How to measure and increase the value created by your captive insurer

1
IRM Risk Forum 2008raising the game

• How to measure and increase the value created by
  your captive insurer
• Erik Johnson, BComm, MSc, ACII, MIRM
• Manager, Deloitte Touche LLP
• Corporate Finance Insurance Practice

2
AgendaAn interactive session

• Understanding the captive market
• Captive value
• Case study
• In practice
• What next?
• Conclusions

3
Understanding the captive marketCaptive insurers
take on various forms

Reinsurer(s)
Reinsurance Agreement
Claims Payments
Captive Insurer
Insurance Policy
Ownership
Parent(s) (Insured)
4
Understanding the captive marketCaptive insurers
take on various forms

5
Understanding the captive marketCaptive insurers
take on various forms

PCC Sponsoring Investor
Cell Investor A
Cell Investor B
Protected Cell Company Assets
Cell A
Cell B
Assets A
Assets B
6
Understanding the captive marketSome commonly
cited advantages of captives

• The price of insurance coverage purchased in the
  conventional market typically reflects a
  significant mark-up.

Reduced Cost of Insurance

• Where the insured enjoys a stable and reasonable
  loss experience, a captive affords the ability to
  price insurance coverage accordingly.

Pricing Stability

• Tax advantages might include the tax-favoured
  accumulation of underwriting and investment
  income, deductibility of premiums paid,
  deductibility of loss reserves and reduced
  premium taxes.

Tax Advantages

• Captives allow parents to aggregate and
  coordinate efficient retention levels and
  insurance programs across various divisions and
  operating jurisdictions.

Global Insurance Programme Coordination

• The ability of a captive to generate investment
  income is an advantage in forming a captive. A
  captive might also offer insurance coverage to
  unrelated customers to generate additional
  profits.

Improved Cash Flow / Profits

• A captive affords direct access to the
  reinsurance market, bypassing insurers,
  eliminating mark-up costs.

Access to Reinsurance

• A captive has freedom to insure risks it chooses
  and customize the terms and conditions of
  policies.

Customized Insurance Programmes

• A captive is free to establish its own claims
  handling policies and procedures. This may lead
  to quicker claims processing and payment.

Improved Claims Handling
7
Understanding the captive marketSome commonly
cited disadvantages of captives

• When the captive is funded, the company must
  allocate funds into an area of operation that is
  not part of the mainstream activities.

Cost of Capital

• A captive involves a commitment of capital and
  start-up costs not incurred with other risk
  financing plans. Some sources state that the
  range of start-up and annual operating costs for
  a captive range from 35,000 to 150,000.

Capital and Start-Up Costs

• Management time required to establish the
  operation in the early stages may be large. This
  may be considerable in terms of effort and cost.
  Management of the parent company may also place
  increased pressure on the captive that would not
  be possible when dealing with a general insurer.

Management Time

• When a company decides to use a captive, there
  must be a firm commitment to a long-term goal of
  lowering costs and absorbing new administration
  costs. The captive is in no way a short-term fix.
  Without a senior management commitment, the
  parent may face unintended tax consequences as
  well as unforeseen exposures via a short-term
  captive strategy.

Long-Term Commitment

• Fronting companies may charge unreasonably high
  amounts for their services (5-15 of premium
  written).

Availability of Fronting

• Reinsurance may not be available at a level that
  sufficiently reduces the uncertainty of retained
  losses with the captive.

Availability of Reinsurance
8
Understanding the captive marketSetting captive
strategy - in practice

• Factors Important When Setting Captive Strategy

Source Marsh and MMC
9
Understanding the captive marketGrowth in the
formation of captives is predicted to continue to
2010
Source Insurance Information Institute
10
Understanding the captive marketThe majority of
FTSE 100 companies have captives

• FTSE 100 Company Use of Captives (2006)

FTSE 250 Use of Captives (2006)
Source Marsh, Fit for purpose 2007 report
Source Marsh, Fit for purpose 2007 report
11
Understanding the captive marketLong-tail risks
dominate business written by UK owned captives

• Business Written by UK Owned Captives (2006)

Source Marsh, Fit for purpose 2007 report
12
Understanding the captive marketSingle parent
captives are the most popular captive structure

• Types of Captives Globally (2006)

