The document discusses captives, which are special purpose insurance companies that insure the risks of their owners. It provides an overview of what captives are, their history and growth, types of captives, benefits of using a captive compared to commercial insurance, considerations for utilizing a captive such as ownership structure and domicile selection, and functions related to managing a captive.

1. AGC / CFMA Conference Self Insurance with Sophistication Are You Ready for a Captive? October 23, 2008 Mark Ouimette, ARM [email_address]

2. What Is A Captive? A captive is a special purpose insurance company that insures the risk of its owners and sometimes related or affiliated third parties. A sophisticated way to self insure. Date back to early 1960’s History of captives Became more popular during insurance crisis periods Today there are over 5,700

3. COST TIME PREMIUMS 1970 1975 1980 1985 1990 1995 2000 2005 2010 LOSSES Market Cycle Impact: Premiums Compared to Losses

4. Growth of Captive Industry* 1970-2008 *Captive Insurance Company Reports Estimate 1970 1975 1980 1985 1990 1995 2000 2005 2010 0 1000 2000 3000 4000 5000 Captive Growth Market Cycle

5. Captive Significance Comprise 20% of Worldwide Corporate P&C Spend Represents Between $55-$60BN Annual Premium U.S. Companies own 57% of the World’s Captives All 30 Companies Comprising the Dow Jones Industrials Construction industry represents 6% of Global Usage – $3.3/$3.6 BN Annual premium spend Source: Marsh Survey Group

6. GENERIC TYPE A.K.A Rent-a-Captives Protected Cell Companies (PCCs) “Cell Captive” Single Parent Captives “Pure Captive” Industry Captives “Group Captive” ASSOCIATION Captives “Group Captive” Risk Retention Group Captives “RRGs” Producer Owned Captives ”For Profit Agency Captive” or P.O.R.C.” Program Business Captives “For Profit Group Captive” Types of Captives and Their Range of Applications From the Simplest to Most Complex

7. Changes in the Traditional Insurance Market Increase in policy exclusions Increase in coverage / definition restrictions Increase in deductible amounts Increase in liberalization by court interpretation Increase in settlement v. trial

8. Why an Alternative to Commercial Insurance? You want to control your destiny You know your risks better than any insurance company underwriter You do not want to be rated based on others and industry losses Certain aspects of “Off the shelf” insurance programs do not suit contractor specific circumstances

9. Captive Ownership The owners of the captive are its policyholders, but also can be 3 rd parties The policyholders have control over management, underwriting, claims, investments, etc. Overall decisions regarding captive operation rests in the hands of the Board of Directors elected by the captive owners.

10. Group Captives Owned by multiple, non-related organizations Designed to insure the risk of these owners Homogeneous – insuring only similar types of business risks Heterogeneous – insuring a wide range of risks Involves risk sharing with others – known and unknown Results in Dividends or Assessments

11. Can be owned by members of a common trade or industry association Can be owned by the Association – Or in combination with members Shares the risks of that industry among its members Possibility of adverse selection Association Captive

12. Why Captives Are Sophisticated? Coverage can be tailored to meet the specific needs of the policyholder(s) Underwriting flexibility to provide coverage where it is unavailable or overpriced in the commercial marketplace Premiums are based on the loss experience of the captive, not on the income and expense needs of an insurance company Premium funding flexibility based on actuarial loss projections via confidence intervals

13. Captive Sophistication continued Accumulated surplus can be used to reduce future premiums or be returned to the policyholders as dividends More incentives for safety programs & loss control Greater control over claim handling Opportunity for premium/loss reserve tax deductibility Insurance company accounting treatment - IBNR Underwriting profit & investment income belongs to the captive, not the insurance company

14. Potential for lower overhead costs so a larger percentage of premium can be used for claim payments or dividends Direct access to the reinsurance marketplace Independence from the conventional insurance marketplace Flexibility – endorsements, cancellations, premiums Potential for tax advantages Access to U.S. Government’s coverage via TRIA Captive Sophistication continued

15. Uses Of A Captive General Liability - Completed Ops / Construction Defect Workers’ Compensation OCIP / CCIP Subcontractor Default (Surety / Performance Bond) Warranty To Fund a Retained Working Loss Layer From $ 0 $ X Builders Risk Earthquake / Windstorm

16. TRIA Excess or Buffer Layer - GL Specialty coverage (Mold etc.) EPLI Professional Liability Difference of Conditions Employee Benefits Uses Of A Captive Continued

