Title Slide JUN 8 – 10, 2015 Intro to Captives.

Title Slide

JUN 8 – 10, 2015

www.bermudacaptive.bm

Intro to Captives

Intro to Captives

Speakers:

Dale Fenwick, President, Sovereign Insurance Services, LLC

Adam Rekerdres, Vice President, Rekerdres & Sons Insurance Agency Inc

Chiara Nannini, Associate, Conyers Dill & Pearman Limited

Moderator:

Peter Willitts , President, Liberty Mutual Management Bermuda Ltd

http://www.bermudacaptive.bm/2015-conference/speakersPopup.asp?ID=543






Intro to Captives

1.Mid 1980s: Excess Liability market – ACE, XL

2.1960s: Frederic Reiss – Birth of captives in Bermuda

3.1990s: Reinsurance market – Hurricane Andrew

4.New waves of capital

• 2001 response to September 11, 2001

• 2005 response to hurricanes

• Innovation in Policy Forms, Cell Companies, Captive Pooling and other specialized commercial vehicles, such as SPIs and Sidecars

Intro to Captives

A Few Facts from 2013:

Bermuda Captives wrote $48 Billion in premium

They had $59 Billion in capital.

Impressive ?????

Bermuda Insurers had $448 billion in Assets !!!

32 Bermuda re/insurers write captive business

Bermuda is vibrant

Largest Captive Market in the world

Last year there were also:

28 New SPIs

16 Commercial Insurers

10 Long term license

12 agents

7 Managers

5 Brokers

An Introduction to Captives

Dale Fenwick CRM, ARM, MBA, CIC

President,

Sovereign Insurance Services, LLC

Intro to Captives

1. Captive Insurance Overview

2. Fronting

3. Risk Transfer and Risk Distribution

4. Captive Feasibility Study

5. Loss Projections

6. Captive Taxes

7. Domicile Selection

8. Advantages & Disadvantages

Intro to Captives

1. What is a Captive

a. A captive insurance company is a legal entity created for the purpose of insuring the loss exposures of its owner(s).

b. A closely held insurance company whose insurance business is supplied by and controlled by its owners, and in which the insured are the beneficiaries.

c. Any insurance company that is owned and controlled by its policyholders(s).

Intro to Captives

• Fred Reiss

• Ohio – 1950s

• Youngstown Sheet & Tube Company

• Mining operations called “captive” mines

• The insurance subsidiary became another form of “captive” operation.

• “The policyholder owns the insurance company; therefore, the insurer is captive to the policyholder.”

-Fred Reiss

Why are they called “captives?”

1. Ownership – Who Owns the Captive?

2. Structure – How is the Captive Owned?

3. Policy – How are the Policies Issued?

Captive Categories

1. Who Owns the Captive?

a. Single Owner

1) Single Parent/Pure Captive

2) Economic Family Captive

Captive Ownership – Who?

12

Insured

Captive

Premiums PoliciesUnderwriting

& Investments Profits

“Pure” Captive (Single Owner)

Parent

Sub 1 Sub 2 Sub3 Sub 4 Sub 5 Sub 6 Sub 7 Captive

Premiums

“Economic Family” Captive

b. Multiple Owners

1) Group Captive

2) Association Captive

3) Risk Retention Group

c. “Related” Owners (3rd Party Risk)

1) Agency Captive

2) “Franchisor” Captive

Captive Ownership – Who?

2. Ownership Structures

1) Owned Captive

2) Rent-a-Captive

a) Protected Cell Company (Guernsey)

b) Segregated Account Company (BDA)

c) Segregated Portfolio Company (KY)

d) Sponsored Captives (VT)

Captive Ownership – How?

Cell AOwner

CORE(Owned by Sponsor)

CellA

CellB

CellC

CellD

CellE

Cell BOwner

Cell DOwner

Cell EOwner

Cell COwner

Premiums Claims

Rent-A-Captive

1. Fixed Annual Fee

2. Variable Fees

a. Percentage of Premium

b. Percentage of Invested Assets

c. Exposure-Based

1. Percentage of Payroll

2. Per Location / Unit

3. Combination (Fixed + Variable)

Cell Captive Fees

3. Policy Structures

1) Direct-Write Captive

2) Fronted Captive

Captive Policies

Captive

Direct-Write Captive Program

19

Insured

Reinsurer

Issues PolicyExample: $1 Million Limit

Retains Primary LayerExample: First $250,000 of each claim

Provides Excess ReinsuranceExample: 750,000 x 250,000

CommercialInsurer (aka Front)

(No Risk)

Fronted Captive Program

20

Insured

CommercialReinsurer(750x250)

CaptiveReinsurer

(First 250K)

Fronting – using one insurance company, usually a domestic, admitted carrier, to issue policies that will meet the regulatory and contractual needs of the captive.

