A Captive Primer: What they are and how

they work

Educate – Evaluate – Elevate

• History of captives & what they are

• How captives are used & what makes a good prospectØ The Captive Wrap Program™Ø Risk Management & TCORØ Key Ingredients of an Insurance CompanyØ Reinsurance

• Various captive structures & expense with a focus on DelawareØ Single Captive Platform Ø Multi-Captive PlatformØ Start-up vs. Annual Expense

• Summary of the captive process

Presentation Objectives

History of Captives

• Captives first used in 1700’s in Europe • Three main markets:

• Europe (Isle of Man, Guernsey, etc.)• Offshore (Bermuda, Cayman, Nevis, etc.)• USA (Delaware, Vermont, Oklahoma, etc.)

• 30+ states currently have captive legislation• Why captives now for the small-mid sized

companies?

The Captive Wrap Program™

Continuum of Risk

Unfunded SelfInsurance

Captive

DeductiblePlan/StopLoss or Excess

Retro Plan/Experience Rated

GuaranteedCost/Fully Insured

P&C

Benefits Equivalent Term

What is a Captive?

• An insurance company you (the insured) own and control

• Can be domiciled on or offshore

• Ownership typically defined by the captive structure

• NOT intended to totally replace a commercial insurance program

• Various captive structures include:Ø Risk Retention Groups

§ Associations or trade groups§ Groups of homogenous risk

Ø Pure (Single Parent) Ø Reinsurance of another insurance carrier (captive or commercial)Ø Enterprise Risk Captive (most elect 831(b))

What Makes for a Good Captive?

• Clear understanding of your own risks & loss history• A belief (based on facts) that the program would be profitable

over time• Sufficient risk to support the captive premium – rule of thumb is

10:1 sales to premium – captive cannot create NOL • Good analytics for quality underwriting standards & pricing• Expert captive design, management & efficient operations• Owners committed to paying appropriate premiums for multiple

years – Captives are NOT short-term options

What is a Captive

Insurance Company

?

Legitimate Business Reason

(Real Risk)

Must Have Distribution

CANNOT be just for

Tax Benefit!!

Must Have Transfer

Legitimate Asset Investment

Pay Claims

Legitimate Governance Quality Reinsurance

Credible Service Providers

Conservative Parental Guarantees or Loan backs

Adequate Capital Domicile Credibility

Key Ingredients

How is a Captive Used?

• Deductible reimbursement & Difference in Conditions (DIC)Ø Raise deductibles and retentions to retain more profit and cut

commercial insurance premiumsØ DIC - covers exclusions and deductibles in your commercial policies, as

well as excess verdicts above your commercial limits

• Risk that is too expensive in the commercial market & uninsured exposureØ Key Contract/Key EmployeeØ Business LitigationØ Product Recall Ø Employee Related Practice Liability/D&OØ Supply Chain RiskØ Business Interruption

• Provide efficient and effective asset management

Enterprise Risk Management (ERM):Total Cost of Risk (TCOR)

Overview: TCOR is the in-depth evaluation of exposure, loss, underwriting and use of capital to reduce risk.

The idea of TCOR has been around since the 1940’s. Traditionally defined:

Ø Cost of insuranceØ Cost of the losses that are retained instead of transferring out, or as part of

your organization—for example, risks the policy doesn't cover, or a company's deductible

Ø Cost for administration of the risk management department (whether you think you have one or not)

Ø TCOR goes beyond just insurance…it’s hiring and retaining the best internal resource, cost of third party service providers (attorneys, CPA’s, etc), payroll perpetuation planning, reputational risk, supply chain risk, and technology or social media risk

Key Factors to Determine InsuranceTransfer & Distribution

Adequate CapitalØ Statutory capital vs. risk capitalØ By end of year, 3:1 premium to surplus ratio

Risk TransferØ Must involve shifting of risk (not just a bank account)Ø Must involve significant chance of a significant economic loss (use of

independent, outside actuary)

Risk DistributionØ Unrelated Risk Model

ü At least 50% unrelated risk - Revenue Ruling 2002-89ü At least seven unrelated entities (Group Captive) - Revenue Ruling

2002-91Ø Brother-Sister Model

ü 12 or more insureds - Revenue Ruling 2002-90ü Each risk must have between 5% and 15% of the overall exposureü Limits on the types of corporate entities that can be counted

Reinsurance

PurposeØ Protect captive against

catastrophic lossØ Preserve CapitalØ Risk Transfer Ø Risk Distribution

StructureØ Cost is 6% of Ceded

Premium (which is 51% of Gross Premium)

Ø On $1M limit, reinsurance pays $300,000 (see diagram)

Ø Only 10% cash is held as a deposit in trust account

Stop Loss Reinsurance

Policy with AM Best A-rated

carrier

Captive Participants

Captive Participants

Captive Participants

Reinsurance

Your Captive

51% of Premium

$650k excess of $300k is

yours

$300k excess of $50k is reinsurers

$50k is yours

831(b) Tax ElectionFor Actual Insurance Company’s Only

Ø $1.2M or less in NET premiums writtenØ Underwriting profit not taxed – ONLY taxed on investment incomeØ May be onshore or offshore (offshore requires 953(d) election)Ø Administrative expenses not deductible (except those having to do with

managing investments)Ø Claims not deductibleØ Net operating loss not allowed to carry overØ Due to attribution in a control group, structure is criticalØ Investments are allowed like any type of captiveØ Most effective in low frequency/ high severity risk models

In our opinion, the 831b election has been seriously abused by promoters that are exclusively pushing the tax benefits of the captive. They are not focused on the insurance and risk management aspects of the captive. This will not hold up.

Captive Structures

Educate – Evaluate – Elevate

Single Parent (Pure) Captive

Captive

Individual or Company

Typical Coverage Examples

Loss of Key Contract/Employee

Reputational Cover

Difference in Conditions

Builders Risk

General Liability Prop/Auto Ded

EPLI/D&O

Business Litigation Code Change

Products/Comp Ops

Use Examples

• Reimburse retentions• Insure low frequency –

high severity coverage• Insure risk of multiple

divisions or subsidiaries of the operating business

• If standalone, statutory capital in DE is $250,000

• If a Series, statutory capital in DE is $50,000

The Series LLC Captive

Why a Series Model?

• Speed of Implementation• Typically more cost

effective:Ø Mgmt FeeØ Audit/Actuarial FeeØ Premium Tax

• Lower barrier to entry – the cell may use the sponsor’s statutory capital until it “grows its own”

• Great for business affiliates

International Risk Insurance Company

(CORE)

Insured-ownedSeries Captive “A”

Reinsurance ProgramEach Captive cedes 51% to Reinsurer

Reinsurer sends back (retrocedes) 51% back to Captive

Insured-ownedSeries Captive “B”

Insured-ownedSeries Captive “C”

$50,000 in Statutory Capital

$250,000 in Statutory Capital

For more information, contact:

Mike Spaan, CEO, InLight Risk ManagementEmail: mspaan@inlightrm.comDirect: 405.443.2012

Or

Jerry Messick, CEO, Elevate CaptivesEmail: jm@elevatecaptives.comDirect: 405.769.8659