© 2005 Towers Perrin March 10, 2005 Ann M. Conway, FCAS, MAAA Call 3 Ratemaking for Captives & Alternative Market Vehicles

© 2005 Towers Perrin 2 Introduction Captive Basics Ratemaking Issues Ratemaking Examples Financial Considerations of a Captive

© 2005 Towers Perrin 3 Captive Basics Types of Captives Domiciles Reasons to Form a Captive

© 2005 Towers Perrin 4 Captive Basics – Types of Captives According to Best’s Captive Directory, a captive can be defined as a closely held insurance company, where much or all of the captive’s business is typically supplied by and controlled by its owners. Single Parent Direct Fronted

© 2005 Towers Perrin 5 Captive Basics – Types of Captives (continued) Group Captive – can be either direct writing or fronted Sponsored Cell Captive (Rent a captive); two ways to share in results Percentage participation Protected cell Risk Retention Group – variant of a captive with a few key differences On-shore vehicle Can write directly Restricted to certain coverages Agency Owned Captive Special Purpose Vehicle

© 2005 Towers Perrin 6 Captive Basics – Types of Captives (continued) A comparison of Captive Structures

© 2005 Towers Perrin 7 Captive Basics - Domiciles Can be either on-shore (Vermont, South Carolina) or offshore (Caymans, Bermuda) Over 30 US States have some form of captive legislation The most popular domiciles are Bermuda, Cayman and Vermont Domicile differences include Capital requirements Regulatory oversight Cost Infrastructure

© 2005 Towers Perrin 8 Captive Basics – Reasons to Form a Captive Cost reduction Benefit from good loss experience Reduce expense Retain investment income Improve cash flow Acceleration of tax deductions Provision of capacity Centralize risk financing Management of retentions Direct access to reinsurance Supporting business partners

© 2005 Towers Perrin 9 Ratemaking Issues – Cash Flows The following chart shows simplified cash flows associated with a captive.

© 2005 Towers Perrin 10 Ratemaking Issues – Data Exposures without losses No closed claims data Combined coverage information Incomplete/inconsistent exposures Missing claim counts Partial loss data

© 2005 Towers Perrin 11 Ratemaking Issues – Industry Statistics Loss development data Size of loss curves Trend Loss costs Statutory changes

© 2005 Towers Perrin 12 Example One – Adding A Coverage to a Captive An indemnification policy for a self-insured workers compensation program where the self-insurer retains the first $500,000 of any occurrence. The company has an existing captive and adding this coverage would allow more diversification in the captive. Analysis Approach Calculate losses limited to $100,000 Develop a limited pure premium Compare large loss experience to industry Incorporate discounting, risk margins and expenses Discounting Approach varies by domicile Investment yield should consider captive asset structure Risk margins may be mandated or elective Closed no pays and/or medical only claims can dampen variability Often data doesn’t reflect “unlimited” severity

© 2005 Towers Perrin 13 Example One – Adding A Coverage to a Captive (continued)

© 2005 Towers Perrin 14 Example One – Adding A Coverage to a Captive (continued)

© 2005 Towers Perrin 15 Example One – Adding A Coverage to a Captive (continued) “Typical” captive expenses can include Captive management Excess or reinsurance Claims handling Actuarial, audit, legal fees Taxes Investment expenses LOC costs Other, including travel and domicile charges In the example the new coverage is assigned a pro-rata amount of expense

© 2005 Towers Perrin 16 Example One – Adding A Coverage to a Captive (continued)

© 2005 Towers Perrin 17 Example Two – Allocating Premiums for a New Group Captive Four physician groups consider establishing a captive to react to increases in premium and retentions Analysis approach Data review Develop an ”experience mod” Apply the mod to industry pure premiums Adjust for policy form, retention level, discounting, risk margins and expenses Data review Exposure information is not provided for all policy years Average values of open claims do not track average paids, nor does frequency track loss volume The data quality appears to vary by entity