Source CRADD 2006
13
Understanding the captive marketTop captive
domiciles for global 1,500 companies by revenue
Source OAN
14
Understanding the captive market How to assess
captive domiciles

• Key Criteria When Assessing Captive Domiciles

Source Deloitte
15
Understanding the captive market Illustrative
comparison of captive domiciles

• Gibraltar background
• A British overseas territory which shares a
  border with Spain
• Joined the EU in 1973
• Population 28,605
• Official language English
• Direct flights from London and Madrid
• Currency Sterling

• Luxembourg background
• Independent sovereign state
• One of founding countries of EEC
• 52 miles long and 32 miles wide
• Population of 459 500
• Official language French
• 100 insurance companies
• Stable social, political and economic environment
• Currency Euro

• Guernsey background
• British Crown dependency in the English Channel
• Not an EU member
• Population 65,573
• Close proximity to London and Europe
• Popular captive and offshore financial domicile
• History of political stability
• Currency Sterling

16
Understanding the captive market Trends in the
captive market

• The rate of growth in on-shore US captive
  domiciles is increasing and this trend is likely
  to continue into the future. Vermont currently
  has more captives than all other US domiciles
  combined.

Onshore US Growth

• Newer domiciles such as Malta, Dubai, and New
  Zealand have yet to develop into major captive
  domiciles. However, the continued emergence of
  new domiciles suggests competition for captive
  business may increase.

New Domiciles

• Many companies are taking advantage of the Single
  Market by using an EU/EEA based captive to write
  into the EU. In particular, US companies appear
  to be taking this approach.

EU Passporting

• More captives are incorporating independent
  non-executive directors on boards, boards are
  more regularly reviewing captive financial data,
  and more captives are establishing audit
  committees.

Governance

• The International Association of Insurance
  Supervisors is currently drafting a guidance
  paper relating to the regulation of captives that
  should be issued in 2008. The aim is to set more
  globally consistent standards for the regulation
  of captives.

Regulation

• Significant growth in captive formations is
  expected to continue in the PCC market with more
  jurisdictions allowing PCC type structures and
  implementing more sophisticated PCC style
  legislation.

PCC Market Growth

• The potential impact of the EUs Solvency II
  regime may have a negative impact on the growth
  of EU domiciles and may lead some captives to
  consider re-domiciling to jurisdictions with more
  flexible regulation.

Solvency II
17
Questions / Discussion
18
Captive valueMeasuring captive value
Theoretical Benefits of Captives
Measuring Cost of Risk
Enhanced / tailored coverage
R E D U C E D C O S T O F R I S K

• Quantitative academic research is limited
• Lack of publicly available information
• Owners of captives have this information

Improved claims handling
Creation of profit centre
Reduced cost of insurance
Premium stability
Tax advantages
Coordinated retention
Improved cash flow
Access to reinsurance
Global insurance program
19
Captive valueWhy measure captive performance?

• Stakeholders could include
• Policyholders (i.e. insureds)
• Chief Financial Officer
• Chief Risk Officer
• Tax Treasury
• Broker
• Risk Manager

• Value can be
• Subjective
• Objective
• Viewed differently by various stakeholders

It is imperative to identify and define an
objective measure of captive value that reflects
the needs of various stakeholders
Economic Profit Analysis
20
Captive valueThe economic profit framework
Value Creation
Adding Economic Value
Value is created for shareholders when the
benefit of an investment is greater than the cost
ROIC is greater than WACC

• Challenges
• Components of a captives ROIC can be manipulated
• ROIC for captives can vary significantly by year
• Analysis Requirements
• Reliable data
• Independence in review process
• Multi-year approach

21
Captive valueThe maths
Captive Capital
Total Assets Cash Current Liabilities -
(Loans to Parent)
Captive ROIC
Net Operating Profit After Depreciation and
Taxes ____________________________________________
_____ Captive Capital
Captive Economic Profit
(ROIC WACC) X Captive Capital
22
Questions / Discussion
23
Case studyPetrochemical company (PetroCo)

• About PetroCo
• Canadian based petrochemical company
• Listed on TSX and NYSE - 2.3bn USD market cap
• Engaged in the production and marketing of
  petrochemicals and commodity plastics worldwide
• Annual revenue of 6.7bn USD
• Majority of PetroCos shares are held by
  institutional investors