• Captive reinsures the fronting carrier

• Policyholder pays premium to the front

• Front cedes premium designated to pay “retained” losses to the captive and purchases “excess” reinsurance from a commercial reinsurer

Fronting

• Front issues policies and pays losses.

• Front recovers claim payments from the captive via a reinsurance contract.

• Front provides the use of its license, name, balance sheet, and services in exchange for a fronting fee.

• Fronting carrier generally requires security from the captive to insure reimbursement for claim payments.

• The front assumes no underwriting risk.

Fronting

When to use a front

• Licensed (Authorized) Policy

• Workers Compensation

• Auto Liability

• CGL (if required for permits, etc…)

• Rated Paper (AM Best)

Fronting

Court rulings require the “commonly accepted notion of insurance,” which include, but are not limited to:

• Sufficiently capitalized (5:1 Surplus Ratio Max)

• Formed for non-tax business reasons

• Premiums are charged at an arms-length rate

• The activities of the company should be typical of commercial insurance enterprises

• Risk Transfer and Risk Distribution

What is an Insurance Company?

1. Is the Present Value of the Benefit (limit) greater than the Premium?

Example:

$1 Million Premium for $1 Million Limit

2. Whose Balance Sheet suffers the impact of a claim?

Risk Transfer

Business Owner(s)

Operating Company

Premiums

Policies & Claim Payments

CaptiveInsurance Company

Risk Transfer

Revenue Ruling 2005-40

• 12 Subsidiaries – 12 Policies

• No One Policy > 15% of Premium

Risk Distribution – Pre-2015

Business Owner(s)

OC 1 OC 3

OC 4 OC 6

OC 7

OC 8

OC 9OC 5

OC 2 OC 10

OC 11

OC 12

CaptiveInsurance Company

Risk Distribution – Pre-2015

Rent-A-Center

• Bermuda captive

• 15 brother-sister companies

• 66% of premium in one of the companies

• Tax Court focused on exposure units not the number of entitieso 3,000 storeso 15,000 employeeso 8,000 vehicles

Risk Distribution – Post 2014?

Securitas

• Vermont captive• 11 brother-sister companies in 2003• 4 brother-sister companies in 2004• 90% of premium in 4 companies in 2003• 90% of premium in one company in 2004• “It is the pooling of exposures that brings about

the risk distribution--who owns the exposures is not crucial.” - Dr. Neil Doherty

• The captive “was exposed to.” a large pool of statistically independent risk exposures.”

Risk Distribution – Post 2014?

Step 1: Feasibility Study

Step 2: Select Domicile

Step 3: Form Company

Step 4: Obtain License

How to Form a Captive

1. Cost of Risk Analysis

a. Analysis of Historic Loss and Exposure Data

b. Retention Selection (Stratification Analysis)

c. Projected Losses

Captive Feasibility Study

Loss Stratification - Frequency

Loss IntervalNumber of

LossesPercent in

IntervalCummulative

Percentage$0 to $25,000 2,372 94.7% 94.7%$25,000 to $100,000 126 5.0% 99.7%$100,000 to $250,000 5 0.2% 99.9%$250,000 to $500,000 2 0.1% 100.0%$500,000 to $1,000,000 0 0.0% 100.0%> $1,000,000 0 0.0% 100.0%Totals 2,505 100.0%

Loss Stratification - Severity

Loss IntervalLosses

($)Percent in

IntervalCummulative

Percentage$0 to $25,000 4,810,000 45.2% 45.2%$25,000 to $100,000 4,200,000 39.4% 84.6%$100,000 to $250,000 875,000 8.2% 92.8%$250,000 to $500,000 762,000 7.2% 100.0%$500,000 to $1,000,000 0 0.0% 100.0%> $1,000,000 0 0.0% 100.0%

