SEGREGATED CELL CAPTIVES. Arthur D. Perschetz, Esquire Kilpatrick Stockton LLP

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1 SEGREGATED CELL CAPTIVES Arthur D. Perschetz, Esquire Kilpatrick Stockton LLP October 22, 2009

2 Overview What is a Cell Captive What s in a Name Where in the World Who Uses Cells The District of Columbia Law Differences The Incorporated Cell The Protected Cell RRG 2

3 What is a Cell Captive Cell captives provide a means to isolate specific risks within a single corporate entity Exist in numerous domiciles Cell captive has general assets and cell assets Cell assets are identifiable assets segregated from other assets of the company for purposes of creditor protection 3

4 What is a Cell Captive (cont d) Cell assets can only be used to satisfy creditors claims with respect to a particular protected cell Protected cell captive may form one or more protected cells to insure individual risks of independent insureds Captive maintains core capital base and each protected cell has additional capital provided by the individual or group using that cell 4

5 What s in a Name Variously known as: Protected Cell Company Segregated Cell Company Incorporated Cell Captive Segregated Accounts Company Sponsored Captive Insurance Company Segregated Portfolio Company Special Purpose Vehicle Special Purpose Financial Captive 5

6 Where in the World Cell Domiciles Gibraltar Arizona Dubai Guernsey Delaware Mauritus Isle of Man District of Columbia Namibia Jersey Hawaii South Africa Malta Iowa Guam Anguilla Kentucky Vanatau Bahamas Montana Barbados Nevada British Virgin Islands Oklahoma Cayman South Carolina St. Lucia Utah 6

7 Who Uses Cell Captives Most of Today s Cell Growth is Profit Center Focused Insurance Company Owned Insurance Producer Owned Associations Entrepreneurs 7

8 Cell Advantages Less expensive to: Organize Capitalize Cost Sharing of Service Providers Turn Key Operation Rapid Implementation Use someone else s capital 8

9 District of Columbia Captive Law: Philosophy Relatively low capitalization Flexible laws Designed to encourage both small and large captives 9

10 District of Columbia Law: Differences From Other Domiciles Capital Requirements Limitations on Business Sponsor Corporate Structure Core Liability Cell to Cell Agreements 10

11 District of Columbia Captive Law: Key Points Apply to All Captives Any form of business entity Any investments approved by Commissioner Any reinsurance approved by Commissioner Favorable U.S. Branch provision Best practices 11

12 District of Columbia Captive Law: Cells and Cell Companies Meaningful legal description of the relationship between core and cell and cell and cell in DC law Two Types of Cell Companies Protected Cell Companies (PCC) Incorporated Cell Companies (ICC) Two Types of Cells Protected Cells (PC) defined legal characteristics Incorporated Cells (IC) own legal identity 12

13 District of Columbia Captive Law: Relationship of Cells to Core DC law clearly defines the relationship of each type of cell to core Incorporated Protected Cell means a protected cell that is established as a corporation or other legal entity from the protected cell captive insurer of which it is a part Protected Cell means a separate account established and maintained by a protected cell captive insurer 13

14 District of Columbia Captive Law: Advantages Agreements between cells specifically permitted A Protected Cell of a PCC may enter into an agreement with the PCC or a cell of the PCC that shall be enforceable as if each cell of the PCC were a separate legal entity Protected Cell (PC and IC) may transfer from one protected cell captive to another 14

15 District of Columbia Captive Law: Advantages (cont d) Existing captive insurer may become a protected cell of a protected cell captive A protected cell may leave protected cell captive and become a stand alone captive A PCC may issue one or more classes or series of securities for one or more cells proceeds to cell 15

16 District of Columbia Captive Law: Incorporated Cells Benefits of Incorporated Cell Captive Cell walls higher and thicker than PC Own FEIN and tax filing Each cell may have own directors and officers Inter cell agreements specifically permitted Each cell treated as a captive insurer for purposes of the Act 16

17 Other Examples of Incorporated Cell Companies REIT Entrepreneurial Insures Real Estate Investment Trusts Cell formed as LLC Life Insurer Formed by insurer Cells owned by agents provide agency incentive Cells also available to insureds Cell formed as corporation Commercial Program Formed by property owner manager Cell for own property Cell for joint ventures Cell for third parties 17

18 Other Examples of Incorporated Cell Companies (cont d) Commercial Insurer Owner traditional insurance company Cells owned by agents Quota share reinsurance Fronted by admitted company Commercial Program Formed by owner of various facilities Cell for owned facilities Provide and manage cells for other non-owned facilities 18

19 19 The Protected Cell RRG

20 Segregated Cell RRG - Basic RRG Members all homogenous GL Cell D&O Cell XS Liability Cell 20

21 Segregated Cell RRG - Alternative Health Care System LLC Hospital Class A Member Cells Class B Members RRG Cell 1 Staff Doctors Cell 2 Low Risk Doctors Cell 3 Higher Risk Doctors Cell 4 Health Care System 21

