EADY HOW TO START A CAPTIVE PLANNING & RATIONALE Reduce TCR and mitigate risk. PERSONNEL Coordinate and involve key stakeholders

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1 EADY ET O HOW TO START A CAPTIVE 2017 PLANNING & RATIONALE Reduce TCR and mitigate risk IMPLEMENTATION Streamline and cover all bases PERSONNEL Coordinate and involve key stakeholders From the publishers of Sponsored by

2 Road to the top is full of risks to be ahead, plan ahead around every corner. To be prudent and prevent economic leakage, entities should and operations are suited for a captive insurance arrangement, evaluate your current and effectively address domestic or cross-border/foreign issues and advise on planning opportunities. Paul H. Phillips III paul.phillips@ey.com Mikhail Raybshteyn mikhail.raybshteyn@ey.com Karey Dearden karey.dearden@ey.com Nikolaos (Nikos) Analitis Global Compliance & nikolaos.analitis@ey.com James Bulkowski Insurance and Actuarial Insurance and Actuarial lisa.martell@ey.com Ernst & Young LLP (EY US) Services Team Innovating Risk Management

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4 HOW TO START A CAPTIVE EY 10 COMMON TRAPS WHEN IMPLEMENTING YOUR CAPTIVE, James Bulkowski and Paul H. Phillips III, of Ernst & Young LLP, lay out the common issues companies implementing a captive may run into The decision to implement a captive is straightforward; however, actual implementation can present significant traps and challenges. Time, premium, capital, taxes and domicile may all have been perfectly laid out in a well done captive feasibility study, but the implementation steps are often downplayed and the complexity overwhelming. Having the right advisers, and knowing the right questions to ask prior to implementation, will help your company avoid traps and time delays that can derail a successful implementation. Trap #1: Assumptions assumptions You have laid the groundwork through the captive feasibility study, but the decision to implement often hinges on a number of key post-implementation assumptions. This is the time to reaffirm those assumptions! Actuarial analysis has a shelf life, and if there is more than six months between feasibility and application submission, this work needs to be redone. Modelling assumptions such as investment return, letter of credit and cost of capital rates may change. A common tax pitfall for a newly formed captive is to analyse the tax impact of the captive entity on a standalone basis rather than analysing it as part of the consolidated group. In year one, the captive will face unfavourable book-to-tax adjustments for unearned premium reserve and loss reserve discounting, so it may appear as though additional tax is due. However, the tax impact must be determined as part of the consolidated group, as the affiliated companies should receive a tax deduction for premiums paid to the captive. is a manager in the Ernst & Young LLP financial services organisation s insurance and actuarial advisory services practice and a member of the US captive services team. She has over 14 years of experience serving the insurance market and is involved in advising captives and commercial insurance clients on insurance and captive insurance matters, and can be reached at or lisa.martell@ey.com James (Jim) Bulkowski James (Jim) Bulkowski is a senior manager in the insurance and actuarial advisory services practice of Ernst & Young LLP s financial services organisation. He has over 25 years of experience in captive and alternative risk financing and is the co-founder of EY s US captive services team, and can be reached at or jim.bulkowski@ey.com. Paul H. Phillips Paul H. Phillips III is a tax partner in Ernst & Young LLP s financial services organisation focused on US federal income tax matters. Phillips has approximately 25 years of experience serving the captive market as a business tax adviser. He is a co-founder and leader of EY s US captive services team and co-leads EY s global captive platform, and can be reached at or paul.phillips@ey.com. Trap #2: Getting the board(s) onboard Forming a new captive entity is often subject to the approval of the parent s board of directors. Not communicating with the board (or C-suite) early and often slows the implementation process. Additionally, captives are companies that require administration and corporate oversight, including the selection of a separate board and the filling of corporate positions. Sometimes, approaching the CFO for a director spot is met with, Wait, what are you doing? and These guys want to see my personal financial holdings? thus bringing a quick end to the project. Socialising expectations early is the key to success. Trap #3: Nightmare on application street Completing a simple 28-page application, with the assistance of a local attorney and professional captive managers, should be a straightforward process. But beware: some applications require personal financial disclosure, police reports stating you have no criminal convictions and other items that many potential board members are reluctant to divulge. Once these challenges are overcome, what you may have expected to be a short application has turned into a 300+ page document with attachments, including company background, actuarial work, feasibility studies and a copy of the 10K. If your company requires a complete legal (internal and/or external) review of these lengthy documents, the process can require more time and effort than initially anticipated. Trap #4: More approvals? Depending on your industry, the selected 8 CAPTIVE REVIEW HOW TO START A CAPTIVE REPORT 2017

