Manager Federal Insurance Tax. Contact:

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2 John Forni Grant Thornton LLP Managing Director National Insurance Tax Practice Leader Contact: Peter Tofilski Grant Thornton LLP Manager Federal Insurance Tax Contact: Jason Clarke Grant Thornton LLP Manager State & Local Tax Contact:

3 What is a Captive? Captive Variations, Benefits and Mini Captives Types of Captives Insurance Risk and Insurance Company Qualification Traditional V.S. Non Traditional Risk Federal Tax Matters Court Cases

4 Overview of How States Tax Insurance Self-procurement Tax Significant Cases Dodd-Frank / NRRA Implications Dodd-Frank / NRRA's Impact on Captives State's Reaction Industries Reaction GT's Observations

5 A closely held insurance company The risk that is insured through the captive organization is a "captive risk" The original insureds are the principal beneficiaries

6 Single parent captives also called "pure captives" Group Captives- have multiple owners or sponsors Risk Retention Groups Protected Cell Companies ("PCCs") Reinsurance Pools (e.g., Section 831(b)) Insurance Linked Securities

7 A properly structured captive insurance arrangement may provide numerous benefits from an operational and business perspective Operational Benefits: Expense reduction Centralized management of risk Minimizing capital requirements Capital is deployed to reserve against losses Flexibility in insurance policy design Reduction or elimination of the self procurement tax Creation of a vehicle to move funds within an organization in a tax efficient manner

8 Business Benefits: Direct access to reinsurers Provision of broader or otherwise unavailable coverage Certification of Insurance Coverage Mitigation of the market swings of commercial insurance Spreading of risks among affiliated groups Improved risk retention capability Small Insurance Company Sec. 831(b) Known as Mini - Captives

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10 The courts established the first insurance company test in Amerco v. Commissioner The court stated that the key to insurance is that the insured faces a hazard and the insurer agrees to pay if or when the loss event occurs The Internal Revenue Service has indicated that an important aspect of an insurance risk is fortuity The courts and the IRS do not accept the following as an insurance risk: Investment risk Timing risk

11 The seminal case for defining an insurance contract was Helvering v. Le Gierse, 312 U.S. 531 (1941) Risk Shifting and Risk Distribution Although the Le Gierse court did not define these terms specifically, subsequent courts have provided guidance as to their meaning

12 Risk shifting is viewed from the presence of the insured In order for risk shifting to exist, the insured must transfer its risk of economic loss due to some hazard to an insurance company Risk shifting is often analyzed under FAS 113 which requires a reasonable possibility of a significant loss to the insured under the contract (i.e., a 10% chance of a 10% loss) The balance sheet test is also frequently applied to determine whether an insured has shifted its risks to the insurer (under this test, a sole shareholder generally cannot shift its risks to its wholly-owned captive subsidiary)

13 Risk distribution is viewed from the insurance company s perspective Based on the actuarial principle of the law of large numbers, risk distribution entails spreading risks among a large group allowing the insurer to reduce the possibility that one claim will exceed the premiums collected While the courts have addressed the concept of risk distribution, no one case defines what constitutes adequate risk distribution in a captive arrangement (e.g. number of underlying insureds, number of entities)

14 Insurance companies other than life insurance companies, that is property and casualty (P&C) insurance companies, are taxed under IRC 831 Pension Funding Equity Act of 2004 defined insurance company The term insurance company means a company, more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies

15 Traditional Deductibles and self-insured retention programs Directors & Officers or General and other professional liability Product Liability Vehicle insurance Non-Traditional Longevity risk (pension plans) Stop loss for self insured health plans Terrorism or acts of war

16 An insurance entity that qualifies as an insurance company is taxed under Subchapter L of the IRC Accelerated deductions allowed under IRC 832(b)(5) and IRC 846 which allow insurance companies to set-up and deduct a portion of their reserves for unpaid claims, including: IBNR (Incurred but not reported) IRC 832(b)(4)(B) IRC 831(b) IRC 953(d) IRC 162 Foreign Excise Tax

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18 Rent-A-Center Inc. v. Commissioner Background Opinion Implications Securitas Holdings Inc. v. Commissioner Background Opinion Implications

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20 Overview of How States Tax Insurance Self-procurement Tax Significant Cases Dodd-Frank / NRRA Implications Dodd-Frank / NRRA's Impact on Captives State's Reaction Industries Reaction GT's Observations

