C5: THE EVOLVING USE OF ENTERPRISE RISK CAPTIVES (ERCs) SIIA NATIONAL CONFERENCE Jeffrey K. Simpson Attorney Gordon, Fournaris & Mammarella, PA 1925 Lovering Avenue Wilmington, DE 19806 302-652-2900 JSimpson@Gfmlaw.com Michael Serricchio Senior VP Marsh Captive Solutions 501 Merritt 7 Norwalk, CT 06856 203-229-6874 Michael.Serricchio@Marsh.com Patrick Theriault Managing Director Strategic Risk Solutions 126 College Street, Suite 400 Burlington, VT 05401 802-861-2630 Patrick.Theriault@Strategicrisks.com SEPTEMBER 26, 2016 @ 3:15PM AGENDA Introductions Where We Are As An Industry? ERC Features What the Structure Looks Like Insurance Lines of Coverages Costs Domicile & Set Up Evolution in ERCs Current Trends Impact of 831(b) Amendments Case Studies 2 1
WHAT ARE ERCs? SIIA Definition Privately held Small to mid-market Uninsured risks Deductibles Exclusions High severity low frequency 831(b) Election Ancillary financial benefits Other labels Small Micro Subset of 831(b) captives 3 BRIEF HISTORY OF ERCs Timeline Development 2000-2005 (esp. after 2002 Revenue Rulings) Proliferation 2005-2010 Massive popularity 2010-present Challenges to Captive Industry Status Quo New users small, private companies New risks high severity, low frequency New delivery channels financial advisors & planners Controversy Skepticism from traditional captive industry Abuse allegations by IRS 4 2
CURRENT STATE OF ERCs Shakeout of Controversial Issues Industry understanding risks Owners incorporating in overall risk management IRS holding line on abuses Changes to 831(b) Increased limit to $2.2 million Elimination of estate planning benefit Evolving Uses More popular than ever Large & public companies taking an interest Integration with commercial insurance program and overall risk management program 5 CONTINUED GROWTH OF CAPTIVES WORLDWIDE YEAR END 12/31/2015 9/11 Attacks Hurricane Katrina Global Recession Small 831(b) Captives Emerge in the US 6 3
CAPTIVE BASICS CAPTIVE SIZE BASED ON NET WRITTEN PREMIUM 44% of captives had premium volume of less than US$5 million, suggesting that not onesize-fits-all applies to the captive market. This finding also suggests, however, that the premium spend required to support a captive is attainable by small, midsize, and large organizations. 7 CAPTIVE BASICS ROLE OF A ERC Disciplined, controlled formalized mechanism for insuring self insured risks. Being reasonable, smart, prudent and conservative. Fund retained corporate risk. Predictable/ high frequency risk. High severity/ low frequency risk. Fund for catastrophic (CAT) losses that are uninsurable in the commercial market. Insure risks that are prohibitively expensive for certain industries. Means to access reinsurance markets for insurance capacity. Profit Center Underwrite the risk of third parties. 8 4
ERCS WHAT DOES THE STRUCTURE LOOK LIKE? RISK DISTRIBUTION: SIBLINGS VS. STRANGERS No bright line test to support the existence of insurance for federal tax purposes Shift financial risk to the captive ( risk shifting ) Appropriately distribute the risks among a sufficient number of insureds ( risk distribution ) Regulated insurance company, Clear business reasons Premiums that are substantively priced and based on the market Adequately capitalized NOT COMMON BASED ON STREAMLINED COMPANIES WITH LLC S & FEWER ENTITIES RISK POOL? 9 APPROACH TO ACHIEVE INSURANCE TAX STATUS FOR ERCS (9%) (25%) Risk Pools Becoming Increasingly More Popular (66%) BROTHER/SISTER APPROACH HYBRID BROTHER/SISTER APPROACH AND UNRELATED RISK UNRELATED RISK 66% 9% 25% 10 5
ERCS WHAT DOES THE STRUCTURE LOOK LIKE? STRANGERS SORT OF Middle Market Businesses Premium Claim payments Dividends Small Captive Insurance Company Premium Claim payments Dividends Insured(s) Claim payments Reinsurance Premium Premium Legend Captive premium(s) treated as tax deductible. Possibly Risk Pool Claim payments Definitely Underwriting income accumulates tax free. Investment income taxed as ordinary income. Dividends taxed capital gains rate-20% (unless C-corp. owner and then Dividends Received Deduction applies). Claim payments are tax neutral. 11 SMALL CAPTIVE CONCEPT WHO SHOULD CONSIDER AND KEY BENEFITS Middle market companies that are concerned with insurance costs or capacity who are seeking alternative solutions. Organizations with retained Casualty losses less than $2-5 million. Significant insurance spend with commercial markets Companies who are current tax payers. Business with more than US$100 million in annual revenue. Firms that wish to begin a captive program and are looking to start small and potentially grow. Privately held companies. Willing to put up capital. Key Benefits Ability to segregate funds and build surplus to stabilize the annual cost incurred for retained loss cost. Customized Coverage Small captives can design their own insurance to suit their specific needs. Potential tax benefits if captive is structured properly and underwriting profits exists. 12 6