© 2005 Towers Perrin 18 Example Two – Allocating Premiums for a New Group Captive (continued)

© 2005 Towers Perrin 19 Example Two – Allocating Premiums for a New Group Captive (continued) Experience Mod Approach Determine at what loss limit it is credible Estimated ultimate losses are calculated by multiplying basic limit incurred losses by loss development factors Ultimate losses are divided by exposures on a base class basis Actual loss costs are compared with expected loss costs to determine an experience modification factor (experience mod) Individual accident year results are weighted (using exposures and reporting patterns) to calculate overall experience mod factors A credibility weighted experience mod is calculated, and an experience mod is selected The selected experience mod is applied to the industry expected loss cost to calculate an experience-modified loss cost The product of the experience-modified loss cost and projected exposures estimate losses for the forecast period Results are then allocated by practice

© 2005 Towers Perrin 20 Example Two – Allocating Premiums for a New Group Captive (continued)

© 2005 Towers Perrin 21 Example Two – Allocating Premiums for a New Group Captive (continued)

© 2005 Towers Perrin 22 Example Three – Develop Premium Estimates for Non-Traditional Exposures Analyze process to generate an insured event Develop frequency and severity (or pure premium) estimates Consider timing of cash flows, expenses and risk margins Example assumes two ways in which a claim could arise: A vaccinated worker contracted smallpox (direct exposure); or A vaccinated worker infected a co-worker (indirect exposure) Estimate claim frequencies for direct exposures and indirect exposures and combine the implied ultimate claims from the two potential exposure sources. The key variables underlying the claim frequency projection are: The percentage of workers vaccinated The estimated percentage of non-vaccinated workers exposed to vaccinated workers The estimated percentage of vaccinated and non-vaccinated workers contracting smallpox

© 2005 Towers Perrin 23 Example Three – Develop Premium Estimates for Non-Traditional Exposures (continued)

© 2005 Towers Perrin 24 Example Three – Develop Premium Estimates for Non-Traditional Exposures (continued) To simplify the example, we assume one of three outcomes (using a workers compensation industry claim categorization) Outcome A - A fatal claim Outcome B - A permanent total claim Outcome C - A temporary total claim Percentage probabilities are assigned to each outcome based on external data and input from the healthcare system and estimated severities are developed for each of the scenarios An overall estimated severity is determined by calculating the weighted average of the estimated cost of the three outcomes The frequency and severity assumptions are then combined to calculate expected losses Expected losses are adjusted to reflect discounting, risk margins and operating expenses.

© 2005 Towers Perrin 25 Example Three – Develop Premium Estimates for Non-Traditional Exposures (continued)

© 2005 Towers Perrin 26 Example Three – Develop Premium Estimates for Non-Traditional Exposures (continued)

© 2005 Towers Perrin 27 Financial Considerations of a Captive There are long-term advantages to prudent pricing Enhancing the flexibility to change the program retention Increasing the ability to raise premiums (i.e., by adding new members to a group captive or adding additional coverage to a single parent captive) Providing the flexibility to support a higher than average level of claim payments in a single year without liquidating assets Positioning the captive to meet solvency requirements of the domicile or a rating agency Some key financial ratios are: The premium to surplus ratio, which reflects a company’s exposure to pricing errors; a range of “normal” leverage ratios for captives is from 1:1 to 5:1 The reserves to surplus ratio, which measures a company’s exposure to reserve errors. A range of reserve to surplus ratios for captives is 3:1 to 5:1. At higher leverage ratios, a relatively small increase in reserve levels would have a significant impact on surplus. Risk retention to surplus ratio – A number of domiciles use the “10% rule” (i.e., a company may not expose more than 10% of its surplus to any single risk or loss)

© 2005 Towers Perrin 28 Financial Considerations of a Captive (continued) Reinsurance is a key tool in “managing” a captive. Uses include: Protection from catastrophe losses Providing capacity Supporting growth Providing an exit strategy