AvengerInc. is looking for an alternative risk financing tool to manage their risk. The company is deliberating the option to develop their own pure captive. The following are costs entailed in the formation. As the risk consultant for the company, yourjob is to evaluate the feasibility of this option and advice the company if they should adopt the option.

To form a pure captive as their licensed reinsurer, Avengerneeds to invest in an initial fee of $375,000 and annual captive administration fee of $95,000. The overhead expenses to operate their own captive is $50,000 per annum. Since the captive will be formed as a reinsurer, the formation requires mediation from a fronting company. Thus, Avengerisrequired to use a fronting insurer, and this involves a$72,000 in yearly fronting fees. The fronting fee will be paid upfront and at the end of every year in which the captive remains active. During the last two years of the project period, Avengerwill enjoy a 5% discount on the captive administration fee and the fronting fee.

Without the captive, Avengerwill have to resort to the traditional insurance plan, which required them to pay an annual premium of $800,000 per year. Their estimation shows that by using their own captive, they will enjoy an 35% insurance premium savings per annum. Insurance premiums are paid at the beginning of each year. The initial process will involve a five-year trial period and the contract has the following additional information: The pure captive does not obtain premium tax deductibility; thecost of capital is 6.75% and corporate tax rate is 34%.

a) Show the cash flows that would occur over the 5 years (round off ALL amount to the nearest dollar).

b) Calculate the Net Present Value (NPV) of this project. Based on the NPV calculation, should AvengerInc. formtheir own captive? Justify your answer.

c) AvengerInc. is totally committed to develop their own captive reinsurer even if the project is not profitable. As theirrisk consultant, you need to make changes in the captive formation plan so that the development of a captive will be beneficial and profitable to Avenger. Theoretically, suggest TWOstrategiesthat couldbe implemented so that the project becomes profitable to Avenger Inc., so that they could proceed with the captive formation.

 

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