Best Captive Practices for 831(b)s Do Them Right or Don t Do Them At All

Transcription

1 Best Captive Practices for 831(b)s Do Them Right or Don t Do Them At All Webcast provided by ICCIE Derek Freihaut Charles J. (Chaz) Lavelle Presenters: Joe LaMantia III Patrick Theriault Monday, March 10, :00 p.m. 4:00 p.m. MT

2 2 Agenda Captives taxed under section 831(a) and 831(b) are fundamentally the same There are some common attributes of captives taxed under section 831(b) Small insurance companies have many risk management aspects in common Many of them also elect to be taxed under section 831(b) Questions from a prospective owner of a captive electing section 831(b)

3 3 Its an insurance company, nothing more, nothing less While insurance companies that elect to be taxed under section 831(b) of the Internal Revenue Code have a different taxation regime than those taxed under section 831(a), both sets of insurance companies are fundamentally the same Few, if any, regulators track whether an insurance company elects section 831(b) taxation

4 4 Both sets of companies are measured by exactly the same standards for regulatory purposes For tax purposes, they have to meet the same tests (and be formed for a non-tax business purpose): Insurance Risk Common Notions of Insurance Risk Shifting Risk Distribution

5 5 In order to elect to be taxed under section 831(b), premiums cannot exceed $1,200,000 The captive is taxed only on its investment income, and not on any of its underwriting income The election is irrevocable and NOLs cannot be used Captives electing section 831(b) often have different attributes than public company captives

6 From the perspective of a Captive Manager 6

7 Typical Small Captive Risk Structure 7 Used to Prefund Self Insured Risks (Known and Unknown) No Change to Risk Profile Budgeting for Volatile Self Insured Risks Claims made coverage so no tail to maximize financial benefits Every claim paid in small captive reduces benefit, so typically targets low frequency & high severity exposures Also, high frequency are typically avoided in risk pool arrangements So, what coverages are most often avoided or targeted?

8 Risks Not Often Seen in Small Captive Structures 8 Working layers of easily accessible commercial coverages or retention under such coverages General / Auto Liability SIR High frequency coverages Workers compensation, employee medical, auto physical damage Coverages that are readily available in the commercial market cheaply Primary layer of coverages seen as risky Medical malpractice Would excess layers of such coverages be a good fit?

9 Common Types of Risks Seen in Small Captives 9 Traditional low frequency / high severity risks Weather risks: earthquake, windstorm, flood Property risk and related coverages (i.e., mold) Pollution liability & clean up Cyber risk & excess liability Wrap coverages (DIC / DIL) Less/Non-traditional exposures Regulatory compliance Misc. loss of income/profit coverages (i.e., increase in cost of raw materials, currency fluctuation, accounts receivable/bad debt, IP infringement, etc ) Misc. business interruption coverages (i.e., loss of key employees, loss of key suppliers, loss of key clients, loss of key contracts, etc ) Others: administrative actions, legal defense, reputational risk, etc One Question: Insurance or Business Risk?

10 10 Standard Pure Captive Ownership Structure(s) Wholly owned Sub of Holding Corp. Small Captive Ownership Structures Traditional Retirement Planning Upper Management Benefits/Incentives Next Generation Transition Estate Planning Combination/Variation

11 From the perspective of an Actuary 11

12 Pricing Overview 12 Many of the coverages in a typical 831(b) are: Low frequency High severity Currently uninsured May have no historical precedent/experience Less commonly or only recently available in the admitted market Therefore, experience rating techniques don t tend to work as well

13 Traditional Funding Analyses vs. 831(b) Funding 13 Issue Traditional Coverage Funding 831(b) Funding Coverages Standard (GL, AL, APD, WC, MPL) Often non traditional Loss Experience Credible (Especially in primary layers) Little or none Rating Method Experience Rating Exposure Rating, Rate on Line, Freq. & Sev. Benchmarks Industry LDFs, Loss ratios Publicly Available Rate Filings Actuarial Judgment Required Limited (weights, treatment of unusual years) Significant, Lots of open ended assumptions

14 Experience-based Pricing 14 Only works when there is credible loss history No claims or one claim is probably not credible Avoid situations where methods overreacts For 831(b)s, usually limited to deductible reimbursement Relies on reasonable loss development, trend and credibility assumptions

