Alternative Risk Approaches Presented by David Kalainoff, Vice President Transatlantic Reinsurance Company Seamus Tivnan, Senior Vice President Marsh Management Services (Cayman), Ltd. Philip Reischman, Executive Vice President Gallagher Healthcare Insurance Services Medical Professional Liability Symposium March 21 – 22, 2002 Chicago, IL

Alternative Risk Defined Alternative (adj.): offering a choice of two or more things; offering a second thing or proposition 1 Risk (n.): the chance of loss; the degree of probability of loss Source: Webster’s Third World International Dictionary (unabridged)

Alternative Risk Defined Alternative Risk (n.): the option for an Insured to pay a lot of premium for limited coverage under a Contract of Insurance or Reinsurance that no one understands, but for which the Broker receives a stout commission! Source: The Cynical Brokers’ Dictionary 2

Characteristics of Alternative Risk Programs  Loss Sensitive  Finite (Aggregate) Limit  Significant Rate On Line  Investment Income Recognition  Prospective Or Retrospective 3

Re-Emergence Of Alternative Risk Programs  Massive Premium Increases  Retention Increases  Desire For Frequency Protection  Desire For Long-Term Stability 4

Business Moves To ART 5

Types Of Alternative Risk Vehicles  Direct Insurance  Captive Vehicles  Risk Retention Groups  Reinsurance  Capital Market Structures 6

A good forecaster is not smarter than everyone else…he merely has his ignorance better organized 7 Deep Thoughts

pt……….. A Captive………..  Take Prisoner  Keep On Confinement Or Under Restraint  Unable To Escape Source: Oxford English Reference Dictionary - 2nd Edition 8

What Is A Captive………..  Licensed Insurance Company  Formed To Insure Or Reinsure The Risk Of Its Owners Or Unrelated Parties Of Their Choosing  Regulated Under Special Legislation  Located Offshore Or Onshore  Admitted Only In Its Domicile And Non- Admitted In All Other Jurisdictions 9

Captive Vehicles  Single Parent  Group / Association  Rent-a-Captive / Cell Type 10

Captive Vehicles - Single Parent  A Licensed Insurance Company Primarily Designed To Insure The Risks Of The Parent  Generally One Shareholder And ‘One’ Insured  Migrated To Multiple Insured 11

Captive Vehicles - Group / Association  Stock Or Mutual Or ‘Single Parent’  Homogeneous Or Heterogeneous  Multi Line  Fully Pooled, Layering Of Losses And Sharing By Participants Within Layers  Aggregate Limits, Securitization Of Gaps 12

Captive Vehicles – Rent-a-Captive / Cell Type  R-a-C - ‘Pooled’ Resources, But Separate Fully Collateralized Programs  Access To ART Market Without The Capital Outlay, Administration  Segregated Portfolio / Protected Cell  ‘Legalized’ R-a-C  Tax Deductibility Issues Pooling / Sharing Within Cells  Biggest Concern - New Untested Legislation 13

IRS Tax Deductibility Test  Existence Of Risk Transfer  Presence Of Risk Distribution  Case Law Matching  Unrelated Premium Or ‘Single Parent’ 14

Captive Vehicles - Why?  Traditional Cash Flow, Reduced Costs, Direct Reinsurance Placement  Recent No Option - Cannot Afford Or Cannot Find  Control Own Destiny 15

Captive Vehicles - How?  Feasibility Months, c. $25k  Implementation Months, From $15k  Capitalization From $120k  Administration From $75k 16

A novice uses statistics like a drunkard uses a lamppost…for support, not illumination 17 Deep Thoughts

Captive Vehicles - Where?  Basically Anywhere  Onshore Vermont Hawaii  Offshore Bermuda  Cayman 550, 47 New In 2001, 70 Plus In 2002? 18

Captive Domiciles - What to Look For?  Accessibility  Flexibility  Stability  Infrastructure Physical Professional Legislative 19

Go Off-Shore - “Less Regulation”  Cayman Islands Removed From FATF Blacklist IMF Visit Tax Treaty Regulator – Autonomous – Enforcement Powers – On Site Inspections  Know Your Customer 20

Healthcare Captive Vehicles - Where?  Cayman Islands  Healthcare Captive Capital  Harvard Group Started And All Followed  180 Healthcare Related Captives  One In Three Of The Market  $800m In Premium  $4B In Assets 21