24
Case studyPetroCos captive (Captive)

• About PetroCos Captive
• Pure-captive formed in 1980s
• Domiciled in Barbados
• Established for the following reasons
• Access to insurance not available in the
  traditional market
• Provide competition to the traditional insurance
  market
• Insurance market leverage
• Access more competitive pricing for good risks

25
Case studyPetroCos captive (Captive)

• About PetroCos Captive
• Through its captive, PetroCo invested in
  industry-sponsored insurers created to meet the
  needs of the chemical and oil industry
• PetroCo uses its captive to access reinsurance
  for its business interruption and property damage
  risks through these affiliated reinsurers
• Captive insures and retains auto liability,
  excess general liability, and umbrella liability
  risks

26
Case studyPetroCos captive (Captive)

• PetroCos Captive Management
• Day to day captive management is provided by a
  local captive manager in Barbados
• PetroCos risk management department also has a
  member of its staff who is responsible for its
  captive

27
Case studyPetroCos captive (Captive)

• PetroCos Claims Management
• The vast majority of claims handling for the
  captive is conducted by its fronting company
• For lines of insurance written by the captive
  that are not fronted, claims handling is
  performed by its parents corporate insurance
  broker or a local loss-adjusting firm as
  appropriate

28
Case studyPetroCos captive (Captive)

• PetroCos Captive Policy Issuance
• The captives fronting company handles policy
  issuance for lines of insurance that are fronted
• For lines of insurance that are written directly
  by the captive, policy issuance is handled by
  various other parties
• The captives does have some ability to issue
  insurance policies directly to its parent when
  necessary

29
Case studyPetroCos captive (Captive)

• PetroCos Captive Risk Control
• The captive does not provide any risk control
  services to its parent company
• PetroCo has its own internal risk control group
  that performs these services
• As part of its risk control program, PetroCo
  invites the various insurers and reinsurers
  participating in its insurance program to attend
  its risk control surveys
• PetroCo ensures that its insurers, reinsurers,
  captive, and insurance advisors receive copies of
  the risk control reports generated by its risk
  control group

30
Case studyPetroCos captive (Captive)

• Setting PetroCos Captive Strategy
• Captive strategy is developed by PetroCos risk
  management department and approved by both
  PetroCos vice-president of risk management and
  its chief financial officer
• For example, strategic decisions that are
  reviewed by executive level management at PetroCo
  are significant changes to limits retained by the
  captive
• The evaluation of the performance of PetroCos
  captive is conducted by its risk management
  department and in certain circumstances outside
  consultants are brought in to conduct independent
  reviews

31
Case studyPetroCos captive (Captive)

• Setting Captive Premiums Retentions
• Seek input from corporate insurance broker and
  the captives fronting company
• Risk management department assesses the companys
  general philosophy towards risk
• Chief financial officer and vice-president of
  finance are involved in the retention decisions
  of the captive
• Captive manager is also involved in retention
  decisions
• When assessing captive retentions PetroCo uses
  outside actuarial expertise

32
Case studyPetroCos captive (Captive)

• Reviewing Captive Strategy at PetroCo
• PetroCo reviews its captive insurance strategy
  every few years
• In 2005 it conducted a review of its captive and
  asked the question, should it have a captive?
• The company wanted to re-evaluate its need for a
  captive and to assess the benefits that its
  captive brought to the firm

33
Case studyPetroCos captive (Captive)

• Reviewing Captive Strategy at PetroCo
• Its independent review of its captive insurance
  program included a review of
• captive reserves
• classes of insurance written
• premium levels
• retention levels
• reinsurance program structure
• intermediation efficiencies such as broker,
  fronting insurer, captive, and reinsurer cash
  flow patterns
• probability of captive bankruptcy

34
Case studyPetroCos captive (Captive)

• Reviewing Captive Strategy at PetroCo
• The review used pro-forma financial statements,
  risk modelling, and trending to assess the
  viability of the captive under various scenarios
• Importantly, the captive review analyzed the
  scenario of PetroCo without a captive
• This analysis also recognized that there would be
  costs to PetroCo in closing down its captive such
  as run-off expenses

