The Purpose of a Captive Captives vs. Traditional Insurance Structuring a Captive Determining the Feasibility and Goals of a Captive Domicile

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2 The Purpose of a Captive Captives vs. Traditional Insurance Structuring a Captive Determining the Feasibility and Goals of a Captive Domicile Selection Partner Selection Operating a Captive Captive Advantages 2

3 Greater Control over Claims Increased Coverage Underwriting Flexibility Access Reinsurance Market Incentive for Loss Control Reduced Insurance Costs Pricing Stability Purchase Based on Need Tax Benefits Investment Income Capture Underwriting Profit Improved Claims Review and Processing 3

4 Risk Management Minimize Costs and Maximize Profits Coverage for Your Changing Needs Complement Estate or Business Planning Strategies 4

5 Design the captive with risk management as the primary focus, for valid business purpose Adhere to IRS Revenue Rulings and all available guidance including requirements for Risk Shifting and Risk Distribution Assure that the captive is operated as a bona fide property & casualty insurance company in accordance with the accepted business plan and a reasonable investment plan Underwrite policies that offer meaningful coverage at appropriate premium levels Avoid structures that are too good to be true in order to generate predictable results 5

6 Independent Distributor Purchase Warranty Reduced Product Cost = Cost of Warranty Company Insurance Premium Insurance Policy Reinsurance Front for Company Captive Program Premium Captive X 12.5% Quota Share Underwriting Profit Trust X

7 Each Captive receives $926,375 share of Premium Primary Insurer (front) Each Captive receives $926,375 share of Premium Captive 1: Owned by Trust #1 Captive 2: Owned by Trust #2 Each Captive pays quota share of Claims Captive 5*: Owned by Trust #5 Captive 6*: Owned by Trust #6 Captive 3: Owned by Trust #3 Captive 7*: Owned by Trust #7 Captive 4*: Owned by Trust #4 Captive 8*: Owned by Trust #8 7

8 Feasibility Studies 8

9 Premium payments made by the operating company allow the client to further manage business risk and should be tax-deductible as ordinary and necessary business expenses Captives which make an election under IRC Section 831(b) collect annual premiums of $1.2MM or less and are entitled to attractive tax benefits Premiums received by the captive are tax-exempt under the annual $1.2MM premium test Captive underwriting profits and surplus accumulation are also tax-exempt; only investment income is taxable annually 9

10 Considerations: Responsiveness of Regulator Availability of service providers Capital requirements Investment restrictions Underwriting restrictions Tax rates 10

11 Captive Manager Actuarial Firm Legal Counsel Audit Firm Financial Advisor Tax Counsel 11

12 Accounting consolidation Timing of Audit Cost considerations Captive Manager Self-Managed Captives 12

13 Company: Large manufacturer with large retentions on GL program Problem: GL carrier wanted $100K to front the program, plus $2.5 million in collateral. The company needed insurance policy evidence to satisfy customer contractual requirements Solution: Established a captive, costing $60,000/year to run. Issue certificates. Collateral is lent back to the parent corporation Results: $40,000/year in savings, $2.5 million improved liquidity

14 Company: Engineering firm with Marine Services subsidiary Problem: Captive was previously established to provide certificates for professional liability similar to Example #1. During the marine renewal, negotiations with the hull underwriter were not going well. Large premium increases were proposed for the vessel fleet, despite a favorable loss ratio Solution: The company calculated a loss pick to place the program with their captive. They told the commercial underwriters to renew within $10,000 of the loss pick, or we are putting it into the captive. A quote within the requested range magically appeared the next day. Results: The program was renewed, saving well over $100,000

15 Company: Large chemical manufacturer Problem: Wanted to reduce variability in self-insured losses from year to year and quarter to quarter. Solution: Joined a group captive to insure its deductibles, including a substantial new retention in the credit risk program Results: $2 million of variability removed; $1.5 million of premium saved on credit risk; $35,000 savings for GL fronting fees

16 Company: Privately owned home builder Problem: Profitable company, but taking risks, ie no product liability or warranty coverage was purchased it s too expensive and we ve never had a claim Solution: Set up a captive owned by the family to insure these risks with a premium just over $1 million per year. Took an 831(b) election. Results: Now, they have $5 million in assets to pay for a problem if one arises (after 4 years), while saving the owner about $350,000 per year in income taxes

17 Company: US-based multi-national post bankruptcy Problem: Huge US tax loss carry forwards aka NOLs. Post bankruptcy, they had virtually no US operations, and a limited ability to use up the US NOLs. Foreign operations are still profitable, paying income tax to foreign governments at an average tax rate of 23.5%. Balance sheet showed warranty reserves of over $50 million Solution: Set up a US domiciled captive subsidiary - insure all uninsured risks - charge premium to local sub s P&L - Make reasonable return in US sub Results: Removed $50 million in liability from the balance sheet. Saved over $10 million a year in taxes. Used up a portion of the NOLs, which would have otherwise expired as useless.

18 Company: Larger retailer with over 300 franchisee owners Problem: Franchisee spending significant premiums via separate programs for GL, Property, WC, and some benefits programs Solution: Company sponsored a captive solution to provide a turnkey insurance solution, in some cases, behind a front company for regulatory compliance Results: This program not only saves franchisees significant premium (and time), the program also generates over $10 million annually in profit for the franchisor

19 Company: A private equity firm with over 70 portfolio companies Problem: Company wanted to utilize a combined D&O program for the firm, as well as its portfolio companies. While this program would save $2 million per year, the required SIR was too high for the individual companies, so it was unattractive Solution: A captive was formed to buy down the deductibles for the portfolio companies to tolerable levels Results: $2 million saved, and deductibles cut in half for the portfolio companies

20 Revenue Ruling The Internal Revenue Service held that a Group Captive Insurance Company - where no shareholder s individual risk exceeded 5% of the total risks of the captive - had sufficient risk shifting and risk distribution Revenue Ruling The Internal Revenue Service abandoned its economic family theory with respect to captive insurance transactions Revenue Ruling Provides a safe harbor determination for risk shifting if a captive has more than 50% unrelated business risk Revenue Ruling Reviews Brother and Sister Operating Subsidiaries and establishes the Rule of 12 for safe harbor purposes Revenue Ruling If the liability of each company is no more than 15% of total risks insured by the captive, significant Risk Shifting and Risk Distribution exists Revenue Notice The service stated that 831(b) no longer should be identified as listed transactions for purposes of disclosure, registration, and list maintenance requirements Revenue Ruling Reviewed cases in which the captive underwrote a significant amount of third party risks, risk distribution and risk shifting were found to be present, even when the captive insurance companies that were wholly owned, or nearly wholly owned by its insured s Revenue Ruling This ruling explains how arrangements between an individual cell and its owner are analyzed for purposes of determining whether there is adequate risk shifting and risk distribution to constitute insurance Proposed Regulations Initial Draft (REG ) On September 14, 2010, the Treasury proposed that domestic series organizations (typically a series limited liability company Series LLC) would be treated as a separate entity formed under local law and general tax principles 20