Offshore Cell Captive World (>20) Protected Cell Captives 101. Cell Company Structure. Segregated Accounts Company (SAC) Separate Accounts Company

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1 Protected Cell Captives 101 Self-Insurance Institute of America 27th Annual Educational Conference and Expo October 29 November 1, 2007 Sheraton Chicago Hotel and Towers Chicago, IL Tom Jones, Partner McDermott, Will & Emery 227 West Monroe Street Chicago, IL tel: (312) fax: (312) Arthur Perschetz, Counsel Muldoon Murphy & Aggugia LLP 5101 Wisconsin Avenue, N.W. Washington, DC tel: (202) fax: (202) Boston Brussels Chicago Düsseldorf London Los Angeles Miami Milan Munich New York Orange County Rome San Diego Silicon Valley Washington, D.C McDermott Will & Emery Cell Company Structure POOLED LAYER - CORE CAPITAL Cell A Cell B Cell C Cell D Offshore Cell Captive World (>20) Segregated Accounts Company (SAC) Bermuda SAC Act 2000 Separate Accounts Company Bermuda Private Acts of Parliament since 1991 Protected Cell Company (PCC) Gibraltar Protected Cell Companies Actof 2001 Guernsey Protected Cell Company Ordinance 1997 Segregated Portfolio Company (SPC) Cayman Islands Companies Law 2000 (Revised 2006) British Virgin Islands Insurance (Amendment) Act

2 Onshore Cell Captive World (>14) Sponsored Cell Captives - Vermont Special Insurer Act of 1999 Leased Capital Cell Captives - Hawaii Hawaii Revised Statutes 2000 Protected Cell Captive Insurers - DC Captive Insurance Company Act of 2004 Protected Cell Companies - SC Protected Cell Insurance Company Act of 2000 What is a Rent a Captive A company typically established in an offshore jurisdiction like Bermuda or Cayman It rents its core capital, surplus, insurance license and legal capacity to policyholders who are not its voting shareholders Segregation between renters achieved contractually Attributes of a Rent-a-Captive Cost-effective and flexible alternative risk management solution when compared to commercial insurance Offers program participants many of the advantages of a wholly-owned captive but without the higher start-up (including capital) and ongoing operational costs But without legal segregation renters in case of financial trouble may be forced to share risk with one another In contrast, a cell captive operates with legal segregation of policyholders under the statute of its domicile 2

3 Varied Uses of Cell Captives What types of captive programs are in cells? Pure/single parent risks Group and/or association shared risks Hospital/clinics/independent physicians Agency risk participation SPVs securitization; funding XXX life insurance reserves How prevalent are Cells? Specific legislation: Bermuda Cayman Islands Gibraltar Guernsey U.S. Vermont, South Carolina, DC, etc. No. of captives worldwide = 5,000 No. of cells & RAC accounts = 1, SOURCE: CICR May ,700 Cell Captives Worldwide Cells: Bermuda + AM Best 2002 = 957 Cells + RACs = 1,534 Are there others? Est 1,600 3

4 General Account Also called core capital Corresponds with general assets and liabilities in standard balance sheet of an ordinary company Segregated Account Generically called a cell Identifiable assets segregated or distinguished from other assets of company for the purposes of creditor protection whether in a solvent situation or insolvency proceeding Examples of Cell Captive Structures Direct self insurance cell Reinsurance self insurance cell Agency reinsurance cell 4

5 Direct self insurance Cell Collateral INSURED(S) INTERMEDIARY Premiums Dividends CAPTIVE CELL Ceded premium REINSURER Reinsurance self insurance Cell INSURED(S) Premiums Collateral Dividends POLICY ISSUING INSURANCE COMPANY Ceded premium CAPTIVE CELL Third party claimants Reinsurers LOC Security Agency Reinsurance Cell INSURED(S) AGENCY Premiums Collateral Dividends POLICY ISSUING INSURANCE COMPANY Ceded premium SEGREGATED ACCOUNT Third party claimants Reinsurers LOC Security 5

6 Will Cells Separateness Be Respected? Concept of separating assets and liabilities in selfcontained cells seems valid, but has not yet been judicially tested Two key factors to enhance success: Governing law/venue must be the domicile Cell assets (i.e., custody of investments) should be located in the domicile Reason: contrary to insolvency principle of horizontal equitable distribution (pari passu) of assets to creditors; cell structure is a vertical distribution only within the cell Bermuda vs. Cayman Cell Law Default Position: Core capital statutorily at risk in Cayman; not usually so in Bermuda As discussed later, presence or absence of risk transfer between cells and core capital can impact tax treatment Directors have personal liability for negligent failure to maintain segregation By statute in Cayman Under common law in Bermuda Legal issue whether one cell can enter into a binding contract with another cell cannot contract with yourself Doubtful in Cayman Specifically permitted by statute in Bermuda Key U.S. Tax Issues - Insurance or Self Funding? Premium Deductibility by Policyholder? Loss Reserve Deductibility by Company? Controlled Foreign Corporation Status? How is Shareholder Taxed under Subpart F? Possible Passive Foreign Investment Company (PFIC) Treatment? Applicability of Federal Excise Tax? 6

7 U.S. Tax Analysis of Cell Companies Single Taxpayer? Or Multiple mini-corporations? Is Risk Sharing and Insurance Tax Treatment Determined on a Cell-by-Cell or on a Company-Wide Basis? Corollary Tax Ramifications How Is Engaging in a U.S. Trade or Business Determined? On a Company-Wide Basis? On a Cell-By-Cell Basis? Impact on U.S.-Bermuda Tax Treaty PE Provision How Do Tax Elections Apply? Onshore Taxation (IRC 953(c)(3)(C) and 953(d)) Small Insurance Company Benefits (IRC 501(c)(15) and 831(b)) Most Likely Tax Outcome Cell-Type Companies Generally Will Be Treated as a Single Corporation - Note Tension with Possible Circumvention of RPII Subpart F Rules But Presence of Insurance (Risk Sharing) Will Be Analyzed on a Cell-By-Cell Basis If No Cells Internally Contain Shared Risks and No Risk Sharing Between Cells, Then Each Cell Is a Deposit or Other Non-Insurance Arrangement 7

8 Recommendations Try to Include Pre-Mixed Risks in Each and Every Cell If Possible, Share At Least Some Risk With Core Capital and Among Cells Or Create Aggregate Layer Super Cell If Impractical, Have Single Proprietor Cells Participate in an Outside Risk Pool Always Make Sure Cell Owners have Substantial Capital at Risk Recommendations (Cont d.) Prior Slide Is Inapplicable to Cells Owned by Tax Exempt Organizations Generally They Seek to Avoid Insurance Status and FET Tax and Loss Reserve Deductibility N/A Unrelated Business Taxable Income (IRC 512(b)(17)) Applies Only to Sec. 953 Insurance Income Latest Development ICC s ICC = Incorporated Cell Company Originated in Jersey (Not New Jersey) Recently adopted by the District of Columbia 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 8

9 Latest Development ICC s Difficult to characterize legal relationship between core and its cells not a parent/subsidiary (but contracts are valid) Tax status is clearer each cell is a separate tax-payer, likely ineligible to file a consolidated federal tax return (# of tax returns = # of cells + 1 for the core ) Insolvency law status also is clearer each cell is a separate juridical person; usual rules to apply creditor hierarchy only within a cell 9