35
Case studyPetroCos captive (Captive)

• Reviewing Captive Strategy at PetroCo
• The analysis found that it might be possible to
  complete PetroCos insurance program without its
  captive
• However, actual attempts by PetroCo to execute
  such a strategy in the past had failed
• The independent review recommended that PetroCo
  continue to use its captive as it is deemed an
  efficient and effective means of managing its
  insurance risks

36
Case studyMaths reminder
Captive Capital
Total Assets Cash Current Liabilities -
(Loans to Parent)
Captive ROIC
Net Operating Profit After Depreciation and
Taxes ____________________________________________
_____ Captive Capital
Captive Economic Profit
(ROIC WACC) X Captive Capital
37
Case studyPetroCos captive (Captive) Year 6

• Captive Capital

• Total assets - 34,991,645
• Cash 703,715
• Unearned premium reserve - 1,469,065
• Non-interest bearing current liabilities -
  52,008
• Advance to parent - 13,000,000
• Captive Capital
• __________________________________
• 19,766,857

• Note
• Advance to parent removed due to it being
  non-interest bearing, unsecured, and funds not
  actually being within the captive

38
Case studyPetroCos captive (Captive) Year 6
Captive Capital
Total Assets Cash Current Liabilities -
(Loans to Parent)35.0m - 0.7m - 1.5m 13.0m
19.8m
39
Case studyPetroCos captive (Captive) Year 6

• Captive Net Operating Profit After Taxes
  Depreciation

• Net underwriting income - 335,832
• Net investment income - 1,899,296
• Administrative expenses - 95,853
• Taxes NIL
• Net Operating Profit After Taxes Depreciation
• __________________________________
• 2,139,275

• Note
• Investment income included as operating income
  due to substantial income generated from
  investment activities, could be considered an
  operating function of a captive / insurer
• No deprecation recorded on this captives income
  statement and Barbados tax rate is nil

40
Case studyPetroCos captive (Captive) Year 6
Captive Capital
Total Assets Cash Current Liabilities -
(Loans to Parent)35.0m - 0.7m - 1.5m 13.0m
19.8m
Captive ROIC

• Note
• ROIC reflects non-rounded inputs

41
Case studyPetroCos captive (Captive) Year 6

• Weighted Average Cost of Capital
• 6.25

• Note
• It is possible to calculate WACC for your
  company, however, using publicly available data
  is quicker. It may also be appropriate to use
  your companys hurdle rate in place of WACC

42
Case studyPetroCos captive (Captive) Year 6
Captive Capital
Total Assets Cash Current Liabilities -
(Loans to Parent)35.0m - 0.7m - 1.5m 13.0m
19.8m
Captive ROIC
Captive Economic Profit
(ROIC WACC) X Captive Capital (10.8 - 6.3) X
19.8m 1.1m
43
Case studyPetroCos captive (Captive) Year 6

• Actual six year economic profit analysis

44
Case studyModified economic profit

• Modified economic profit analysis - Captive
  owners should attempt to quantify the difficult
  to measure costs and benefits of captives, such
  as premium savings over the traditional market,
  and incorporate them into an economic profit
  analysis framework.
• Attempting to incorporate measures of the
  difficult to quantify benefits and costs of
  captives into the economic profit framework for
  captive evaluation should provide captive owners
  a more complete evaluation of the actual economic
  profitability of their captives.
• Quantifying in dollar terms, many of the costs
  and benefits of a captive is difficult. However,
  captive owners should work to develop reliable
  ways to estimate them in order to develop a more
  accurate and all-encompassing analysis of the
  economic profitability of captives.

45
Case studyModified economic profit
Captive Capital
Total Assets Cash Current Liabilities -
(Loans to Parent)
Modified Captive ROIC
Net Operating Profit After Depreciation and Taxes
(Market Premiums Captive Premiums) __________
_______________________________________
Captive Capital
Modified Captive Economic Profit
(ROIC WACC) X Captive Capital
46
Questions / Discussion
47
In practice Real examples of value creation

• A groups cost of insurance reduced by 45 or
  8.0m by consolidating the deductibles of
  operating companies into the captive and
  increasing the combined deductible.
• A captive operated with a combined ratio of less
  than 95 over a five year period and declared a
  steady stream of dividend payments to the parent
  over the same period while being premium
  competitive with the market.