ERCs LINES OF COVERAGE: TRADITIONAL AND NON-TRADITIONAL Growth in Non-Traditional coverages 2014-2015 Source: Marsh s Benchmarking Survey Analysis 13 COMMON ERC COVERAGE STRUCTURE 14 7
COMMON ERC COVERAGE STRUCTURE 15 INSURING TRADITIONAL HIGH SEVERITY RETAINED RISK THROUGH AN ERC Property Risk, including wind and quake Product Recall Product Liability Errors & Omissions Environmental Employment Practices Liability Cyber Risk Crime Wage and Hour Cargo Terrorism Supply chain Why Consider Ability to segregate funds over time to stabilize the annual cost Means to obtain formal evidence of coverage Reimbursement purposes Meet contractual requirements with third parties or regulators Ability to build up captive income exempt from state income taxes Potential to build up underwriting profits of the captive exempt from federal income tax per Section 831(b) of the U.S. Tax Code: Premiums cannot exceed $1.2 million annually (Effective 1/1/17 maximum premium threshold increases to $2.2 million) Captive must operate as an insurance company for U.S. federal tax purposes The captive must reside onshore, or if offshore, take the 953(d) Election to be treated as a U.S. taxpayer 16 8
CAPTIVE COST ESTIMATES LARGER ERC PROGRAM Category Fees Cost Startup Costs: Excludes tax/legal advice Implementation Fee 15,000 Application Fee/Incorporation Fees 5,000 Actuarial Certification (if required) 7,500 Legal Fees 5,000 Feasibility Study Fee 35,000 TOTAL $67,500 Annual Operating Costs: Risk Pooling Costs are in addition to these Fees Captive Management Fee 45,000 Actuarial Certification 7,500 Audit Fee 10,000 Legal Fees 5,000 License 300 Miscellaneous 4,700 Government Fees TBD Domicile Premium Tax (Typically 0.40% first $20 million and sliding scale thereafter) TBD TOTAL $72,500 17 US DOMESTIC CAPTIVE DOMICILES Source: Business Insurance Directory - Captive Managers and Domiciles, Counting Captives, March 2015: 3. Captive Domicile, Number of Captives Alabama 40 Arizona 114 Arkansas 2 Colorado 3 Connecticut 7 Delaware 333 District of Columbia 191 Florida 0 Georgia 9 Hawaii 194 Illinois 1 Kansas 1 Kentucky 122 Louisiana 0 Maine 3 Michigan 15 Missouri 47 Montana 177 Nebraska 4 Nevada 160 New Jersey 17 New York 63 North Carolina 52 Oklahoma 47 Ohio 0 Oregon 0 Rhode Island 0 South Carolina 158 South Dakota 14 Tennessee 72 Texas 24 USVI 8 Utah 422 Vermont 587 Virginia 0 West Virginia 1 18 9
BUILDING A CAPTIVE PROGRAM * Including selection of captive manager, auditor, attorney, bank, actuary, and asset manager (optional) 19 ERCs SOME CURRENT TRENDS NOTICED Evolution of risk insured in ERCs Ins and outs of lower level deductibles Forms of business interruption coverage available continue to evolve and expand despite questions raised by IRS around business vs. insurance risk Commercial markets increasing involvement with coverages with significant use in ERCs Cyber Risk General growing interest in medical stop loss as more mid-size organizations are turning to self-insured programs New focus on more traditional lines 20 10
ERCs SOME CURRENT TRENDS NOTICED (CONT D) Risk pools Reviews focused on claim activity Structures Explosion around the use of cells and Series even though IRS has yet to come out with final guidelines Montana court case supports cell structure risk segregation 21 CELL AND SERIES CAPTIVES 22 Cells at 12/31/2014 Net Additions Cells at 12/31/2015 Captives + Cells at 12/31/2015 Cayman 606-3 603 1,310 Delaware 624 78 702 1,061 Tennessee 206 98 304 430 North Carolina 120 120 240 334 Vermont 78 12 90 678 Utah 71-3 69 516 Total 1,705 282 2,011 3,149 The growth in number of cells and series in 2015 across these six domiciles alone exceeded captive growth. Cells and series are growing at much faster rate. 22 11
ERCs SOME CURRENT TRENDS NOTICED (CONT D) Service provider activity Some mergers/acquisitions Pace of new entrants appears to have slowed down Number of existing programs going to RFP increasing Domicile activity Onshore focus continues Domiciles with favorable cell legislation are most active Lots of talk around self procurement minimal activity to date 23 ERCs IMPACT OF THE NEW STANDARDS COMING INTO EFFECT IN 2017 Existing ERC programs Consultants hard at work Some closures; many ownership restructuring Some converting to traditional captives Many business plan changes ERC DEFINITION IS LIKELY TO evolve Increased used expected by: Larger and/or publicly traded companies Group captives Established/mature captives changing elections Old 831(b) captives falling back under the election (knowingly or not) 24 12