Risk Retention Groups  All Insureds Are Members (Owners)  Single State Domicile  Registration In 49 States  Can Eliminate Need For Fronting  Subject To NAIC Reporting Requirements  Higher Capitalization Requirements 22

Alternative Risk Finance Captive Option  Advantages Long-Term Solution Generate Investment Income Benefit From Experience Tax Advantages Access Reinsurance Control Of Destiny Executive Focus  Disadvantages Assumption Of Risk Costs To Form And Operate Internal Costs Restricted Capital Fronting Challenges 23

Captive Option Role of Primary Carrier  Fronting Vehicle  Claims Management  Underwriting / Actuarial Report  Excess Of Loss Or Quota Share 24

Captive Option Role Of Reinsurers  Underwriting and Actuarial Support  Excess Of Loss And Quota Share  Loss Portfolio Transfers  Capacity Support 25

Facts are stubborn, but statistics are more pliable 26 Deep Thoughts

Goal:Achieve Efficient Frontier Of Risk Retention / Risk Transfer For Mutual Benefit Of Buyers And Underwriters Excess Alternative Risk Structures Types Of Structures  Annual Aggregate Deductibles (AAD)  Buffer Layers  Commutation Options  Co-Insurance  Swing Rating Plans  No Insurance 27

Example: Current Retention =$5 Million Each And Every Renewal Retention =$10 Million Each And Every Annual Aggregate Deductible 28 Comments:  Insured Has Protection For Frequency Of Severe Losses  Insurer / Reinsurer Gets Larger Risk Margin  Works Better On Excess Layer AAD Approach: Renewal Retention =$5 Million Annual Aggregate Deductible = $5 To $10 Million

Example: Current Retention =$2 Million Each And Every Renewal Retention =$5 Million Each And Every Buffer Layer 29 Buffer Approach: Renewal Retention =$3 Million Each Loss First Excess Layer = $2 Million Per Loss / $4 Million Agg. Comments:  Insured Maintains Comfortable Retention Level  Insurer / Reinsurer Collects Premium At Significant Rate On Line And Losses Are Capped  Traditional Excess Attaches Above Buffer Layer  May Be Enhanced With Commutation Option

Example: Insured Has Option To Commute Coverage And Assume The Previous Insured / Reinsured Risk Retrospectively Commutation Options 30 Formula: Gross Written Premium –Expense Component – Risk Margin +Accumulated Investment Income =Experience Account Commute At: 24 Mos. Post Expiration =100% Of Experience Account 36 Mos. Post Expiration =75% of Experience Account 48 Mos. Post Expiration =50% of Experience Account After 48 Mos. = Option Lost

Comments:  Works Better On Working Layers Or On First Excess Layers  Insured Has Retrospective Look At Losses Before Assuming Higher Retention  Contract Documentation Is Critical  Insured Solvency Is Important  Initial Premium Is Higher Than Similar Deal Without Commutation Commutation Options 31

Like dreams, statistics are a form of wish fulfillment 32 Deep Thoughts

Other Approaches  Swing Rates  Co-Insurance  Indexing 33 Comments:  Designed To Protect Underwriter, But Give Benefit Of Favorable Experience To Insureds  Work Best In Working Layers  All Are Re-emerging As Rates Increase

The “No Insurance” Option  Formal Self Insurance Vehicle Captive Trust  Prudent Funding Level Actuarially Developed Limits Consistent With Balance Sheet And Industry  Modified Negotiation Postures No Insurance Community Support 34

The statistics on sanity are that one out of every four Americans is suffering from some form of mental illness. Think of your three best friends. If they’re okay, then it’s you. 35 Deep Thoughts

Material Underwriting Issues  Insured / Reinsured Funding Levels  Claims Management  Loss Control / Risk Management 36

Alternative Risk Structures The Future  Clearly Market Driven And Utilization Will Increase  Preserves Premium (And Hopefully Underwriting Profit) For Commercial Insurers / Reinsurers  Downward Bias In Retention Levels And Risk Margins As Market Softens 37

Statistics are like bikinis…what they reveal is suggestive, but what they conceal is vital. 38 Deep Thoughts

Questions And Answers Alternative Risk Approaches 39