15 Market or Benchmark Pricing 15 Premium estimate based on provided coverage quote or quote developed using publically available rate manual filings Filed rate manuals represent credible benchmarks Reflects one insurance company s underwriting perspective/appetite for the insured s risk What is the expected loss ratio Not always available Coverage mismatch Potential abuses Hearsay quotes I heard they couldn t get the coverage for less than Hard for regulators to validate Significant assumptions involved

16 Frequency & Severity Pricing 16 Premium based on projected frequency of claims and expected average severity of claims Logical approach, especially when coverage does not fit industry pricing models Relies on assumptions Widely used and abused Potential abuses Significant assumptions involved Can be difficult to substantiate undocumented assumptions

17 Rate on Line Pricing 17 Premium based on applying Rate on Line percentage to coverage limit Similar to approach based on pricing for an X year return period Considered in reinsurance Intuitive Relies on assumptions Potential abuses Significant assumptions involved How high does a rate on line need to be to no longer be transferring risk?

18 Risk Margins 18 Increase the confidence of the captive owner and the captive regulator that the premium and capitalization of the captive will be sufficient Can be based on simulation models of frequency and severity Especially important for very low frequency-very high severity coverages May also help form basis for adverse scenario pro forma financials Potential Abuses How large of a risk margin is reasonable? Unreasonable assumptions, particularly underlying simulation models

19 From a tax perspective 19

20 20 Insurance Risk Not Investment Risk Not Business Risk Traditional vs. Non-traditional Investments Loan Backs Life Insurance

21 21 Risk Distribution Unrelated Business how much 10%? 30%? 50%? Pools The IRS has informally approved each of the three primary structures Losses in pools Insurance risks Brother-Sister How may subsidiaries? Percentage risk in each subsidiary Rent-A-Center case

22 Small Pools - PLRs and (modified) 22 RED CO. $45x of risk from Red Co. RED INSURANCE LTD. 45% of Layer 2 pooled risk YELLOW CO. $35x of risk from Yellow Co. Front 45X Red Co + 35X Yellow + 20X Blue Co YELLOW INSURANCE LTD. 35% of Layer 2 pooled risk BLUE CO. $20x of risk from Blue Co. BLUE INSURANCE LTD. 20% of Layer 2 pooled risk This slide illustrates pooling, but does not address the number of insureds or insurers needed for sufficient risk distribution.

23 Small Pool - PLR BEFORE AFTER Red Co. Group RED INSURANCE LTD. $45x of risk from Red Co. RED INSURANCE LTD. 45% of pooled risk Yellow Co. Group YELLOW INSURANCE LTD. $35x of risk from Yellow Co. Lead Ins. Co. YELLOW INSURANCE LTD. 35% of pooled risk 45X Red Co Risks + 35X Yellow Risks + 20X Blue Co Risks Blue Co. Group BLUE INSURANCE LTD. $20x of risk from Blue Co. BLUE INSURANCE LTD. 20% of pooled risk This slide illustrates pooling, but does not address the number of insureds or insurers needed for sufficient risk distribution.

24 PLRs P ship A & Corp A Operating Entities Corporation B Operating Entity Partnership C Operating Entity CAPTIVE A* CAPTIVE B* CAPTIVE C* Contractual Pool; no captive exceeded 15% This slide illustrates pooling, but does not address the number of insureds or show the number of insurers (15) resulting in risk distribution.

25 25 Risk Shifting Sufficient Capital Even if regulator will permit a cell to have reduced capital, the capital still has to support the insurance program Letter of Credit Guarantees

26 26 Questions of a Prospective Captive Insurance Company Owner

27 Premium Coverage Participating Companies 27 $200, 000 Vehicle Physical Damage A, B, C Insures $50,000 $400,000 Warranty Coverage A, B, C $200,000 All Risks Weather Related A, B, E, F 12 Owners Pass Through Entity D + O A, B, C, D, E, F 27

28 28 Topics for a Prospective Captive Owner Costs and Premium Level Insurable Risks and Losses Premium Calculation Structure, Pooling and Risk Distribution Investments

29 Speakers 29 Derek Freihaut Pinnacle Actuarial Resources, Inc Reed Road, Suite 2 Bloomington, IL / dfreihaut@pinnacleactuaries.com Joe LaMantia III L&F Distributors 3900 North McCool McAllen, TX / Joe.lamantia@infdist.com Charles J. (Chaz) Lavelle Bingham Greenebaum Doll LLP 3500 National City Tower 101 S. First Street Louisville, KY / clavelle@bgdlegal.com Patrick Theriault Strategic Risk Solutions 126 College Street, Suite 400 Burlington, VT / patrick.theriault@strategicrisks.com