Long-Haul Trucking currently has an annual self-insured retention of $500,000 per occurrence for both workers’ compensat
Posted: Thu Apr 28, 2022 1:42 pm
Long-Haul Trucking currently has an annual self-insured
retention of $500,000 per occurrence for both workers’ compensation
and auto liability insurance. The combined premium for its
excess workers’ compensation insurance, which pays losses without a
per occurrence limit, and for excess auto liability coverage, with
a $3 million per occurrence, is $2.15 million. Long-Haul is
considering establishing a captive in Vermont to fund its retained
losses. If it forms the captive, it will incur start-up costs
in the amount of $140,000 for licensing the captive and one-time
administrative costs.
If Long-Haul forms the captive, it will be able to obtain
comparable excess coverage in the reinsurance market for an annual
premium of $2 million, for a savings of $150,000. Long-Haul
also plans to use a captive management firm to administer the
captive on an on-going basis. The fees paid to this firm will
increase its total administrative costs by $30,000 per year.
If it establishes the captive, Long Haul also will use a fronting
company arrangement with an insurance company to meet state
requirements concerning the purchase of coverage from an admitted
insurer. The fronting insurer then will reinsure the coverage
with the captive, which in turn will purchase the excess
reinsurance coverage. The fee for this fronting arrangement
is $40,000 per year.
Long-Haul plans to pay the same amount to the captive to fund
its retained losses as it maintains under the current program, and
it will not change the way in which funds are invested. In
addition, it does not plan to write outside business in the captive
or seek to have the transactions with the captive treated as
insurance for federal income tax purposes. As a result,
neither its investment income on assets dedicated to fund retained
losses nor its income taxes will be affected by the establishment
of the captive.
Assume that the captive agreement will be effective for 4 years
as shown below. The cost of capital is 5.7%.
Long-Haul’s tax bracket is 30%. What is the net present value
and internal rate of return? Should the captive be
formed? Support your answer.
(Hint: consider how you would calculate the after-tax cash flow
and use NPV)
retention of $500,000 per occurrence for both workers’ compensation
and auto liability insurance. The combined premium for its
excess workers’ compensation insurance, which pays losses without a
per occurrence limit, and for excess auto liability coverage, with
a $3 million per occurrence, is $2.15 million. Long-Haul is
considering establishing a captive in Vermont to fund its retained
losses. If it forms the captive, it will incur start-up costs
in the amount of $140,000 for licensing the captive and one-time
administrative costs.
If Long-Haul forms the captive, it will be able to obtain
comparable excess coverage in the reinsurance market for an annual
premium of $2 million, for a savings of $150,000. Long-Haul
also plans to use a captive management firm to administer the
captive on an on-going basis. The fees paid to this firm will
increase its total administrative costs by $30,000 per year.
If it establishes the captive, Long Haul also will use a fronting
company arrangement with an insurance company to meet state
requirements concerning the purchase of coverage from an admitted
insurer. The fronting insurer then will reinsure the coverage
with the captive, which in turn will purchase the excess
reinsurance coverage. The fee for this fronting arrangement
is $40,000 per year.
Long-Haul plans to pay the same amount to the captive to fund
its retained losses as it maintains under the current program, and
it will not change the way in which funds are invested. In
addition, it does not plan to write outside business in the captive
or seek to have the transactions with the captive treated as
insurance for federal income tax purposes. As a result,
neither its investment income on assets dedicated to fund retained
losses nor its income taxes will be affected by the establishment
of the captive.
Assume that the captive agreement will be effective for 4 years
as shown below. The cost of capital is 5.7%.
Long-Haul’s tax bracket is 30%. What is the net present value
and internal rate of return? Should the captive be
formed? Support your answer.
(Hint: consider how you would calculate the after-tax cash flow
and use NPV)