Loss Projection - Step 1

YearTotal

Incurred ($)

Severity Development

Factor

Ultimate Total

Losses ($)

Inflation Index

Inflation Indexed Losses

2010 125,986 1.00 125,986 1.76 221,987 2011 469,091 1.11 520,691 1.57 819,568 2012 386,550 1.30 502,515 1.41 706,034 2013 291,555 1.57 457,741 1.25 574,007 2014 357,171 2.51 896,449 1.12 1,004,023

Loss Projection – Step 2

YearDeveloped & Indexed

Losses

Employees (Exposure)

Loss Rate

2010 221,987 494 449 2011 819,568 535 1,532 2012 706,034 543 1,300 2013 574,007 552 1,040 2014 1,004,023 565 1,777

Average Loss Rate = $1,220 per Employee2015 Projected Employees = 589

Projected Losses = 589 x 1,220 = $718,000

1. Cost of Risk Analysis

a. Analysis of Historic Loss and Exposure Data

b. Retention Selection (Stratification Analysis)

c. Projected Losses

2. Administrative (non-Loss) Expenses

a. Domicile Fees (Fixed Costs)

b. Policy-Related Fees (Variable Costs)

c. Taxes


Captive Administrative CostsAnnual Domicile Fees (Fixed Costs)

Captive Management $10,000 to $50,000

Audit Fees $10,000 to $50,000

Actuarial Fees $5,000 to $50,000

Government Fees $5,000 to $15,000

Legal Fees $1,000 to $10,000

Meeting Costs $1,000 to $100,000

Misc. $5,000 to $20,000

Total $50,000 to $150,000

Captive Administrative CostsPolicy-Related Fees (Variable Costs)

Fronting 5% to 15%

TPA 2% to 8%

Premium Taxes 2% to 5%

Commissions 2% to 10%

Consulting 2% to 5%

Misc. 1% to 3%

Total 14% to 46%

1. U.S. Federal Income Tax• 831(a) Tax on underwriting income (>1.2 M)• 831(b) Tax only on Investment Income (<1.2M)

Note: To be eligible to make the 831(b) election the entity must be an Insurance Company in the eyes of the IRS…

Captive Taxes

Federal Income Tax ComparisonExtreme Example – Zero Losses

831(a) 831(b)Premium 1,100,000 1,100,000 Administrative Expenses 100,000 100,000 Losses - - Underwrting Profit 1,000,000 1,000,000 Investment Income 100,000 100,000 Net Income 1,100,000 1,100,000

Taxable Income 1,100,000 100,000 Taxes (374,000) (34,000) After Tax Income 726,000 1,066,000

1. Federal Income Tax• 831(a) Tax on underwriting income (>1.2 M)• 831(b) Tax only on Investment Income (<1.2M)

2. Federal Excise Tax – Offshore Captives • Direct Premiums (4%)• Assumed Insurance (1%)

3. Premium Taxes• Onshore Domiciles = 0% to 0.5%• Offshore Domiciles = 0%

4. Direct Procurement Taxes• 5.0% in many states

Captive Taxes

43

Captive Premium Tax Rates

DomicileDirect

Procurement Captive

Premium MinimumArizona 3.00% 0.00% $5,000 Utah 4.25% 0.00% $5,000 Oklahoma 6.00% 0.20% $5,000 Delaware 2.00% 0.20% $5,000 District of Columbia 0.00% 0.25% $7,500 Hawaii 4.68% 0.25% -Missouri 5.00% 0.38% $7,500 Vermont 3.00% 0.38% $7,500 Montana 2.75% 0.40% $5,000 South Carolina 0.00% 0.40% $5,000 Tennessee 0.00% 0.40% $5,000 Nevada 3.50% 0.40% $5,000 Kentucky 2.00% 0.40% $5,000 Texas 4.85% 0.50% $7,500