17. Captive Utilization By Industry Source: Marsh Survey Group Manufacturing 10% Financial Institutions 20% Construction 6% Chemicals 3% Aviation and Aerospace 2% Other 7% Automotive 2% Health Care 11% Life Sciences 3% Mining, Metals and Minerals 3% Power & Utilities 8% Real Estate 3% Retails and Consumer Products 10% Technology & Telecom 6% Transportation 6%

18. Utilizing a Captive Takes Place of: Traditional Risk Transfer Funded Reserve - Set aside Unfunded Reserve - Current expense Balance sheet accrual

19. How Are Captive Insurance Policies Written? Deductible or SIR Reimbursement Policy Most Common Same coverage as the policy above it No certificate issues Direct Write Policy Common for certain circumstances Manuscript Form Possible certificate issues – No “A” Rating Reinsurance To A Fronting Company Less Common in Today’s Market (popular in 1990’s) No Certificate issues Collateral Intensive - Stacking

20. Hypothetical SIR/Deductible Structure Captive Contractor Insured Excess Insurance Policy $0 $1M SIR $9M Pays Premium Issues Policy Issues Policy Common Ownership Pays Premium

21. Contractor Insured Captive Reinsurer Common Ownership Policy(s) Issued May Purchase Coverage Hypothetical Direct Write Structure Pays Premium

22. Fronting A licensed insurance company utilized by a captive when the type of coverage or entity requires a licensed carrier or an AM Best “A” rated carrier The captive reinsures the fronting carrier for the risk it assumes by having funds ceded it to the captive Fee is usually a percentage of gross premium Collateral requirements

23. Insured Contractor “ A” Rated Ins. Co “ Front” Captive Reinsurer Issues Policy Acts as Reinsurer Common Ownership Hypothetical Fronted Structure Pays Premium Cedes Premium Less Front Fee May Purchase Coverage

24. Domiciles Owners select the jurisdiction where they want the captive to be based – called a “domicile” “ On-Shore” = within the U.S. “ Off-shore” = outside the U.S. Captive must adhere to the laws and regulations of their domicile

25. Domicile Comparison Capitalization Registration & incorporation expenses Premium Taxes Investment restrictions Resident Agent requirements Reporting requirements

26. Domicile Chart Source: Marsh Survey Group Bermuda, 25% Cayman Islands, 12% Guernsey, 6% Ireland, 5% Isle of Man, 3% Luxembourg, 12% Singapore, 3% U.S. - Hawaii, 5% Sweden, 3% U.S. - Vermont, 15% Other (U.S), 6% Other, 5%

27. Who Should Consider a Captive A large general contractor or group of GC’s or Subcontractors with sufficient insurance premium to achieve savings Track record of low loss ratios/safety/loss control Disproportionate premium to policy limits Uninsurable exposures Allocation or Profit Center Opportunity/ CCIP Ability to capitalize Usually 3:1 premium to capital

28. Taxes and Issues Affecting Captive Consider tax treatment Controlled Foreign Corporation IRC 951-964 United States Taxpayer IRC 953(d) Small Insurance Company IRC 831(b) Arrange for professional tax assistance Avoid adverse tax consequence

29. Meeting the Definition of “Insurance” Rev. Rul. 2001-31: economic family theory n/a 12 subs (Rev. Rul. 2005-40) 8 Subs are enough (Malone & Hyde, 1993) 4 Subs might suffice (FSA 199945009) 1 Sub not enough for risk pool (FSA 200202002) 30% third party risk required – Harper Group (CA 9, 1992) 50% third party risk (Rev. Rul. 2002-89) Homogeneity? (FSA 200202002) Risk Measured by written premium received Brother – sister captive Parent Sub 1 Sub 2 Sub 3 Sub 4 Captive Captive Parent Parent-subsidiary captive 3 rd Party 3 rd Party 3 rd Party

30. Who Will Run the Captive? Independent captive management companies International brokers/agencies – captive management arm Reinsurers captive management arms

31. Captive Management Captive Managers have sufficient resources to perform insurance, accounting, underwriting, and claims functions. This can involve the following: Annual reports and filings for regulators Bind coverage and issue insurance or reinsurance contracts Perform banking and investment functions Rate and underwrite risk exposure Issue Policies

32. Captive Management continued Captive Managers have sufficient resources to perform insurance, accounting, underwriting, and claims functions. This can involve the following: Allocate premiums, losses and dividends as needed Adjust claims

33. Typical Structure Captive Insurance Company Issues Policies, Collects Premiums, Disburses Funds to TPA, States, and Feds Insured(s) Domicile Regulator Captive Manager Corporate Legal Counsel Auditor & Tax Bank & Investment TPA Claims Board of Directors Actuary