RISK POOLING – KEY CONSIDERATIONS FOR

GROUP AND PURE CAPTIVES

Doug MacGinnitie, River Oak Risk, LLCPhyllis Ingram, Carr Riggs & IngramRick Kohan, FCAS, MAAA, NCDOI

AGENDA

IntroductionsRisk Pooling: Origin, Purpose, & Types of PoolsRisk Pooling: From An Auditor’s PerspectiveRisk Pooling: From A Regulator Perspective PATH Act Of 2015 Impact On Risk Pooling Questions

RISK POOLING:ORIGIN, PURPOSE, AND TYPES OF POOLS

RISK POOLING – WHAT IS IT?

• Risk Pooling is essentially sharing of risk. • It is a method using the law of large numbers to

spread and distribute risk, therefore conceptually making losses more predictable.

• It is the core of the concept of insurance.

HISTORY OF RISK POOLING

• Risk Pooling has been traced back to Roman times and was used by soldiers in the Roman Legion. When soldiers went to war, they pledged to take care of the families of their fellow warriors who died in battle. Each soldier put in a little bit of money so there would be enough to help a family that suffered a loss.

• Risk Pooling emerged as a real concept much later in the 1600s at the same time certain concepts of mathematics began to be developed. The concept of probability became widely known at that time and is a core concept used in successful Insurance/Risk Pooling.

REASONS FOR RISK POOLING

• Diversification of risk amongst a number of different insureds to fund losses, results in more predictability and profitability of the particular insurer’s business.

• Lay off risk to multiple parties versus concentrating on one or a small number, thereby reducing loss costs across the board.

• Generate larger premium amounts to fund losses.• Required by law (State or Federal) either to satisfy certain

insurance company taxation requirements or to protect solvency of insurers.

EXAMPLES OF RISK POOLING

• Commercial Insurance - Homogeneous and Heterogeneous risks pooled through different lines of coverage offered by an insurer.

• Group Captives - Homogeneous or Heterogeneous captives covering certain specified risks. Each insured participant has retained risk related to each line of coverage and a shared or pooled risk, usually on an excess basis to the retained risk. Participants are actually shareholders in some of the companies, while others are insureds but ones that receive shared profits related to the entire entity performing well.

EXAMPLES OF RISK POOLING (CONTINUED)

• Association Captives - companies in the same industry join a Captive put together by a business association. Typically providing primary casualty and possibly property coverage to its members.

• Pure Captives - participate in a reinsurance pool for certain types of risks, like worker’s compensation, to meet federal tax risk distribution requirements, or pooling for many different types of risks to meet federal tax risk distribution requirements.

• Commercial Reinsurance - pool risk from a number of commercial insurers, can be Homogenous or Heterogeneous risk.

RISK POOLING:FROM AN AUDITOR’S PERSPECTIVE

ISSUE – RISKS WITH LOW FREQUENCY

• Do insurance agreements constitute insurance?• Are premium amounts actuarially priced based on loss

exposure?• Do the coverages have minimal claims history?• Are any claims payments made?

ISSUE – INSURANCE AGREEMENTS

• Are there written insurance agreements that outline the lines of business and coverages with limits?

• Are the written agreements executed by all parties and dated?• Do the written agreements include the specific details of the

pooling arrangement?

ISSUE – CASH FLOWS

• Do the premiums paid agree to what is outlined in the pooling agreement?

• Do the reinsurance premiums disbursed agree to what is outlined in the pooling agreement?

• Are there segregated checking accounts used to receive premiums, disburse premiums for reinsurance, and pay claims of the participants?

ISSUE – CASH FLOWS (CONTINUED)

• Does the captive manager require an accounting of the funds transferred to a pooling entity by CPA firm?

• Do trust accounts exist that hold the premiums received by the pooling entity on behalf of the captive?

• Do the cash balances exceed FDIC limits?

ISSUES – OTHER

• Regulatory - Did the insurance regulators approve the pooling arrangement as part of the licensing process? And does the regulator require filings annually for the pooling entity from the captive?

