1. INSURANCE MANAGEMENT SERVICES kpmg Chad C. Wischmeyer, FCAS, MAAA, MMC Enterprise Risk Bob Gagliardi, CPA, AIG Insurance Management Services George Levine, FCAS, MAAA, KPMG LLP Captive Insurance Overview September 24, 2002

2. Introduction

3. 3 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

4. 4 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

5. 5 n Distinctions Among the Various Options l Risk Retained versus Risk Transferred to a Third Party l Timing of the Cash Flows (Investment Income) l Tax Treatment of the Cash Flows l Legal Obligation to Bear the Risks Guaranteed Cost Dividend Plan Retro Rated Plan Deductible Policies Captive Self- Insurance The Evolution of Alternative Risk Financing

6. 6 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

7. 7 n Licensed Insurance Company n Formed to insure or reinsure the risk of its owners or unrelated parties of their choosing n Regulated under special legislation regulating captives (regulated less stringently than state insurance laws which govern fully admitted insurance companies) n Located offshore or onshore n Admitted only in its domicile and non-admitted in all other jurisdictions. Characteristics of Captives

8. 8 n Single Parent (Pure) Captive n Wholly owned by one parent company n Formed primarily to insure or reinsure the risks of the corporate parent or unrelated parties of their choosing n Group Captive n Owned by two or more companies, usually a trade association or homogenous companies n Formed to insure or reinsure the risks of the group Four Types of Captives

9. 9 Four Types of Captives (continued) n Rent-a-Captive (Cell Captive) n Organized to insure or reinsure the risks of unrelated shareholders; the insureds are "renting" capacity of the insurer capitalized by outside sponsors n Risk Retention Group n Operates similar to a group captive yet is regulated under federal legislation n Can operate in all fifty states yet only required to be licensed in its state of domicile n Insureds must be owners and owners must be insureds n Can only write liability lines of risk n The RRG cannot provide reinsurance

10. 10 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 Captive Domiciles

11. 11 Current Captive Growth (from 5/01 and 5/02 Captive Insurance Company Reports)

12. Perspective of a Captive Manager

13. 13 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

14. 14 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.

15. 15 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

16. 16 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

17. 17 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

18. 18 Regulatory Process Domiciles – Onshore vs. Offshore – Tax considerations  Premium Tax  Income Tax

19. 19 Domiciles On-shore – Vermont – Hawaii Off-shore – Bermuda – Cayman Islands Differences becoming smaller as domiciles compete for business

20. 20 Premium Taxes Onshore domiciles – Minimal premium taxes – No state income taxes Offshore – Zero premium tax, but potential for other taxes (Federal Excise Tax)

21. 21 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”

22. 22 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

23. 23 Current Developments Employee Benefits Cell/ Sponsored Captives Tax Developments

24. 24 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

25. 25 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

26. 26 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”

27. 27 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

28. Actuarial Perspective

29. 29 Scope of Actuarial Involvement 1) Feasibility Study and Financial Planning 2) Design of Alternative Risk Transfer Products 3) Formation Process 4) Certification of Reserves

30. 30 1. The Captive Feasibility Process n Define Objectives – Financial – Business n Forecast Ultimate Retained Loss Costs n Perform NPV/Cash Flow Analysis of Alternatives n Develop Program Structure of Captive n Domicile Analysis n Determine Optimal Ownership Structure n Analyze Tax Issues – Deductibility of Captive Premium – Tax Treatment of Captive Income

31. 31 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

32. 32 Tax Treatment of Captives Cash Flow Year Payout Per Year Losses Payments Value of Tax Deduction Year 118.00%$1,800,000$630,000 Year 2 25.00%2,500,000875,000 Year 3 23.00%2,300,000805,000 Year 418.00%1,800,000630,000 Year 5 16.00%1,600,000560,000 Total 100.00%$10,000,000 Cash Flows under Self Insured Arrangement Present Value of Tax Deduction = $2,958,077

33. 33 Tax Treatment of Captives Cash Flow Year Payout Per Year Losses Payments Premium Paid to Captive Value of Tax Deduction Year 1 18.00%$1,800,000 $10,000,000$3,500,000 Year 2 25.00%2,500,000 Year 3 23.00%2,300,000 Year 4 18.00%1,800,000 Year 5 16.00%1,600,000 Total 100.00%$10,000,000 Cash Flows under Captive Arrangement Present Value of Tax Deduction = $3,500,000!

34. 34 3. The Captive Formation Process Business Plan – Forecasts of Annual Expected Losses – Program Structure (Premiums, Limits, Capitalization) – Proforma Captive Financial Statements

35. 35 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)

36. 36 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.

37. 37 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 31 st 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.

38. 38 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)

39. 39 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

40. 40 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

41. 41 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

42. 42 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?

43. 43 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

44. 44 Conclusion Questions