48
In practice Real examples of value creation

• A captive generated a profit of 2.4m from
  underwriting cargo insurance on a competitively
  priced basis for distributors of the parent
  companys products.
• A captive of an entertainment company underwrote
  the risk of explosion for a film production which
  was not insurable on suitable terms and at an
  appropriate cost in the conventional market, but
  which was required by law to be in place.
• 40 million in surplus capital tied up that could
  be released back to the parent company by
  relocating the captive to another jurisdiction.

49
In practice Real examples of value erosion

• A company accumulated four captives, some of
  which were over and under capitalised. There was
  also a complex web of reinsurance and
  co-insurance amongst the captives. After a
  strategic review the company was able to release
  469m million of surplus capital. However, poor
  execution of the transfer of some of the business
  between captives to facilitate the capital
  release led to reinsurance policies not being
  properly novated. This eventually resulted in
  denied claims and disputes between the captives,
  the parent, and reinsurers on a number of
  significant claims which were ultimately deemed
  uninsured.

50
In practice Real examples of value erosion

• Poor governance of a captive resulted in
  third-party (competitor) risks being
  underwritten. Exposures in these contracts
  eventually crystallized and forced the captive
  into run-off. There was also an alleged element
  of fraud in the captive.
• Inability of an inactive captive to wind-up and
  release capital back to its parent due to a lack
  of claims, policy, and reinsurance records.

51
Questions / Discussion
52
What next?Options to enhance value or reduce
erosion
Illustrative ranking of options
High Time to Execute Low
Status quo
Low Cost High
53
What next?Options to enhance value or reduce
erosion
Illustrative ranking of options
High Time to Execute Low

• Evaluate Captive Value Chain Captive owners may
  be able to increase the value of their captives
  by examining the captive insurance value chain,
  re-tendering captive service relationships, and
  establishing and monitoring service level
  agreements to reduce captive expenses and improve
  service levels.

Evaluate captive value chain
Status quo
Low Cost High
54
What next?Options to enhance value or reduce
erosion
Illustrative ranking of options
High Time to Execute Low

• Change Underwriting Strategy A change in
  underwriting strategy may improve the economic
  value generated by a captive.

Change underwriting strategy
Evaluate captive value chain
Status quo
Low Cost High
55
What next?Options to enhance value or reduce
erosion
Illustrative ranking of options
High Time to Execute Low
Release excess capital

• Release Excess Capital Releasing excess capital
  back to the parent frees up funds to be
  reinvested in the parents operations.

Change underwriting strategy
Evaluate captive value chain
Status quo
Low Cost High
56
What next?Options to enhance value or reduce
erosion
Illustrative ranking of options
High Time to Execute Low
Sale or transfer
Release excess capital
Change underwriting strategy
Evaluate captive value chain

• Portfolio Transfer Transfer lines of captive
  business that a parent no longer wishes to
  underwrite to an insurer via a portfolio
  transfer.
• Sale A market exists for captive owners that do
  not feel that their captive is adding value or
  that having a captive no longer fits within a
  firms overall risk strategy.

Status quo
Low Cost High
57
What next?Options to enhance value or reduce
erosion
Illustrative ranking of options
Run-off
High Time to Execute Low
Sale or transfer
Release excess capital
Change underwriting strategy

• Run-Off If the sale of a captive is not
  possible, a firm may decide to put its captive
  into organized run-off and finally liquidation.

Evaluate captive value chain
Status quo
Low Cost High
58
Questions / Discussion
59
ConclusionsKeys to assessing captive value

• Annual Review of Captive Performance - Captive
  owners should adopt an economic profit framework
  to conduct annual reviews of the performance of
  their captives.
• Regular Strategic Review of Captive Performance -
  Captive owners should conduct actuarial and
  strategic reviews of their captives at least once
  every underwriting cycle (e.g. every five to
  seven years) to ensure that captives are adding
  value and being used to maximize the wealth of
  their owners.

