Is It Time for a Captive Insurance Company Audit?

1
Is It Time for a Captive Insurance Company Audit?

• Is it Time to Change your ART Strategy?
• June 2008

Michael Zuckerman, JD Senior Vice President,
National Director Healthcare Alternative Risk
Professional Development Aon Risk Services
2
Learning Objectives

• This is not a review of an accounting (CPA) audit
  or a formal insurance department/or governmental
  compliance audit
• Focus is from a risk management perspective
• Purpose is to examine
• Adherence to Best ART Management Practices
• Mission-does it reflect a clear captive purpose?
• Compliance
• Governance
• Board make up
• Cost control
• Strategic Planning
• Are captive board meetings productive to the risk
  management process
• Maintaining Financial Security
• Is current program structure still relevant

3
Characteristics of Successful Alternative
Risk/Self Insurance Programs (ART)

• Well identified objective
• Realistic expectations
• Support of senior management
• Long-term commitment
• Prudent funding
• Careful Underwriting
• Homogenous risk

• Reasonable administrative expenses
• Experienced consultants
• Proactive claims administration
• Dedication to loss prevention
• Fairness
• Involved, committed Board

Source Aon National Healthcare ART Practice
4
Our FocusThe Ten Best Practices of Successful
Captive

• Devise a living mission statement to reflect a
  clear captive purpose
• Establish underwriting discipline
• Build a responsive management team
• Develop board member expertise
• Assume ownership of financial modeling
• Invest in strategic planning
• Provide comparative information in shareholder
  reports
• Ensure capital adequacy
• Devote time and attention to managed investments
• Orient and indoctrinate Insureds

From Katherine WestoverTen Best practices of
Successful Captives, The Risk Report, Vol. XXVI,
No. 8, April 2004.
5
What We May Find Ten Signs of a Stale ART Program

• Same program structure including
  excess/reinsurance untested for more than three
  years
• Same service providers without review for more
  than 5 years
• Reinsurance and/or retention strategy tied to
  market cycles
• Discount rates unchanged despite change in
  interest rates
• Use of discount rate to manipulate funding level
  in a soft market
• Unchecked travel policy
• Perfunctory board meetingsnot tied to the
  indemnitees risk management program
• Senior management not represented at board
  meetings
• Operations not represented at board meetings
• Ignoring ERM opportunities

6
Mistakes That Stale ART Programs Make

• Issuing pay-on-behalf-of policies directly from
  an off-shore captive
• Certificates of Insurance issued on-shore for an
  off-shore captive without a front
• Taking a premium holiday when the captive is
  not financially strong to compete with soft
  market
• Not having a complete history of the coverage
  underwritten by the captive program
• Not understanding when excess or self procurement
  taxes may apply to a captives program
• Not knowing what position a captive takes as to
  insurance vs. non-insurance

Source Aon Healthcare ART Group
7
Qualified Captive Service Providers-Still Meeting
the Captives Needs?

• Captive Manager-- Company
• Captive Manager Individual
• Parent ART legal counsel including tax
• What Bank does the Captive use?
• Who is the custodian?
• ART/Insurance consultant

• Captives Domicile legal counsel
• Actuary
• Auditor
• Reinsurance broker
• Investment manager-is it the same as the parents

8
Auditor

• Is the auditor qualified and independent?
• Is the Audit unqualified?
• If not, are all deficiencies corrected?
• Parent company Auditor
• Is an annual Sarbanes-Oxley procedures audit of
  parent company completed?
• If yes, re these results communicated to the
  Captive Board?

9
Governing the Captive Proactively

• Does the Captive maintain a living mission
  statement?
• Does the Parent(s) Risk Management Group have
  clear operating objectives for the captive?
• Is the Board properly structured and engaged?
• Does the Captive have committees in place?
• Does Captive maintain underwriting guidelines?
• Does the Captive have an Investment Policy?

10
Governing the Captive Proactively

• Does the Captive and/or Service providers provide
  ongoing education for Board Members?
• Does the Board partake in Strategic Planning?
• Are insureds aware of the Captives purpose,
  functions and programs?
• Does the Board periodically have the following
  reviewed
• Organization Documents and Bylaws?
• Performance of Service Providers?
• Selection of Domicile?

