Actuarial Considerations for Captive Insurance Companies Presented by Allan P. Harris September 11, 2007

Why do we perform captive actuarial valuations in-house?  Develop expertise, cost efficiency over long term  Better understand our data by getting dirty with it

What lines  AL, GL, WC  EE benefits (LTD, GTL) – for now, relying on carriers w/benefits consultant oversight; long- term goal is to develop in-house expertise  Management liability (PL, Bond, D&O, Fiduciary, Employment Practices) – increasing number of data points, still not enough for full-blown actuarial conclusions, rely on combination of actual loss history & market pricing to set our premium rates and reserve levels

Methodology  Casualty: all info is captured in RMIS (Stars)  Triangles are developed For Work Comp, separate CA & Non-CA Separate triangles for major acquisitions Separate triangles for pre-merger, old WFC work comp (completely different development patterns)  Year-over-year and ultimate development factors are computed  For forecasting and premium setting, use industry published law level and inflation factors

Uses  Set premiums for captive  Determine adequacy of reserve levels  Weigh quotes from (re)insurers

ISSUE: Standard triangle and loss development method is incomplete, as it does not price the cost of capital of retained risk, i.e. the potential earnings hit from a large outlier loss within retained limits SOLUTION: Risk models that weigh the probability of various loss levels against the associated costs of risk transfer CHALLENGE/OPPORTUNITY: Risk management departments need to develop (or outsource) this expertise

Third-party Support?  KPMG certifies reserves in conjunction with the audit as required by domicile (Vermont)  Many years ago we had an independent actuarial review, with strong confirmation of our methodology and results

Old Business  Concentric Risk Integration program Multi-year, multi-line – given the spread of risk with “black hole” deductibles and aggregate retention, allowed reasonable estimate of exposure based on loss history (more or less actuarial) Reinsurers are no longer interested in writing this business – not interested in risk transfer in this working layer

New Business  Employee Benefits – Long-term Disability and Term Life Pro: Predictable cost; risk diversification Con: Catastrophe correlation (Life) with other captive lines (WC, Property)  Other – e.g. Lender Placed Hazard, Crop Insurance (and large deductible management liability) Pro: Profitable business; risk diversification Con: Large cat exposure

ISSUE: Deterministic actuarial models (mine) fail to alert management to size and probability of significant loss SOLUTION: Need new tools employing stochastic, random methodology, e.g. Monte Carlo models CHALLENGE/OPPORTUNITY: Need new technical and interpretive skills, software, large amounts of data

Captives : Truth and Fiction  Truths Eliminates third-party insurers’ margins (partially the result of subsidizing companies with poorer risk profiles) Retains cash flow benefits Allows direct control of administrative and claims handling fees Access to cheaper reinsurance market Avoid cyclical hard/soft markets or coverage unavailability Internally, can eliminate volatility for business lines Promotes aggregation and analysis of risks

Captives : Truth and Fiction  Fictions Tax breaks – Same deduction exists from simply buying insurance (captive deduction is less, as IRS requires discounting of captive reserves to calculate the tax deduction); savings derive from reducing commercial insurer profits, not tax breaks Reinsurance of employee benefits puts parent company employees’ benefit programs at risk – No –the insurers, whether in a fronting or insuring position, remain on the hook for these liabilities if captive cannot meet its reinsurance obligations

Contact Information: Allan P. Harris Wells Fargo