• Excise Tax – Is the pooling entity a foreign corporation creating Federal excise tax issues for reinsurance premiums paid?

RISK POOLING:FROM A REGULATOR’S PERSPECTIVE

RELEVANT QUESTIONS

– What do regulators consider in their review of Risk Pooling arrangements?

– Has the North Carolina Department of Insurance (“NCDOI”) ever denied a Risk Pooling arrangement?

– What is the NCDOI licensing process for a Risk Pooling entity?

– What does the NCDOI consider in its review of Risk Pooling entities licensed in other domiciles?

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TYPICAL REINSURANCE STRUCTURES

• Quota Share – 51% Quota Share– 53% Quota Share

• Excess of Loss – $750,000 Excess of $250,000– $210,000 Excess of $15,000

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SIZE – NUMBER OF MEMBERS IN RISK

• Many established Risk Pools have 100+ members.• 50 to 100 members is an appropriate size.• The minimum target is 20 members.• The NCDOI provides flexible yet prudent regulation and each

Risk Pooling arrangement is considered on a case-by-case basis.

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WHAT ARE REGULATORS LOOKING FOR IN THEREVIEW OF POOLING ARRANGEMENTS?

• The solvency of the pool is the most critical consideration. For an existing pooling entity, the NCDOI reviews the most recent audited financial statement and actuarial opinion to determine the pool’s financial condition.

• The terms and conditions of the pooling agreements are reviewed for reasonableness and adherence to the NC Captive Insurance Act (“Act”).

• Annually, the NCDOI conducts an analysis of the financial condition of each pooling entity licensed in NC and each pooling entity in which NC licensed captive insurers participate.

The NCDOI’s review does not consider IRS distribution requirements, which are federal requirements and not requirements of the Act.

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HAVE ANY POOLING ARRANGEMENTS BEENDENIED?

During the licensing process, the NCDOI is typically able toresolve any concerns through additional communication with thecaptive insurer applicants and the pooling entity.

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WHAT IS THE NCDOI LICENSING PROCESS FOR ARISK POOLING ENTITY?

• The licensing process for a pooling entity is similar to the licensing process for any Captive insurance company.

• Draft pooling agreements are reviewed for reasonableness and compliance with the Act.

• The amount of risk retained by the pooling entity, if any, is considered by the NCDOI when determining the appropriate capital levels for the pooling entity.

• The financial condition of the entities participating in the pooling arrangement are considered during the licensing process of a pooling entity.

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WHAT DOES THE NCDOI CONSIDER IN THEREVIEW OF RISK POOLING ENTITIES LICENSED

IN OTHER DOMICILES?• The NCDOI reviews the audited financial statement and

statement of actuarial opinion filed by the pooling entity with its domiciliary regulator to determine the financial condition of the pooling entity.

• The NCDOI may request information about out-of-state pool participants to determine if they have the capacity to withstand pooled losses.

• The NCDOI communicates with the regulators in the pooling entities’ domicile to determine if any concerns exist.

PATH ACT OF 2015 IMPACT ON RISK POOLING

EFFECT OF PATH ACT CHANGES TOSECTION 831(B) POOLING ARRANGEMENTS

• Little to no guidance except language of one of the ownership diversification rules says no more than 20% of premiums for a small captive making the election can come from one policy holder.

• Does this mean a reinsurance company will be deemed to be a “policy holder” under the new rule?

• What are the options for pooling? One pool with 80% of risk from each captive? Multiple pools dividing the 80% amongst the pools? Commercial reinsurance? Fronted programs?

Thank you for attending our session:

Risk Pooling – Key Considerations for Group & Pure Captives

DISCLAIMERS:

•The information contained in this presentation is for illustration purposes only and not intended to constitute formal tax or legal advice.

•The rules imposed by IRS Circular 230 require us to state that, unless it is expressly stated, any opinions expressed with respect to a significant taxissue are not intended or written by the practitioner to be used, and cannot be used by the recipient, for the purpose of avoiding penalties that may beimposed on the recipient or any other person who may examine this correspondence in connection with a Federal tax matter.