11
Is There a Clear Objective for the Captive to
Meet the Parent(s) Risk Managements Goals?

• Strategic vehicle to elevate (or consolidate) the
  risk management function?
• Provide stable and cost effective risk financing?
• Provide the most cost efficient
  insurance/self-insurance possible?
• Vehicle to finance and manage enterprise risk?
• Facilitate access to world reinsurance
  marketplace?
• Accommodate Third Party Business?
• Addressing the parents strategic business plan

12
Captive Mission Statement

• Must reflect the goals of the captivenot the
  parent
• For exampleproviding cheap insurance maybe the
  parent(s) goal but may put the captive at an
  unnecessary financial risk
• Can focus on meeting the needs of its insureds.
• But must promote or identify the clear purpose of
  the captive as an independent subsidiary with its
  own board

13
Is the Board Composed of Those with Expertise and
Authority to Carry Out the Mission Statement?

• How many and are they active?
• Any independent board members?
• Are directors paid a fee?
• Do board members have the time, interest, vision
  and presence to serve?
• Do they possess the needed competencies and
  expertise
• Risk management, claims, and patient and employee
  safety
• Finance
• Legal
• Physician/clinical
• System Board/Senior Management/Operations
• Service providers can supplement expertise needed
• Does the board (if independent?) allow
  management to efficiently conduct of business?
• Set term limits to allow for new blood
• Local directors to facilitate business and meet
  regulatory requirements

14
Is The Captive Board Effective?

• How many meetings does the Captive Board have per
  year?
• Does the board have one or more meetings per year
  in the domicile of the Captive?
• Business purpose?
• Does the Board meet independently with auditors?
• Do Board Members and Management team participate
  in captive governance?
• Is there a strategic planning process looking at
  opportunities arising from parent growth, change
  and ERM?

15
Is There Strategic Planning Process?

• Does the Captive have an established 5 year plan
  that
• Is consistent with the parents long range plans?
• Identifies specific programs for consideration?
• Is periodically quantified with a 5-year
  financial proforma analysis?
• Is monitored to insure financial and other
  performance metrics are consistent with plan?
• Assures that ART is being used to raise risk
  management to the senior management level?
• Examines the use of the captive to fund on an ERM
  basis?
• Pandemic exposures
• Operational losses
• Financial risks

16
Is Board Education a Part of the Meeting Agenda?

• Establish an Ongoing formal Education Program for
  the Board
• Actuarial-funding and managing variation
• Legal, domicile, and regulatory issues
• Status of insurance marketplace by line of
  coverage
• Developments in claims and emerging risks
• Developments in risk management
• Mind and management for conducting business

17
Does the Captive Have Board Committees?

• Are they committees of the parent/insured v. the
  captive
• Audit
• Finance
• Underwriting
• Claims
• Risk Management

18
Are the Board Committees Working for the Benefit
of the Captive and the Insured(s)?

• Membership?
• Responsibilities?
• Reporting to the captive board?
• Large claims
• Ultimate loss development over time
• Loss cost, frequency and severity Benchmarking
• Underwriting issues and cost of risk
• Improving underwriting (cost allocation), claims
  and loss control?
• Improving the parents risk management culture?
• Providing Risk Management grants?

19
Captive Governance-Document Retention

• Does the Captive Manager maintain 10-years of
  historical records of each of the following
• Loss Runs?
• Program Charts?
• Total Cost of Risk?
• Total Cost of Risk per Exposure?

20
Does the Domicile Still Make Sense?

• Domicile
• Offshore v. Onshore
• Political correctness, geography, regulation,
  etc
• Tax Position
• Reinsuring an RRG

21
Is There a Travel Expense (Policy) to protect
Captive Assets?

• Establish a Travel and Expense Policy and Monitor
  Performance
• Consistent with duration of the Board Meetings
• Define allowable expenses
• Only for Board members not spouses
• First class vs. coach airfare
• Documentation of expenses
• Excess benefits issue

22
Are There Board Meetings?

• Preceded by an annual shareholder meeting?
• Does the meeting address regulatory as well as
  operational issues?
• Is the meeting connected to the insureds risk
  management process?
• Who prepares the board book?