60
ConclusionsKeys to assessing captive value

• Independent Service Provision - To eliminate any
  real, apparent, or potential conflicts of
  interest that may arise in the provision of
  captive and insurance related services, captive
  owners should use an entity that is not
  affiliated with their insurance brokers or
  captive management firms to conduct reviews of
  their captives.
• Integrated Approach to Captive Performance
  Evaluation - Checklists and analytical techniques
  should be developed to assess how captives add
  value relative to their stated objectives.
• Disclosure of Captive Captive owners should
  evaluate the benefits and risks of disclosing
  captive ownership in their annual reports in
  light of regulatory and corporate disclosure
  trends.

61
Questions / Discussion
62
Your Presenter
Erik Johnson Manager - Corporate Finance
Insurance Practice Direct 020 7007
1454 Mobile [phone] Email
erikjohnson_at_deloitte.co.uk

• Current role
• Erik is a Manager within Deloittes Corporate
  Finance Insurance Practice in London. Prior to
  joining Deloitte, Erik completed an MSc in
  Insurance Risk Management from Cass Business
  School. He was previously employed as a Client
  Manager with Marsh Canada Limited, where he
  completed its Graduate Training Program, and as
  an Associate with The FirstCity Partnership in
  London. Erik holds a Bachelor of Commerce degree
  with a joint concentration in Finance, Risk
  Management, and Insurance and his ACII and
  Chartered Insurance Practitioner qualifications
  from the Chartered Insurance Institute. He also
  completed a Diploma of International Business
  from Viennas University of Economics and
  Business Administration and is a Member of the
  UKs Institute of Risk Management.
• Examples of recent experience include
• Conducted a review of the in-house insurance
  broking and risk management strategy of an
  international car manufacturer to identify areas
  for improvements against best practice standards
  and presented recommendations for improvement.
• Regularly conducts corporate and captive
  insurance due diligence projects to investigate
  the corporate insurance and captive insurance
  programmes of firms in support of private equity
  and MA transactions.
• Targeted and profiled potential targets within
  the captive insurance market for a private equity
  fund pursuing a global captive acquisition
  strategy.
• Provided strategic advice to a global financial
  institution to enable controlled growth in the
  its international insurance business. Eriks
  work focused on carrying out detailed competitor
  and country analysis.
• Developed remuneration structure model options
  for the integrated insurance intermediation and
  underwriting business of a global financial
  institution focusing on personal accident and
  hospital cash insurance.
• Regularly conducts commercial due diligence
  projects in support of insurance broker and
  insurer MA transactions in the UK.
• Specialisms / expertise include
• Corporate and captive insurance strategy
• Insurance market strategy
• Insurance market analysis
• Market activities
• Erik presented on the topic of assessing and
  measuring the value of captives at the 2006 RIMS
  Canada Conference and the 2007 Bermuda Captive
  Conference
• Published an article on assessing the economic
  value of captives in Risk Management Magazine
  published by RIMS

63
This presentation is confidential to the
attendees of the IRM Risk Forum Raising the
Game, 15 - 17 September 2008, de Havilland
Campus, University of Hertfordshire, Hatfield, UK
hosted by Institute of Risk Management and
prepared solely for your information in
connection with Deloittes presentation at the
conference. Therefore you should not, without our
prior written consent, refer to or use our name
or the presentation for any other purpose,
disclose them or refer to them in any prospectus
or other document, or make them available or
communicate them to any other party. No party is
entitled to rely on our presentation for any
purpose whatsoever and thus we accept no
liability to any party who is shown or gains
access to this presentation. In this
presentation Deloitte refers to one or more of
Deloitte Touche Tohmatsu, a Swiss Verein, its
member firms, and their respective subsidiaries
and affiliates. As a Swiss Verein (association),
neither Deloitte Touche Tohmatsu nor any of its
member firms has any liability for each others
acts or omissions. Each of the member firms is a
separate and independent legal entity operating
under the names Deloitte, Deloitte Touche,
Deloitte Touche Tohmatsu, or other related
names. Services are provided by the member firms
or their subsidiaries or affiliates and not by
the Deloitte Touche Tohmatsu Verein.
Deloitte Touche LLP is a limited liability
partnership registered in England and Wales with
registered number OC303675. A list of members'
names is available for inspection at
Stonecutter Court, 1 Stonecutter Street,
London EC4A 4TR, United Kingdom, the firm's
principal place of business and registered
office. Deloitte Touche LLP is authorised and
regulated by the Financial Services Authority.