1. 5-Year Pro Forma Financial Statement

2. Risk Transfer Analysis

3. Risk Distribution Analysis

4. Non-Tax Business Purpose

5. Captive Ownership Structure

6. Capital Structure

7. Reinsurance Structure

8. Domicile Recommendations


Captive Domicile Selection

1. Domicile – The jurisdiction that issues a license and is responsible for regulating the captive insurance company.

Captive Domicile Selection

47

Established Domiciles2014 Captive Activity

Domicile Jan New Closed Dec Growth

Bermuda 841 16 16 841 0%

Cayman 758 22 21 759 0%

Vermont 588 16 17 587 0%

Utah 343 106 25 424 24%

Delaware 298 87 52 333 12%

Hawaii 184 15 5 194 5%

Montana 150 34 7 177 18%

Nevada 148 26 9 165 11%

South Carolina 145 20 5 160 10%

Kentucky 128 - 6 122 -5%

DC 126 5 6 125 -1%

Arizona 106 13 5 114 8%

Emerging Domiciles2014 Captive Activity

Domicile Jan New Closed Dec Growth

North Carolina 4 49 0 53 1,225%

Tennessee 29 43 0 72 148%

Oklahoma 10 37 0 47 370%

Missouri 35 12 0 47 34%

Texas 0 12 0 12 NM

Connecticut 4 3 0 7 75%

New Jersey 14 3 0 17 21%

Total 96 159 0 255 166%

1. Capitalization required

2. Surplus required

3. Premium Taxes

4. Ownership structure

5. Reserving requirements

6. Regulatory environment

7. Meeting requirements

8. Investment regulations

9. Geographic convenience

10. Offshore v. onshore

Domicile Selection Criteria

How Long Does it Take?How Much Does it Cost?

Step 1: Feasibility Study - 30 to 90 Days

$20,000 to $30,000

Step 2: Select Domicile - 0 to 10 Days

Step 3: Form Company – 10 to 30 Days

$5,000 to $10,000

Step 4: Obtain License - 30 to 60 Days

$10,000 to $20,000

Use a Rent-a-Captive facility.

Still need a Feasibility Study.

10 to 30 days from post-Feasibility Study decision

Do You Have a Need for Speed?

1. Reduced Long-term Total Cost of Risk

2. Stabilize Premium & Availability

3. Greater Control Over Claims

4. Tailored / Increased Coverage

5. Investment Income

6. Direct Access to Reinsurance Markets

Captive Advantages

1. Risk of Loss

2. Initial Capital Investment

3. Formation Time

4. Runoff Time

5. Long-term Commitment

Captive Disadvantages

1. >$1 Million Premium

2. “Good” Loss Ratios

3. “Good” Risk Management Programs

4. Risk Tolerance

5. Predictable Losses

6. Limited Choices for Coverage

7. Funds for Capitalization

8. Long-Term Outlook

Captive Owner Characteristics

Long Term Commitment

Working Example

Mr. Adam Rekerdres, MBA, CIC, ACI

A Change of Perspective

Captive Benefits

Cost

• Benefit of positive loss experience

• Reinsurance

• Cost Allocation

• Reduced volatility

Coverage

• Tailored

• Uninsured Risks

• DIC

Capacity

• Access to Reinsurance Market

• Good faith to primary insurers

Control

ClaimsService ProviderFocused Risk ManagementEnhanced Loss Control & Prevention

Captive Considerations

Claims

Impact of adverse claims experience

Costs

Start up costsOperating costsCapitalization costs

Regulatory

Some countries don’t allow non-admitted insuranceSpecial non-admitted taxes

Fronting

An additional costCollateral requirementFinancial information

1. Corporate Visibility2. Management Attention3. Market Flexibility

Real World Examples

Before…

•Global properties “insured” internally

Assets = $75mil

After

•Global properties insured by captiveAssets = $125mil

Real World Examples

Other Benefits…

• formalized claim history

• formalized history of risk improvements

• quick notifications from local mangers

Real World Examples

Management Attention to Claims

“Turn on the lights and the cockroaches run”

•How quickly can you get the director’s attention when the captive insurance company is running a loss?

Real World Examples

Market Flexibility

Have the flexibility to assume more risk when the market is hard and less risk when the market is soft.

