Captive Funding – How Do We Know If We Have Enough?

1. Captive Funding – How Do We Know If We Have Enough? June 2008 Tom Stewart Vice President Innovative Captive Strategies Leigh Collier Vice President Risk Management Baptist Health System, Inc.

2. Captive Funding – How Do We Know If We Have Enough? AGENDA Part 1: Understanding the key questions to be asked and answered Tom Stewart, Innovative Captive Strategies Part 2: From Theory to Reality: The BHS Experience Leigh Collier, Baptist Health Systems

3. Captive Funding – How Do We Know If We Have Enough? KEY QUESTIONS TO BE ANSWERED • What is “Captive Funding”? • How does a captive develop its “Funding Strategy”? • What key factors impact funding strategies, and determine whether “what you have is enough”?

4. What is “Captive Funding”? • Key Sources • Paid in or contributed capital and surplus • Shareholder or member assessments • Net premium • Retained earnings • When considering funding adequacy, all • sources should be considered

5. Developing Funding Strategy • Begin with understanding of captive business purpose • Risk retainer versus risk transferor • Short term versus long term risk financing goals • Predictable versus non-predictable risk • - Or both

6. Captive Business Purpose • Risk retainer versus risk transferor • Historical focus of captives was access to reinsurance • Transfer loss frequency and severity i.e. “renting” capital of reinsurers • Current focus is retaining risk in tax and cost efficient manner • A question of whose capital is cheaper • The risk retainer’s purpose is more likely to produce conservative funding strategies • Risk transferors only purpose was funding reduction

7. Captive Business Purpose 2. Short term versus long term risk financing goals • Insureds’ time horizon (to derive benefits from captive program) may differ from shareholder’s • Understand motives of operating company management • Motives may be to reduce funding levels (Compensation may be impacted by pre-loss risk financing) • Shareholder may be looking for conservative funding • Motives may be estate planning or accelerating contract reimbursement

8. Captive Business Purpose 3. Financing predictable versus unpredictable risk • Funding strategy will always be driven by credibility of loss projections • Multiple strategies required for different lines of business in the captive • Not possible to assume that unpredictable risk requires higher funding levels than predictable • Requirements impacted by type of shareholder, type of captive, program structure • Good first step is to begin with understanding of domicile requirements

9. Captive Funding: Domicile Requirements Regulation by ratios vs regulation by business plan • Ratios establish relationship between premium (net of reinsurance) and capital, reserves and capital, and risk retained and capital • Business plans are used in domiciles without statutory ratios • Allow regulator to take into account predictability of losses and rating methodology • Assuming business strategy is capital efficiency, determine whether the business plan regulator is more conservative than the “standard” ratio requirements

10. The Impact of Type of Shareholder • Tax exempts or captive shareholders with NOLs may not care whether the funding is capital or premium • No benefit to acceleration of deduction for premium paid • Exception if collecting premium from tax paying insureds • Tax paying shareholders want to maximize premium and reduce capital to lowest level possible • Regulation by business plan may be preferable, but need to ensure adequate capital at risk (to pass risk transfer tests)

11. Captive Funding: Type of Captive • Group captives typically rely on assessment features to collect more capital or use retrospective rating methodology • Allows for less funding, but creates credit risk • Rental captives typically are fully funded to the participant’s annual aggregate limit • Could allow for posting of LOC in lieu of capital • Make sure funding method does not negate risk transfer (tax and accounting requirement for capital at risk) • Single parent captive has more flexibility but tax payers need to ensure adequate funding • Avoid shareholder guarantees

12. Captive Funding: Program Structure • Fronted captives typically have collateral requirements that drive conservative funding • Ultimate expected losses times 150%+ • Deductible reimbursement programs typically allow the insured’s contractual liability to provide collateral to be transferred to captive, so conservative funding still required • Exception is single parent or rental captives insuring risk with no collateral requirement • Simply fund to a selected loss confidence level or limit set at the maximum probable loss

13. Part 2: The BHS Experience • Baptist Health System, Inc. (“BHS”) • Tax exempt corporation • Operates a multi-facility health care system • Located primarily in northern Alabama and headquartered in Birmingham, AL. • Purchases commercial GL/PL insurance excess of self insured retention • Trust funded • Participated in Reciprocal of America (ROA) • Insolvent reciprocal group • Organizational restructure resulted in divestitures

14. The BHS Captive • Affinity Southeast Insurance Company • Licensed as a Barbados exempt Insurer 2005 • Initial focus was unrecoverable insurance (ROA) and divested entity risks • 2006 added coverage for medical education residents • In 2008 will begin to “buy down” the entire PL/GL SIR for all active entities

15. Ownership and Purpose of Affinity • 100% of captive shares owned by BHS Affinity, Inc. • Holding company for the for-profit entities within BHS (owned physician practices, several joint ventures, and Affinity Southeast) • Captive business purpose • Remove uncertainty associated with risk retention from the operating entities, providing a fixed cost and budgetable premium • Transfer funding for the retained risks of divested entities into a separate risk taking entity

16. Process Used to Set Funding Levels • Unrecoverable Insurance Liabilities and Divested Entity Cover • Written on a “Difference in Conditions/Difference in Limits” basis • Ultimate liability actuarially determined when Affinity was formed • Selected funding (premium and capital) equal to 90% confidence level losses • Monitored semi-annually, as losses paid

17. Process used to set funding levels • Medical Education Residents’ General and Professional Liability • Fund to the actuarially determined ultimate losses but take into account “market” pricing • Objective is to charge residents a “fair” price • Risk management works with captive consultant, actuary, and BHS finance department to agree on loss pick • Pure premium grossed up to cover captive operating costs • BHS contributed additional capital to support this risk • Affinity policy has an annual aggregate limit

18. 2008 Funding Levels • All policies are direct written on “corporate reimbursement” basis • No captive funds used for collateral • Prior to finalizing details of the new business (Active Entity GL/PL) Affinity prepared new five year pro forma projections • Reflects current ROA and Divested Entity liabilities • Projects liabilities for active entity program • Directors will declare dividend of surplus (loss experience has been favorable) • Subject to Barbados statutory solvency ratios

19. Questions Discussed • Should Affinity finance 100% of the BHS active entity retention, or set a captive policy aggregate limit at a lower amount e.g. a 90% confidence level • Directors decided to match captive limit to 100% of the SIR • Satisfies business objective of providing fixed premium to transfer risk from insureds • Captive will not finance 100% of the limit (which falls outside of the actuarially determined MFL)

20. Thank You