5 EY HOW TO START A CAPTIVE domicile and coverages contemplated, you may need to obtain non-captive regulatory approvals. For example, utility companies must obtain regulatory approval for captive costs to be included in their billing to ratepayers. Financial institutions can require know your customer information and approvals from banking regulators that oversee them. Loan covenants should also be considered, and advance approval by lenders may be required. Additionally, depending on local admitted rules in certain countries and the coverages being contemplated, it may be necessary to establish a fronting carrier relationship. While these approvals are not uncommon, it is critical to take steps early in the process to avoid unnecessary violations or scrutiny. Trap #5: Ground control, we have a problem All is well on the flight path to incorporation. The perfect application is submitted including robust actuarial supporting work and solid pro forma financial statements; and a quick turnaround is expected. After six weeks of regulatory review, your captive manager receives a three-page list of questions and additional analysis required. Questions often arise surrounding the premium and loss calculations for unique coverages, aggressive investment returns and other financial assumptions. While a short list of questions is common, the domicile chosen may be new and the licensing staff not seasoned in reviewing captive applications. They may need more time and further explanation of the details. Under tight timelines, a pre-application meeting to explain the business plan often expedites the review process. Additionally, many domiciles have application deadlines, such as 1 November for a January inception date, which are rigidly adhered to. Trap #6: All domiciles are not created equal How much capital?!? The regulators said you could not fund the capital of your captive with corporate goodwill. Unless domicile capital regulations are formulaic, actual capital requirements could be dramatically higher than estimated in a feasibility study. This is certainly the case in domiciles that have adopted Solvency II and impose those requirements on captives. The traditional industry standard provides a premium-to-capital ratio of 4:1, so for every $4 of premium written, $1 of capital is needed. Solvency II turns those ratios around, and a 1:2 premium-to-capital ratio may be closer to reality, potentially eroding financial benefits as much of the capital needs to be in liquid, shortterm investments. Trap #7: A taxing issue Somewhere in the feasibility study appendix lies good advice: We are not qualified tax advisers, and we recommend seeking appropriate tax advice. Bar none, this is sage advice. The US has nefarious guidelines, such as the third-party harper test, the humana structure or the four pillars of insurance company qualification, as well as other safe harbours. Falling afoul The implementation steps are often downplayed and the complexity overwhelming could draw unwanted IRS scrutiny or auditor questions. Additionally, excess capital and surplus (or retained earnings) to be distributed to the parent may face withholding tax, or tax on income at the parent level. Local country non-admitted, direct placement or self-procurement taxes could erode premium. And on and on. Trap #8: Bogged down by the policy Your feasibility study stated that you should create tailored insurance policies with your exact coverage needs in mind. This sounds great, until you actually have to produce a policy. Crafting insurance language is arguably the most difficult task in all of insurance. You can copy off-theshelf policy terms and conditions, but it is difficult if a new or emerging coverage is desired. While a benefit of a captive is that you can craft your own policies, it must be reasonable to justify pricing and support transfer pricing requirements. Coverage too broad may spark captive losses, having an effect on captive capital, and may reverse anticipated economic and tax efficiencies. Trap #9: This application will go down in time as You may hear that two to three months is how long it will take to incorporate a captive, and for the most part, it is a true statement, if everything runs perfectly. However, this is really referring to the time it takes for a regulatory body to review and accept the application. How long it takes your management to work through the application is another matter. Once you actually receive the certificate of general good or incorporation, you must mobilise your internal functions to actually provide the capitalisation and generate premium. It typically can take six months or longer from the time the feasibility study is complete until an initial premium payment is made. A realistic timeline should be contemplated if payment is due before fiscal year-end. Trap #10: Residency what? EU captives under the new Organisation for Economic Cooperation and Development (OECD) base erosion and profit shifting (Beps) guidelines require substance or operations in a country to avoid the appearance of shell companies and tax avoidance schemes. No longer is a simple post office box sufficient, or relying on the manager to provide a resident director. Care must be taken to demonstrate alignment with Beps objectives, such as avoiding tax planning strategies that result in a disconnect between the geographic assignment of taxable profits and the location of the underlying real economic activities that generate these profits (action 11 56) and transfers of profits that are not in response to changes in the location of real economic factors, labour and capital (action 11 68). While this list is not all-inclusive, care must be taken to avoid these potential traps surrounding the creation of a new insurance subsidiary. Feasibility due diligence, skilled external resources and internal support and focus can mitigate or eliminate most traps. The views expressed are those of the authors and do not necessarily reflect the views of any member firm of the global EY organisation. 9 CAPTIVE REVIEW HOW TO START A CAPTIVE REPORT 2017