Real World Examples

Real World Examples

Ocean Marine Cargo

($35mil Building, $30mil Vessel, no limit #)

Various Deductibles

Property Program $60,000,000

Various Deductibles

Global Liability Excess

Global Liability

Real World Examples

Ocean Marine Cargo


Captive Insures $1mil Deductible


Captive Insures US$2mil Deductible


Captive Self Insures

Ocean Marine Cargo


Captive Insures $1mil Deductible


Captive Insures US$2mil Deductible


Captive Self Insures

Captive takes $5mil x of $10mil

Real World Examples

Real World Examples

Before After

Overview Legal & Governance Issues

Chiara T. NanniniConyers Dill & Pearman

Limited

Place Title Here

1. Companies Act 1981

2. Insurance Act 1978

- Insurance Accounts Regulations 1980

- Insurance Returns & Solvency Regulations 1980 (together, the “Regulations”)

3. Segregated Accounts Companies Act 2000 (for segregated account companies)

Key Governing Statutes

1. General Business

a. Classes 1, 2 & 3 – Captives

b. Classes 3A, 3B, 4 – Commercial

2. Long Term Business (annuity, life accident & health)

a. Classes A&B – Captives

b. Classes C, D, E – Commercial

3. SPIs (insurer fully funds liabilities through a debt issuance or some other approved financing mechanism)

Insurance Act – License Classifications

Any general business or long-term insurer wishing to operate segregated accounts may apply to be registered under the Segregated Accounts Companies Act 2000 (the “SAC Act”).

Segregated Accounts

1. Application to incorporation / amalgamate / merge/ continue into Bermuda / register under the SAC Act is made to the Registrar of Companies.

2. Beneficial owners (10%+ beneficial owners) are vetted by the lawyers and approved by the Bermuda Monetary Authority (in accordance with the Exchange Control Act 1972).

3. Application to incorporate can be made separately from the insurance license application (before or after), but is often made in tandem.

4. For amalgamations / mergers / continuances / SAC registrations, completion of the transfer may not occur until the BMA provides its no-objection to the Registrar of Companies.

Process to Establish a Company in Bermuda

Pre-Licensing Considerations

1. Decisions made to form captive / re-domicile into Bermuda

2. Consideration given to class of captive

3. Selection of service providers:

a. Insurance managers

b. Lawyers

c. Auditors

d. Banker

e. Actuary / Loss Reserve Specialist

Registration under the Insurance Act

Pre-Licensing Documentation

Consists of:

1. Business Plan

2. 5 year pro-forma financials (Balance Sheet and Income Statement)

3. Pre-Incorporation Form (for registration as an insurer)

4. Parent company financial statements

5. Resumes (senior management / directors)

6. Acceptance letters for service providers

7. SAC Form 1 (if applying for SAC registration)


Pre-Licensing Application

1. Application filed with BMA by 5:00 p.m. on Monday prior to Assessment and Licensing Committee consideration at their weekly meeting the following Friday.

2. Four possible outcomes:

a. Approved

b. Approved, but subject to [x]

c. Deferred

d. Declined


(A) Meetings to be held:

a. Provisional Meeting

b. Statutory Meeting

c. First Board Meeting

(B) Items to be approved:

a. Approval of service providers (auditors, insurance manager, principal representative, resident representative, approved actuary / loss reserve specialist etc.)

b. Bank account opening

c. Bye-laws

Organising the Company

• Once required capital is paid into the company, Form 1B (registration application) may be submitted to the BMA.

• Insurance license may be issued in three days if application complete.

• Captive can start writing business once certificate of registration has been issued.

Formal Insurance License Application

1. Minimum Paid – Up Share Capital

a. $120,000 for Classes 1, 2 & 3

b. $120,000 for Class A

c. $250,000 for Class B

2. Principal Representative and Principal Office / SAC Representative

a. All Bermuda insurers are required to maintain a principal office and appoint a principal representative resident in Bermuda (usually the insurance manager).

b. SACs must appoint a SAC representative resident in Bermuda.

Insurance Act – Main Provisions

3. Independent Approved Auditor

All Bermuda Insurers are required to appoint an independent approved auditor who will audit and report on the insurer’s statutory financial statements and statutory financial returns.

4. Actuary / Loss Reserve Specialist (LRS)

• Class A& B insurers must appoint an approved actuary – must be an individual – responsible for preparing the actuary’s certificate filed with the annual statutory return.

• Class 2 and 3 insurers (and Class 1s if required by the BMA) must appoint an approved loss reserve specialist – must be an individual- responsible for preparing the LRS opinion in respect of company’s loss and loss expense provisions in its annual statutory return.