ERCs IMPACT OF THE NEW STANDARDS COMING INTO EFFECT IN 2017 Coverages Increased use of more traditional lines of coverage expected Will this mean a similar trend for risk pools as well? Higher limits Structure trends changes? Will larger premiums = slow down in the use of cells? Less multi-captive structures? Larger owners = decrease use of pools? More regulation expected (with some clarification soon hopefully) 25 CASE STUDIES 26 13
CASE STUDY #1 Privately held organization Demolition, Dismantling & Asset Recovery Organization Complex legal structure consisting of in excess of sixteen legal entities Performed a detailed commercial coverage and self insured claims review and identified self insured risks that could be better managed via a captive insurer Property DIC, Excess Pollution & DIC, Medical Stop Loss, Cyber Risk Liability Company operation review also identified high severity risk exposure for which no commercial coverage was available Loss of Profit due to Safety Events Third party actuarial review priced risks at slightly over $1 Million Formed onshore single parent captive ($350K capital) Captive owned by a Trust for the benefit of the Owner s children 27 CASE STUDY #1 FORWARD LOOKING Review determined that Program does not meet requirements of new guidelines Put captive in dormant status Evaluating whether to convert to traditional captive, leave dormant or close down Considering forming a new captive with new ownership Interested in looking at underwriting more traditional lines 28 14
CASE STUDY #2 Privately held organization - Furniture manufacturer and importer Simple legal structure consisting of only two legal entities Client identified several self insured risk with history of manageable claims activity, but with large claims potential. Commercial review also identified some coverage gaps that could be better managed via formalized pre-funding of future claims Business Interruption, Property Damage in Transit and Mold & Fungi, Loss of Key Employee Third party actuarial review priced risks at roughly $900K Formed onshore single parent captive ($250K capital) Accessed quota share risk pool to provide risk diversification and obtain a level of risk transfer for uninsurable risks Captive owned by certain key employees as part of compensation/retirement plan 29 CASE STUDY #2 - FORWARD LOOKING Program appears to meet requirements of new guidelines Considering potential plans to introduce new lines of coverage including medical stop loss in light of recent change to self insured employee medical program Contemplating increased risk pool participation and potential on risk profile of the captive Start mid-term plan captive program review in light of anticipated ownership changes at operating companies 30 15
CASE STUDY #3 Successful small one-state medical malpractice risk retention group Been in operation for 4+ years Roughly $1.8 Million annual premiums Anticipating steady slow growth in light of soft medical malpractice market Program structured to encourage long term participation (viewed as a quasi retirement investment by shareholders) 31 CASE STUDY #3 - FORWARD LOOKING Program will become 831(b) eligible effective 1/1/17 Historical results demonstrate significant opportunity cost of not having been able to make the election for years in operation Beginning analysis to determine long term pros and cons of making election in 2017 in light of long tail nature of medical malpractice and anticipated growth Reviewing potential side impact on program operation if making election in 2017 32 16
CASE STUDY #4 Successful large beverage distributor in New Jersey Been in operation for 30+ years Roughly $100 Million annual sales No availability for Accidental Product Contamination insurance Other employee benefit and medical stop loss coverages reviewed with captive feasibility study 33 CASE STUDY #4 - LOOKING BACK AT PROGRAM Program became a Nevada 831(b) eligible captive in 2013 NJ does not allow pooling Company did not have risk distribution so they participated in a Utah risk pool for 45% of its premiums Pool was vetted by Actuary, Auditor and Captive Board prior to joining. Captive was owned by trusts to allow for Estate Planning In early 2016 Client changed the ownership to comply with the new 2015 law changes Captive running smoothly and expects to increase premiums in 2017 34 17