23
What is the Quality of the Board Materials?

• Are the Board Books
• Easy to follow and thorough in its contents?
• Professional in appearance?
• Distributed one week or more before the meeting?
• Serve as a historical record and reference?

24
Captive Governance--Miscellaneous

• Does the Board maintain Directors Officers
  liability insurance?
• Understand limitation of coverage under the
  parents program?
• Insurance company errors and omissions?
• Are all books and records resident in the
  domicile?
• Are procedures, controls and operating policies
  documented and tested?
• Are claim reporting and handling systems timely,
  accurate and effective?
• Do the directors and officers have current bio
  affidavits on file with the Department of
  Insurance (DOI)?
• Have all changes in the Business Plan been
  submitted and approved by the DOI?
• Are all Board Meeting Minutes on file?

25
Tax Position Understood?

• Has the parent taken a tax position on the
  Captive (insurance, non-insurance)?
• If the Captive has taken the position that the
  Captive is Insurance
• Is the Parent taking a tax deduction?
• Is the Parent paying Federal Excise tax?
• Is the Parent paying Self-Procurement tax?
• Does the parent take a 953D election?

SourceAon Healthcare PropertyFebruary 2006
26
Tax Position Understood?

• If it has taken the position that the Captive is
  not insurance
• Is the Parent paying Self-Procurement tax?
• Is the Parent paying Federal Excise tax?
• Is the Captive paying Domicile tax?
• Is the Parent or Captive paying Surplus Lines tax
  (fronting)?
• Are there any other tax issues to note?
• If yes, what are the issues?

27
What is the Captives Financial Condition

• Financial strength of reinsurers
• Captive performance
• Solvency
• Liquidity
• Profitability

28
Insurer/Reinsurer Financial Rating for each part
of Program

• Are any current or former insurers or reinsurers
  in liquidation?
• Have all current and executed reinsurance/fronting
  agreements been provided to the DOI?
• Is there a clear and agreed upon claim reporting
  and handling protocol?
• Are per occurrence and aggregate retentions
  monitored correctly?
• Are all reinsurers accredited/admitted and
  eligible for credit?
• Current AM Best, SP, Moody's, Fitch rating, etc

29
How Strong is the Captive Balance Sheet?

• Balance Sheet Items (most recent audited)
• Short Term/Current Assets
• Long Term Assets
• Total Assets
• Stated Reserves
• IBNR/Development Reserves
• Additional reserves for Advance Loss Development
• Additional reserves for ULAE
• Total Loss Reserves
• Adequacy of Capital and Surplus
• If necessary, what is the organizations position
  in the event of a capital call?

30
How Strong is the Captive P and L?

• Income Statement Items (most recent audited)
• Adequate Annual Premium
• Provision for ultimate loss, ALAE and ULAE
  Reserves for Annual Period
• Expenses Other than Reserves
• Net Underwriting Profit (Loss)
• Investment Income

31
Captive Financial Condition-Other Issues

• Are all assets admitted?
• Are all investments in accordance with domiciles
  or fronts collateral regulations?
• Do all of these ratios meet domicile regulatory
  guidelines?
• Is the actuarial opinion signed, unqualified and
  shows any adverse comments?
• What does the CPA Audit Management Letter say
  about systems and accounting deficiencies?

32
Accounting Issues

• Has FASB 5 and FASB 60 been applied?
• Tail
• IBNR
• DDR
• ALAE and ULAE
• Has FASB 113 been applied to prospective and
  retrospective contracts?
• Risk Transfer Testing
• Deposit accounting for contracts that dont
  transfer significant risk
• Other Accounting issues?
• FIN 48

33
Is the Captive Profitable?

• Ratios
• Expense Ratio
• Expenses other than reserves/Annual Premium
• Loss Ratio
• Loss Reserves for Annual Period/Annual Premium
• Combined Ratio
• Expense Ratio Loss Ratio
• Operating Ratio
• (Loss Reserves for Annual Period Expenses other
  than Reserves) / (Annual Premium Investment
  Income)
• Annual Investment Rate of Return
• Investment Income/Total Capital and Surplus
• Use of retained earnings?

