Topics of Discussion. Patrick Theriault Managing Director Strategic Risk Solutions Ph

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1 Patrick Theriault Managing Director Strategic Risk Solutions Ph Melissa Hancock Regional Manager Strategic Risk Solutions District of Columbia & Delaware Ph Arthur Perschetz Counsel Baker & Daniels LLP Washington D.C. Ph Topics of Discussion What is a Captive Insurance Company? Why Captives are Formed Solving the Risk Management Problem Insurance Company Tax and Accounting Overview The Formation Process Small Insurance Company Tax Considerations 2 1

2 What is a Captive? Definition: A closely held insurance company that is owned and controlled by its insureds Characteristics A licensed insurance company Formed to insure or reinsure the risks of its owners or related parties of their choosing Regulated under special legislation regulating captives Located onshore or offshore Generally licensed in only one domicile non-admitted in all other jurisdictions 3 Who Uses Captives? Publicly Traded Companies Large &Mid-Size Privately Held Organizations Not-For-Profit Organizations Associations or Groups of Individuals or Small Organizations Wealthy Individuals Insurance Agents/Brokers or Other Similar Service Organizations 4 2

3 What Risks are Most Often Insured? Workers Compensation & Employment Practices General & Auto Liability Product Liability & Recall Professional Liability All Risk Property Directors & Officers Liability Employee Benefits and Medical Stop Loss But the sky is the Limit! 5 Types of Captive Insurance Companies Rent-a-Captive (Segregated Cell Captive) Organized to insure or reinsure the risks of unrelated shareholders; the insured are renting capacity of the captive insurer capitalized by outside sponsors Each insured utilize underwriting cell within the overall company Activity in cell is governed by participation agreement or preferred share arrangement No legal entity formed by the insured (traditional cell captive) Other legal arrangements are available (incorporated cell) Critical tax and collateral issues need to be considered 6 3

4 Traditional Rent-A-Captive Structure 7 Pure Captive Structure - Fronted 8 4

5 Pure Captive Structure - Direct 9 Why Captives are Formed Solving the Risk Management Problem 10 5

6 Solving the RM Problem 1. Reduce Cost of Risk 2. Increased Control 3. Entrepreneurial Opportunity 4. Improve Consolidated Tax Position 5. Estate Planning Reduce Cost of Risk Captives can generate cost savings vs. third-party insurance market 12 6

7 2. Increased Control Captives can: Facilitate unbundling of insurance transaction Stabilize insurance costs through portion of pricing based on individual experience Increase transparency through formal reinsurance relationship requiring full disclosure Provide more control over the claims process Entrepreneurial Opportunity Captives have been formed to capture profit on specific coverage lines such as: Credit Life / Debt Cancellation Product Warranty Agency captives focused on certain lines/books of business Risk of suppliers, customers or other related third parties Risk needs to be fortuitous and the captive will require premium and capital to support assumption of risk 14 7

8 4. Improve Consolidated Tax Position Companies thinking about a captive need to study their organizational structure and determine if there is a sufficient fact pattern to support insurance company treatment. When the captive jumps various tax-related hurdles 1. Premiums paid to a captive can be tax deductible 2. Loss reserves can be deducted in a captive Estate Planning If properly structured a captive can be used as an estate management tool. The captive is owned by the heirs of the insured company. Conservatively funded. Premiums are tax deductible to the insured company. Profit earned by captive owners taxed at personal tax rate or capital gains rate. Additional benefits through 831B election, if available. 16 8

9 Insurance Company Tax and Accounting 17 Requirements Underwriting Risk Transfer -10% - 15% chance of a 10% - 15% loss Risk Shifting and Distribution transfer of risk from many insured to adequately capitalized insurer Commonly accepted notion of insurance transaction must function like real insurance limited loan backs, retro provisions, payback provisions, timely payment of premium, claim processing Non-tax business purpose 18 9

10 Meeting the Requirements Requirements for Risk Transfer, Insurance Company Practices and Non-Tax business purpose are most easily met Where most captive structures create uncertainty is related to risk shifting and distribution. Two separate tax deductibility theories have developed: Theory 1 Sufficient unrelated business to make the related business into insurance safe harbor: 50% / case law: 30% Theory 2 Deductibility under the brother-sister structure or balance sheet theory safe harbor:12 insureds with each having 5-15% risk allocation 19 Risk Distribution Most companies do not have an even distribution of risk and must be reviewed from this perspective to determine strength of tax position and ability to establish insurance reserves

