Call 3 Ratemaking for Captives & Alternative Market Vehicles

1. Call 3 Ratemaking for Captives & Alternative Market Vehicles Ann M. Conway, FCAS, MAAA

2. Introduction • Captive Basics • Ratemaking Issues • Ratemaking Examples • Financial Considerations of a Captive

3. Captive Basics • Types of Captives • Domiciles • Reasons to Form a Captive

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

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

6. Captive Basics – Types of Captives (continued) • A comparison of Captive Structures

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

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

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

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

11. Ratemaking Issues – Industry Statistics • Loss development data • Size of loss curves • Trend • Loss costs • Statutory changes

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

13. Example One – Adding A Coverage to a Captive (continued)

14. Example One – Adding A Coverage to a Captive (continued)

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

16. Example One – Adding A Coverage to a Captive (continued)

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

18. Example Two – Allocating Premiums for a New Group Captive (continued)

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

20. Example Two – Allocating Premiums for a New Group Captive (continued)

21. Example Two – Allocating Premiums for a New Group Captive (continued)

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

23. Example Three – Develop Premium Estimates for Non-Traditional Exposures (continued)

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.

25. Example Three – Develop Premium Estimates for Non-Traditional Exposures (continued)

26. Example Three – Develop Premium Estimates for Non-Traditional Exposures (continued)

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)

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