34
Is the Captive Solvent and Able to Pay its
Obligations?

• Meet domicile requirements?
• Or meet domiciles minimum capitalization and
  funding requirements
• Solvency
• Premium to surplus
• 10 of loss reserves
• Reserves to surplus (3 or 4 to 1 is customary
  range)
• Liquidity
• Ability to pay claims over the near term
• Relevant assets gt75 of relevant liabilities

35
Establish Financial Performance Indicators for
the Company
36
Captive Structure

• If Captive is pure, are all insureds owners,
  affiliates or controlled unaffiliated?

• Type of Captive
• Single Parent
• Industrial insured
• Association
• Risk Retention Group
• Captive is organized as a
• Stock Company
• Reciprocal
• LLC
• Mutual
• Cell Captive
• If cell, number of cells?

Segregated or Protected
37
RRG Structure

• If Captive is organized as an RRG
• Is the RRG in compliance with LRRA as well as the
  domiciles requirements?
• Are all members insureds?
• Are all insureds members?

• Do all members have a financial investment in the
  RRG?
• Do all members have the opportunity to be on the
  Board?
• Is the NAIC filing being completed quarterly with
  adequate disclosures?

38
Analysis of Current Program Structure Policy
Form/Indemnification Agreements

• Analysis of adequacy of layers
• How layers are currently structured vis-á-vis
  losses?
• Opportunities to improve structure of layers?
• Are policy limits adequate?
• Analysis of limits relative to exposures?

39
Analysis of Current Program Structure Policy
Form/Indemnification Agreements

• Number of policies
• Potential for gaps?
• Opportunities to combine policies?
• Identification of duplicative or superfluous
  policies?

40
Analysis of Current Program Structure Policy
Form/Indemnification Agreements

• Terms and Conditions
• Is the Captive policy an Indemnification policy?
• Have any uninsured exposures been identified?
• If yes, what are they?
• Identification of unusual or inappropriate
  exclusions?
• What are they?
• Identification of other problematic wording?
  Describe
• Does coverage include Batch wording?
• Are Punitive Damages covered?
• Recommendations for enhanced terms and conditions?

41
Analysis of Current Program Structure Policy
Form/Indemnification Agreements

• Loss Funding and Premium
• If actuarially determined, what is the Loss
  Forecast?
• What Confidence Level is used?
• Discount Rate (0 if undiscounted)
• Risk factor?

42
Analyzing Reinsurance Commitments

• The captive as a reinsurer
• Is collateral being managed against exposure and
  loss reserves?
• Collateral a function of expected losses or
  aggregate limits?
• Benefit of a Section 114 Trust v. LOC
• Reviewed every 12 months to reflect current
  expected loss level?
• Front fees competitive?
• Minimum v. of funding
• Documents up to date to reflect current program
• Reinsurance agreement?
• Claims management agreement?
• Collateral agreements?
• Reasons for front still needed
• Regulatory?
• Custom?
• Commercial/contract?

43
Captive Direct Issue Excess Policies?

• Reduce frictional costs associated with the
  retail excess and surplus lines market
• 953 d election if offshore domicile no Federal
  Excise Taxes?
• Cost of a reinsurers fronting paper
• Access to a larger global reinsurance market
• More control
• Claims Management and Reporting
• Policy construction
• Program structure
• Reinsuring the horizontal bleed
• Treaty v. facultative market
• Excess of loss v quota sharing layers
• Reinsurers like underwriting captives
• Multiple layers of oversight

44
Are the Regulators Hearing What They Want to Know?

• Periodic meetings with the regulator?
• Business plan amendments filed?
• Loan Backs approved?
• Notice of
• Material changes to the parent(s) operation or
  financial condition
• Material changes to the financial condition
  and/or operations of the captive
• Negative shareholder equity and plan to cure
• Material change in business plan
• Loss of reinsurance and impact
• Change in captive manager
• Recovery plan, if needed

45
Compliance ChecklistRegulatory
Reporting/Activities

• Audited financial statements
• Statutory financial filing requirements
• Paid premium tax
• Certify loss and LAE reserves
• Annual license fees
• New board member proper board resolution,
  notification provided to regulators, biographical
  affidavit completed
• Changes in business plan approved by regulators,
  captive manager, investment policy
• Signed issued policies
• Financial complianceliquidity and solvency

46
Thank You