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
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
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 Characteristics of Successful Alternative Risk/Self Insurance Programs (ART) Source: Aon National Healthcare ART Practice
Our Focus—The 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 Westover—”Ten Best practices of Successful Captives”, The Risk Report, Vol. XXVI, No. 8, April 2004.
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 meetings—not tied to the indemnitee’s risk management program • Senior management not represented at board meetings • Operations not represented at board meetings • Ignoring ERM opportunities
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 captive’s program • Not knowing what position a captive takes as to “insurance vs. non-insurance” Source: Aon Healthcare ART Group
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 Captive’s Domicile legal counsel Actuary Auditor Reinsurance broker Investment manager-is it the same as the parent’s Qualified Captive Service Providers-Still Meeting the Captive’s Needs?
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?
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?
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 Captive’s purpose, functions and programs? • Does the Board periodically have the following reviewed: • Organization Documents and Bylaws? • Performance of Service Providers? • Selection of Domicile?
Is There a Clear Objective for the Captive to Meet the Parent(s)’ Risk Management’s 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 parent’s strategic business plan
Captive Mission Statement • Must reflect the goals of the captive—not the parent • For example—providing “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
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
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?
Is There Strategic Planning Process? • Does the Captive have an established 5 year plan that: • Is consistent with the parent’s 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
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
Does the Captive Have Board Committees? • Are they committees of the parent/insured v. the captive • Audit • Finance • Underwriting • Claims • Risk Management
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 parent’s risk management culture? • Providing Risk Management grants?
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?
Does the Domicile Still Make Sense? • Domicile • Offshore v. Onshore • Political correctness, geography, regulation, etc… • Tax Position • Reinsuring an RRG
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
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?
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?
Captive Governance--Miscellaneous • Does the Board maintain Director’s & Officer’s liability insurance? • Understand limitation of coverage under the parent’s 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?
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? Source:Aon Healthcare Property—February 2006
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?
What is the Captive’s Financial Condition • Financial strength of reinsurers • Captive performance • Solvency • Liquidity • Profitability
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, S&P, Moody's, Fitch rating, etc…
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?
How Strong is the Captive P and L? • Income Statement Items (most recent audited) • Adequate Annual Premium • Provision forultimate loss, ALAE and ULAE Reserves for Annual Period • Expenses Other than Reserves • Net Underwriting Profit (Loss) • Investment Income
Captive Financial Condition-Other Issues • Are all assets admitted? • Are all investments in accordance with domicile’s or front’s 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?
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 don’t transfer significant risk • Other Accounting issues? • FIN 48
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?
Is the Captive Solvent and Able to Pay its Obligations? • Meet domicile requirements? • Or meet domicile’s 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 >75% of relevant liabilities
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? If Captive is “pure”, are all insureds owners, affiliates or controlled unaffiliated? Captive Structure *Segregated or Protected
If Captive is organized as an RRG: Is the RRG in compliance with LRRA as well as the domicile’s 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? RRG Structure
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?
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?
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?
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?
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?
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
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
Compliance Checklist—Regulatory 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 compliance—liquidity and solvency