21 For state purposes a tax may be imposed on the insurer, insurance producer or policyholder, depending on whether insurance is sold by a licensed insurer or through the non-admitted insurance market How States tax insurance: Premium Tax: imposed on insurance companies licensed or admitted in the state based on gross premiums written, collected or received Income Tax: imposed on non-licensed or non-admitted insurance companies doing business in the state based on FTI or Stat Accounting Capital Tax: imposed on non-licensed or non-admitted insurance companies doing business in the state based on net worth Self-procurement Tax: imposed on the insured doing business in the state who purchases insurance from a non-licensed or non-admitted insurance company; based on gross premiums paid

22 The Get-Along-Gang: Approximately 40 states impose a premium tax on insurance companies licensed or admitted in the state The Hateful 8: Approximately 8 states impose an income tax on nonlicensed or non-admitted insurance companies doing business in the state (FL, IL, IN, LA, MS, NE, NY, WI) The Others: Approximately 4 states impose a business profit, net worth, excise, or gross receipts tax on non-licensed or non-admitted insurance companies doing business in the state (AL, NV, NH, OR) ********** Every state imposes a self-procurement tax on the insured for premiums paid to a non-licensed or non-admitted insurance company

23 Insured receives insurance from an insurance company licensed or admitted in the state Not subject to tax (insurance company pays premium tax) Insured receives insurance from an non-licensed or non-admitted insurance company Todd Shipyards, 370 U.S. 451 (1962) The US Supreme Court held that Texas could not tax the purchase of insurance by a New York company from a New York insurance company, just because the risk insured was located in Texas Associated Electric & Gas Insurance Services, 676 A.2d 1357 (R.I. 1996) The Rhode Island Supreme Court held that Todd Shipyard was not controlling since, albeit a sales tax case, Quill Corp v. North Dakota (1992) was decided after, it represented the US Supreme Court's current view, and therefore ruled that AEGIS was subject to the tax in Rhode Island

24 In 2010, Congress passed the federal Nonadmitted and Reinsurance Reform Act (NRRA) which was part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L (July 21, 2010) No State other than the Home State of an insured may require any premium tax payment for non-admitted insurance Where is the insured s Home State? What qualifies as Nonadmitted Insurance?

25 Where is the insured s Home State? Section 521(a): (A) the term Home State means: (i) the state in which an insured maintains its principal place of business or, in the case of an individual, the individual's principal residence; or (ii) if 100 percent of the insured risk is located out of the state referred to in clause (i), the State to which the greatest percentage of the insured's taxable premium for that insurance contract is allocated The Home State analysis must be performed on a policy by policy basis

26 Insured (CT) Insurance Company (VT) Policy #1 (NY) Policy #2 (MD)

27 What qualifies as Non-admitted Insurance? Section 527(9): The term "non-admitted insurance" means any property and casualty insurance permitted to be placed directly or through a surplus lines broker with a nonadmitted insurer eligible to accept such insurance Independently Procured Insurance Captive Insurance???

28 Does Dodd-Frank consider insurance provided by captive insurance companies as "non-admitted insurance"? A few state follow. However, many States contend that because NRRA does not expressly include captive insurance companies, Dodd-Frank does not apply, and therefore imposing self-procurement taxes on insured entities located in their states is permissible

29 Insured (CT) Start Do you have a valid insurance company? Yes Are you licensed in the state? Yes Insurance Company subject to premium tax No No Insurance Company (VT) Subject to income taxes. Does the state follow Dodd-Frank? Yes Is the state the Insured's "Home State?" Yes Insured subject to selfprocurement tax No No Subject to income or non-income taxes Yes Does the state tax Insurance Company's? Insured not subject to tax Policy #1 (NY) Policy #2 (MD) No Insured may be subject to selfprocurement tax

30 NRRA encourages, but does not require, States to adopt, by way of an interstate compact or a similar agreement, uniform "requirements, forms, and procedures that provide for the reporting, payment, collection, and allocation of premium taxes" on nonadmitted insurance Non-admitted Insurance Multi-State Agreement (NIMA) Surplus Lines Insurance Multi-State Compact (SLIMPACT) Some states have amended their statutes to tax 100% of the premium to the Home State with no compact authorized (e.g. NY, MD) Some state have used this provision to try to incentivize captives to re-domicile to the insured s Home State

31 Actively working with Congress to craft new language to clarify ambiguities in present law In 2015, S.B. 1561, the Captive Insurers Clarification Act, was introduced by Vermont Senator Patrick Leahy and South Carolina Senator Lindsey Graham and referred to the Senate Banking, Housing and Urban Affairs Committee. Organizing coalitions Coalition for Captive Insurance Clarity (CCIC) Vermont Captive Insurance Association (VCIA)

32 Clients with mature captives are using their historical positions and taking a wait-and-see approach before making any changes Some clients are re-domiciling their captive to the insured's Home State Some clients are establishing new captives to direct write and cede to its original captive New formations are being setup with more thoughtful insight

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