22 Segregated Cell RRG Actually Licenses and Registered in Most States Delivery Company RRG Cell 1 Delivery Company Cell 2 Delivery Company Cell 3 Delivery Company Cell 4 Risk Sharing 22

23 Segregated Cell RRG An Alternative Policy Reinsurance RRG PCC Owned by Member 1, 2, 3 Member 1 Insured Member 2 Insured Member 3 Insured Member Cell 1 Member Cell 2 Member Cell 3 23

24 Arthur D. Perschetz, Esquire Kilpatrick Stockton LLP Suite th Street Washington, DC Telephone October 22, 2009

25 Recent IRS Cell Captive Guidance Tom Jones, Partner McDermott Will & Emery LLP 227 West Monroe Street Chicago, Illinois (312) (312) Captive Insurance Council of the District of Columbia Eighth Annual Conference The DC Difference L Enfant Plaza Hotel Washington, DC October 21-22, Boston Brussels Chicago Düsseldorf Houston London Los Angeles Miami Milan Munich New York Orange County Rome San Diego Silicon Valley Washington, D.C. Strategic alliance with MWE China Law Offices (Shanghai) 2009 McDermott Will & Emery LLP. McDermott operates its practice through separate legal entities in each of the countries where it has offices. This communication may be considered attorney advertising. Previous results are not a guarantee of future outcome. The following legal entities are collectively referred to as "McDermott Will & Emery," "McDermott" or "the Firm": McDermott Will & Emery LLP, McDermott Will & Emery/Stanbrook LLP, McDermott Will & Emery Rechtsanwälte Steuerberater LLP, MWE Steuerberatungsgesellschaft mbh, McDermott Will & Emery Studio Legale Associato and McDermott Will & Emery UK LLP. These entities coordinate their activities through service agreements. This communication may be considered advertising under the rules regulating the legal profession.

26 IRS Priority Guidance Plan Released 9/10/08 Captive related matters listed: Guidance on the classification of certain cell captive insurance arrangements. Previous guidance was published in Notice Revenue ruling providing guidance on reinsurance arrangements entered into with a single ceding company. Guidance concerning the classification of series LLCs and cell companies under

27 Key Tax Considerations of the Cell Captive Who is the taxpayer? Entire company Each cell viewed separately The sponsor organization or the participant At what level is the determination of insurance status made? Entire company level Cell level The sponsor organization or the participant level 27

28 Cell Companies: Rev. Rul General Account Y X Preferred Shares Insurance Policy Cell X Cell Y Insurance Policy Covering Brother/Sister Group 1 12 No Insured except for X No guarantee of Cell X obligations Adequate capital No loans Annual policy Adequate capital No subsidiary < 5% nor >15% No loans No guarantees by Y or Y1 Y12 of Cell Y obligations No other insurance contracts Homogeneous risk Annual policy 28

29 Cell Companies: Rev. Rul Look to existing rules; apply on cellular basis Risk shifting Risk distribution Arrangement between X and Cell X akin to a parent and wholly-owned subsidiary under Rev. Ruls & Arrangement between Y and Cell Y characterized as brother/sister insurance under Rev. Rul Should have been a 3rd situation in which Cell Z owned by Z wrote over 50% unrelated risk with holding of insurance under Rev. Rul

30 Cell Companies: IRS Notice Proposed Guidance Cell of a PCC would be treated as an insurance company separate from any other entity if: Assets and liabilities are legally segregated Based on facts and circumstances cell would be classified as an insurance company taxable under IRC 816(a) or 831(c) Tax Effect Elections at cell level Cell must apply for FEIN if subject to U.S. tax jurisdiction Cell activities not taken into account in characterizing PCC s general account (core) Cell (or parent, if consolidated) responsible for filing returns and paying tax PCC does not include income items with respect to cell 30

31 Cell Companies: IRS Notice To implement this guidance, taxpayer comment requested by 5/5/08 regarding: Transitional rules Reporting, if any, necessary to ensure PCC has needed information Special rules regarding foreign entities (including CFCs) Treatment of PCCs and cells under consolidated return rules How to handle segregated arrangements not involving insurance Note explicitly states no inference should be inferred as to tax status of PCC core or its non-insurance cells Effective date would be for tax years beginning more than 12 months after this guidance is finalized 31

32 Chief Counsel Advice Offshore cell captive that made an onshore tax election Wholly owned by a mutual with numerous unrelated policyholder/member-owners IRS assumed each cell is a separate taxpayer Each cell was tied to a specific mutual member via a participation agreement Held Cell 1 qualifies under the brother-sister test IRS agent was wrong to aggregate 1 st & 2 nd tier subs No IRS conclusion on aggregate analysis versus by lines of business because IRS position on homogeneity issue remains unclear as of the CCA release date (12/5/08) 32

33 Latest Development ICC s ICC = Incorporated Cell Company Originated in Jersey (not New Jersey) Adopted by the District of Columbia (only onshore) By statute, each cell is a distinct legal entity and can have its own governing body Addresses cell participants demand for governance input where core owners don t want to share their power 33