11 A Changing Environment Tax Position on captives continues to evolve while fundamentals remain: Insurance Risk plus Shifting and Distribution ib ti Act and operate as insurance company in the commonly accepted notion of insurance Arm s length development of premium and reserves Compelling non-tax reason for forming and operating entity Adequate capital and surplus as compared to risk Follow brother-sister approach with as many siblings as possible Consider adding third party/unrelated risk Avoid parental guarantees and keep intercompany loans to a minimum Strong, reputable domicile 21 The Formation Process 22 11

12 Captive Feasibility Process The steps in considering and forming a captive are: 1. Prefeasibility Discussion Are goals realistic any fundament issues? 2. Formal Feasibility Does it make sense for us? 3. Implementation Making the concept a reality! 4. Begin Operations The steps should be considered sequentially and estimated costs range from: Pure Group 1. Prefeasibility Free $ 5,000 Free $10, Feasibility Study $15 50,000 $25-100, Implementation $10 30,000 $ , Ongoing Operation $80 200,000+ $100, Common Deal Breakers Insufficient funding available or higher than expected expense ratio Differential between parent s rate of return on invested capital ( hurdle rate ) and lower rate of return on captive s investments Change in focus at the parent level Change in personnel Not getting buy-in of senior management early in the process Inability to achieve insurance tax status and premium deductibility 24 12

13 Keys to Successful Captives Sense of urgency problem to solve or clearly defined objective Properly funded relative to risk profile Long-term commitment - discipline to stay the course through markets cycles Strong business partners captive manager, claims service, actuary, banking and investment advisors Clear understanding of the benefits and issues Trust and transparency if sharing risk with other parties Contain operating expenses Focus on risk control and claims management 25 Small Insurance Company Tax Considerations 26 13

14 Alternative Tax for Small Insurance Companies What is Small? Section 831(b)(2)(A)(i) )() states that the net written premiums (or, if greater, direct written premiums) for the taxable year do not exceed $1,200,000 Company must elect and can only be revoked by the Commissioner or if the Company fails to meet the criteria (b) Captive Definition 831(b) is not a type of captive, but rather purely a tax election available to certain insurers (just like a LLC could elect to be taxed as a corporation or as a partnership) All types of property & casualty insurers, captive or traditional/commercial insurers, that meet certain requirements, could make this election Other descriptions used for captives that often make an 831(b) election: Small captive, micro-captive, mini-captive 28 14

15 Alternative Tax for Small Insurance Companies Controlled Group If there is more than 1 insurance company that is part of a consolidated return or member of a controlled group, the premiums of all insurance companies must be aggregated in order to determine if the $1.2 million threshold has been exceeded. See Section 831(b)(2)(B) 29 Insurance Considerations Why it s important to approach this from an insurance perspective p.. 831(b) is a tax election available to insurance companies only If the captive does not meet the requirements to be an insurance company the election cannot be made, or worse would be reversed after being made with resulting negative implications You therefore need to make sure you have a real business purpose for the establishment of the captive, with a true insurance risk NO DIFFERENT THAN ANY OTHER CAPTIVE! 30 15

16 Insurance Considerations What works well Common 831(b) structure Captive Insurer Used to Prefund Self Insured Risks (Known and Unknown) No Change to Risk Profile Budgeting for Volatile Self Insured Risks Common types of risks seen in 831(b) captives Weather risks: earthquake, windstorm, flood Difference in Limits i / Difference in Conditions i Property risk and related coverages (i.e. Mold) Cyber risk & excess liability Pollution liability & clean up 31 Brother-Sister Approach Premium Payments Parent Sub Sub Sub Sub Sub Sub Sub 12 Subsidiaries inferred from Revenue Ruling Captive Not Tax-Deductible Tax-Deductible (Note: Subsidiaries must be legal C corporations or other qualifying associations but NOT disregarded entities for tax purposes) 32 16

17 Questions 33 17