5. Statutory Financial Statements and Returns

a. Every insurer must prepare annual audited statutory financial statements and submit to the BMA with its statutory financial return.

b. Rules and guidance for preparation are set out in the Regulations.

c. Statutory financial statements not prepared in accordance with GAAP.

d. The statutory financial statements and statutory return are not public documents.

An insurer is also required to submit, at the same time as it files its statutory financial statements, a declaration of compliance declaring whether or not that insurer has, with respect to the preceding financial year, (i) complied with the minimum criteria applicable to it, and (ii) compiled with its minimum solvency margin and enhanced capital requirement (if applicable) as at its financial year-end.


6. Minimum Solvency Margin

An insurer’s statutory assets must exceed its statutory liabilities by an amount greater than its prescribed minimum solvency margin.

7. Minimum Liquidity Ratio (MLR)

Every general business insurer must maintain the value of its relevant assets at not less than 75% of the amount of its relevant liabilities.


8. Restrictions on Dividends and Distributions

a. A company may not declare or pay a dividend or distribution if it is in breach of its MSM (or MLR for general business) of if declaration or payment would cause such as breach.

b. Any company that fails to meet its MSM (or MLR for general business) on the last day of any financial year is prohibited from declaring or paying any dividends during the next financial year without BMA consent.

9. Restrictions on Reduction of Capital

a. No Bermuda insurer may reduce its total statutory capital (as per previous year’s financial statements) by 15% or more without prior BMA approval.


10. Insurance Code of Conduct

All Bermuda insurers must comply with the Insurance Code of Conduct.

- Designed to ensure sound corporate governance, risk management and internal controls are implemented.

- Captive insurers should be mindful of the proportionality principle in establishing a sound corporate governance, risk management and internal controls framework.


Captive Governance

• A system of rules, practices and processes by which a company is directed and controlled.

• Per the Insurance Code of Conduct, every insurer must establish and maintain a sound corporate governance framework. The framework should have regard for international best practice on effective corporate governance. Corporate governance includes principles on corporate discipline, accountability, responsibility, compliance and oversight.

• Every insurer is required to implement such corporate governance policies and processes as the BMA deems appropriate given the nature, size, complexity and risk profile of the company in question. The insurer is also required to appoint such number of non-executive directors as it considers appropriate having regard to its circumstances and the nature and scale of its operations.

What is Corporate Governance?

• Directors manage the affairs of the company – “mind and will”.

• Appointed by the shareholder(s) on an annual basis.

• Powers generally derive from the constitutional documents of a company e.g. bye-laws.

• Cannot act outside powers – a company may be able to recover from its directors any loss to the company arising from acts of the directors which constitute a breach of their duties to the company.

• Duties are generally owed to the company, not individual shareholders.

The Role of the Directors

• Notice – generally, any director may call a Board meeting at any time on reasonable notice.

• Quorum – usually 2.

• Voting - one man/one vote.

- resolutions are passed by simple majority.

- if allowed in the bye-laws, the chairman may cast a tie-breaker vote.

• Personal Interests – whenever a director has a personal interest in the business of the Company, he must declare it to his co-directors at the first board meeting where the matter is discussed.

• Written Consents – anything done at a Board meeting can be done by the unanimous written consent of the directors (often called a UWR).

Board Meetings

Fiduciary Duties

• A duty to act in good faith in the best interests of the company (and not for any collateral purpose).

• A duty to exercise powers for a proper purpose.

• A director must not put himself in a position where there is an actual or potential conflict between his personal interest and his duty to the company.

• A director must not take a personal profit from opportunities that result from his directorship.

Directors Duties

Duty of Skill and Care

• A director must exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.

• A director must diligently attend to the affairs of the company, but he is not bound to give continuous attention to the affairs.

• A director is entitled to rely on a subordinate put in a position of charge for the express purpose of attending the detail of management. However, directors cannot absolve themselves entirely of their responsibility by delegation to others.

Directors Duties

Questions?

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Intro to Captives

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Title Slide JUN 8 – 10, 2015 Intro to Captives.

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Transcript of Title Slide JUN 8 – 10, 2015 Intro to Captives.