34 Latest Development ICC s Difficult to characterize legal relationship between core and its ICs not a parent/subsidiary (but contracts between and among ICs clearly are valid) Tax status is clearer each IC is a separate taxpayer, likely ineligible to file a consolidated federal tax return (# of tax returns = # of ICs + 1 for the core ) Insolvency law status also is clearer each IC is a separate juridical person; usual rules to apply creditor hierarchy only within each separate IC 34

35 Questions 35

36 CELL CAPTIVE CAPTIVE ACCOUNTING Presented to: Captive Insurance Council of the District of Columbia 8th Annual Conference Presented by: Glenn Saslow, CPA Audit Partner, Saslow Lufkin & Buggy, LLP October 22, 2009

37 Cell Captive Financial Reporting Cell Structure is unique under U.S. GAAP and International Accounting Standards No specific authoritative literature available Possibility of inconsistent reporting Financial statement user needs may not be met (regulator, owner/participant, lender, investor, rating agency) 37

38 Cell Captive Financial Reporting Each protected cell shall be accounted for separately on books and records to reflect: The financial condition and results of operations of the protected cell net income or loss Dividends and distributions to participants Annually file financial statements of each protected cell with Commissioner 38

39 Protected Cell Presentation Styles Columnar presents separate columns on the face of the statements and in the footnotes for the core (general account) and for each individual protected cell Singular summarizes all segregated portfolio assets, liabilities and equity as single segregated asset and liability balances on the balance sheet with no income statement items being disclosed except for those of the core (general account) 39

40 Annual Audit Annual Audit by Independent CPA Due on or before June 30 In accordance with GAAP Which presentation style is GAAP or STAT? 40

41 Operations of a Cell Company: Example 1 - GAAP Involves a Sponsor and Cell The Cell was created for benefactors other than the Sponsor Potential deficits arising from investment and underwriting risk of the Cell are recoverable from the Sponsor 41

42 Operations of a Cell Company: Example 1 - GAAP (cont.) Management fees are paid to the Sponsor with regards to: Participation Fee - percentage of premium for insurance contracts entered into Cost of Surplus Fee - maintenance of surplus requirements Administration Fee - reimbursement for all cost related to the Cells The Cell operates a line of insurance business and all operations are separately accounted for and all insurance activity is independent of the Sponsor Effectively separate companies (although the Sponsor s surplus is at risk for the Cell operations as a backstop ) 42

43 Operations of a Cell Company: Example 1 - GAAP (cont.) GAAP Presentation Total Assets and Liabilities and Capital of the Cell are shown as separate line items on the balance sheet of the Sponsor Single line items for asset held for protected cell and liabilities and capital held for protected cell Revenue, expenses, cash flows and equity activity can be shown in separate columns within the Sponsor s financial statements or in the footnotes (not required) Statement of Operations of Cells are not combined with sponsor To the extent the Cell has an operating deficit and the Sponsor s capital is at risk - known as a contingency reserve 43

44 Contingency Reserve Deficits arising from the underwriting and investment risk of the Cell could ultimately be recoverable from the Sponsor Contingency Reserves represent the dollar for dollar accumulated deficit and other comprehensive loss of the Cell on a standalone basis Cell captive laws vary state by state and where the sponsor capital is not at risk the concept of a contingency reserve may not exist 44

45 Disclosures Related to GAAP Clear and concise footnote 1 related to the structure, formation and relationship of the sponsor to the cells and cells to other cells Option to include consolidating schedules in supplemental schedule Option to have separate statement of operations, changes in capital and cash flows for the Sponsor and each Cell Option to have investment footnote for the Sponsor and each Cell 45

46 Disclosures Related to GAAP (cont.) Insurance activity by each Cell All related party transactions and fee arrangements occurring between the Sponsor and the cells and also between the cells and other cells Income tax allocation for the Sponsor and each Cell Assets and Liabilities of each Cell Footnote describing the contingency reserve amount and policy 46

47 Alternative GAAP Presentations Accounting for the sponsor and cells will always look through to the substance of the relationship as opposed to the formation or name to arrive at the proper presentation within the financial statements GAAP Presentations: Consolidated Sponsor and Cell statements with accompanying consolidating schedules (FIN 46R) Separate account presentation with sponsor assets not at risk Separate account presentation with sponsor assets at risk 47

48 Operations of a Cell Company: Example 2 STAT STAT Presentation All Admitted Assets and Liabilities and Capital of the Cells are shown combined within the statutory financial statements All revenue, expense, cash flows and equity activity is shown combined All intercompany activity between the Cell and Sponsor is eliminated No contingency reserve 48

49 Disclosures Related to STAT Supplemental schedules showing combining statements related to the statement of admitted assets, liabilities and capital and surplus and statutory statement of operations with eliminating entries Similar footnotes to GAAP Presentation 49

50 Questions and Comments Thank you to The Captive Insurance Council of the District of Columbia 50