsuranceCompany

Insured

Ownership of Holding Company will typically mirror

that of Insured

Why a holding company?1. Not regulated, so no

NAIC bio or D&O issues2. Flexible ownership

changes3. Used in ”Golden

Handcuff” structure4. Some cash flow benefits

Group Captive with Fronting CompanyFunding Model

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Holding Company

Group Captive(Insurance Company)

Insured A

Insured B

Insured C

Premium

Capital Loans or

Investments

100% Capitalization Surplus Note

Capital Loan Repayments or Dividends

Three FundingPhases:

1. Feasibility2. Statutory Capital3. Growth Capital

Fronting Company

Captive Examples and Expense Examples

Educate – Evaluate – Elevate

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Single Parent Captive Example(Mixed P&C – Stop Loss)

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Captive with $250,000 in

Statutory Capital

Holding CompanyCoverage Examples

Loss of Key Contract Reputational Risk

Hedge Fund E&O DIC

Loss of Key Employee

“Fat Finger” Endorsement

Network/Cyber Liability

EPLI/D&O

Business Litigation Business Interruption

Crisis Management

Commercial renewal in 2013 (without a captive):

• $840,000 premium• $250k SIR on commercial policy• Fully-insured on health plan• Multiple gaps/exclusions

Commercial renewal in 2017 (with a captive):

• $515,000 premium• $500,000 SIR on commercial

policy• $30,000 Spec Ded ($10,000

excess $20,000 in captive)• $1m DIC limit with Zero SIR in

captive• $5.3m in captive assets• $4.3m in premium deductions• $325,000 in annual premium

savings, $1.6m total so far

Reinsurance - Why you might need or want itGround-up Quota-share

PurposeØ Protect captive against

significant lossØ Preserve capitalØ Risk transfer Ø Risk distribution

StructureØ Quota-shareØ 49/51% RatioØ 2.5% Cost

Captive Participants

51%of

prem.for

51% of Limit

Captive Participants Captive

Participants

Reinsurance

Your Captive

51% of Premium/Risk

1M Limit –Quota-share

49%of

prem.kept in

the Captive

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5-year Financial OverviewPure Captive with Reinsurance

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• Expense ratio should be much lower than commercial at 35%+• Reduction in commercial premium due to retentions (10-20%+)• Claims are paid to owner (they do not come out of your cash flow)• Highly efficient regardless of tax election

This table reflects a 35% loss ratio, 2% ROI, WITH reinsurance:

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Premium 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000 10,000,000

Admin/Operational (est.) 75,000 75,000 75,000 75,000 75,000 375,000

Reinsurance 51,000 51,000 51,000 51,000 51,000 255,000

Paid Claims 655,900 655,900 655,900 655,900 655,900 3,279,500

EBITDA 1,218,100 1,218,100 1,218,100 1,218,100 1,218,100 6,090,500

Investment Inc (net of tax) 48,724 99,397 152,097 206,905 263,905 771,027

Net Profit 1,266,824 1,317,497 1,370,197 1,425,005 1,482,005 6,861,527

Available Captive Assets 1,266,824 2,584,321 3,954,518 5,379,523 6,861,527

Loss Ratio Paid Claims Available Captive Assets

5% 486,500 10,028,38625% 2,342,500 7,917,14750% 4,685,000 5,278,09880% 7,496,000 2,111,239

Actual Claim Examples

Ø Wage & Hour: $480,000 due to allegations the insured didn’t follow strict guidelines on breaks, lunchtimes, and overtime rules. Excluded from commercial EPLI/D&O policy.

Ø Trade Credit: $260,000 due to large client (of the insured) filing bankruptcy and continuing to use security services. Insured’s IT system failed to flag nonpayment’s. Commercial policy declined claim due to “prior acts” date on policy.

Ø Reputational Risk (Headline): $63,000 due to homicide investigation of elder death. Nurse falsified medical records. Hiring of PR firm not covered under General Liability policy and claim denied due to ”actual or alleged” wording in commercial policy.

Ø Sexual Abuse Allegation: $140,000 due to defense of Owner by previous employee alleging sexual abuse. Commercial carrier declined due to retro-date. Defense verdict and insured fully reimbursed.

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Risk and Insurance Review Process & Foundations

Educate – Evaluate – Elevate

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Elevate CORE™ Review

Coordinated Overviewof Risk and Exposure

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The Captive Creation Process

Step I:CORE™Process

Insurance review

Actuarial rates

Captive lines of insurance

Loss projections

Domicile and Service provider

Go/no go

Step II:Regulatory

Filing

Regulator discussion

Corporate structure creation

Bank accounts

Investment plan

Business plan

File

Step III:Funding &

COA

Receipt of Cert of Authority

Capitalize

Fund Premium

Policy Issuance

Implement investment plan

Governance plan

30 Days 15 Days 30 Days

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Our family is blessed to do what we do, and we love doing it.

Thank you for allowing us to visit with you today.

Jerry D. Messick, ACICEO

Elevate CaptivesM: 405.550.2651

jm@elevatecaptives.com

Questions and Answers

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