PC2: Introduction to Captives Martin Eveleigh Chairman, Atlas Insurance Management Kirk Mooneyham Managing Director, Wilmington Trust SP Services, Inc. What is a Captive Insurance Company? A captive insurance company is, in its simplest and purest form, an insurance company that only insures risks of its owners. An insurer that writes risks whose origins are restricted or risks to which it has unique access. A captive is a tool for managing risks in a formal, measured, tax efficient manner. It is a privately held insurance company, which insures the risks of an affiliated business, its customers or others. Licensed in a captive domicile (onshore or offshore). Regulated under special enabling legislation. Admitted only in its domicile; non admitted in all other jurisdictions (unapproved status). 1
History of Captives Captive term coined by Frederic M. Reiss. First Captive formed in the 1950 s. Bermuda initially the jurisdiction of choice due to favorable regulatory environment. Captives at that time predominantly owned by large US corporations. Subsequent growth in the number of jurisdictions. Currently 37 States have captive legislation. Offshore domiciles include: Cayman Islands, Bermuda, Anguilla, Nevis and Bahamas. The Current Captive Marketplace 6,000 captives worldwide and growing. Over $50 Billion annual premium. Originally reserved for Fortune 500 companies (80% have captives). Increasingly being used by middle market companies. Further development in the types of captives available. 2
What is a Captive for? A captive is a vehicle for financing risk that is retained. Business owners and managers should ask themselves, What risk do I want to retain? and What risk do I want to transfer? The answer will depend on various factors, particularly on the availability and cost of insurance in the commercial market. The questions cannot properly be answered without first identifying risks within the business. Retaining Previously Transferred Risk Dilemma.. My premiums keep going up but my claims do not increase. I have been buying insurance because my balance sheet wasn t strong enough to withstand a claim. 3
Identifying Retained Risk Items to think about: Deductibles Exclusions Excess layer Risks for which the commercial marketplace provides no or limited cover Risks that you hadn t thought about Questions to ask: What does the business do? How does it do it? What environments exist regulatory, supply chain, distribution channels? What makes the business go? What keeps you up at night? Traditional Risks Liability Coverages long tail, opportunity to generate investment income. Property Risks multiple locations, high aggregate value, high deductibles imposed (e.g. windstorm). Workers Compensation accounts for high proportion of alternative risk market. Professional Liability Classes challenging commercial marketplace. 4
Traditional Risks Breakdown Other Risks All businesses have uninsured risks: Legal Expense Reimbursement Loss of Key Client/Account Administrative Actions Business Interruption Intellectual Property Machinery Breakdown Political Risk Patent Infringement Employment Practices Liability Reputational Damage Product Recall Supply Chain Risks Cyber Liability 5
Why Go Captive at all? Self insurance is cheaper right? Popular forms of retaining risk: Self Insurance Large deductible (partial self insurance) Both involve internal loss funds set aside to pay claims: Pay for current claims not necessarily the ultimate loss. Not tax deductible until claim is paid. Remain on the firm s balance sheet as an asset. An insurance (captive) company has benefit of: Ability to reserve monies to pay claims in future. The policy premium paid is tax deductible (policyholder)* Captive as a Risk Funding Mechanism Alternative risk structure offer and insured mechanisms for funding risk exposures. Benefiting from favorable underwriting performance on retained risks. Utilizing Deductibles both (large and small). Deploying captive insurance solutions (owned or not). Often combinations of retained and transfer of risk used. 6
Traditional Market Factors Commercial market factors favor the carrier No or little leverage or control. Underwriting profit retained by the carrier not necessarily policyholder.. Expense ratio not controlled by policyholder perspective. Mostly non negotiable vendor agreements/services. Nature of insurance cycle makes planning and forecasting difficult in both soft and hard market phases. Advantages of a Captive Strategy Reduced reliance on commercial insurance. Reduction of the costs of risk management. Stabilization of pricing. Cash flow advantages. Provision of cover where otherwise unavailable. Access to reinsurance markets. Ability to customize insurance programs. Formalize the allocation of deductibles for selfinsurance retention. Possible tax advantages. 7
Types of Captive Insurance Companies Single Parent Captives Single owner, for whom captive provides insurance coverage. Association or Group Captives Formed by an association or group to provide insurance coverage for members. Risk Retention Groups (RRGs) Liability only insurance company that is owned by its policyholders. Protected Cell Captives (PCCs) A company which separates into "protected cells in which the assets and liabilities are separated from the main assets ( core ) of the company. Enterprise Risk Captives Formed by an individual to provide insurance coverage for exposures (often unrecognized) that otherwise would reside on the corporations balance sheet. Direct Captive Structure Basic captive arrangement. Parent pays insurance premiums directly to a captive. Claims are paid by the captive to the Parent. 8
Deductible Reimbursement Structure General Liability or WC Large Deductible potential for premiums to be tax deductible. Benefits current tax deduction, asset protection, and enterprise risk management. Alternative funding mechanism retention of underwriting profits. Deductible Reimbursement Structure Policy issued by commercial insurer subject to high deductible. Client buys a Deductible Reimbursement policy from captive to cover the high deductible. Captive provides a Letter of Credit to commercial insurer. Client Insurer Captive 9
Fronted Captive Structure Policy Issuing Carrier Front AM Best Rated Front receives premium, issues policies plus provides other services 19 Fronted Captive Structure Alt #2 Existence of a licensed and AM Best rated fronting insurance company. Satisfies regulatory requirements. Captive reinsures some or all of the risks. 20 10
Fronting Considerations Fronting Commercial insurance carrier issues policy. Captive is reinsurer. Carrier is licensed and takes credit risk. Collateral Held for several years. Letter of Credit. Funds Withheld. Reg. 114 Trust. Cash. 21 RRGs and Group Captives Risk Retention Group Policyholders are owners Owners eligible for profits Can only be domiciled in US Does not require a front Primarily a liability carrier Homogeneous risks only Created under Congress Group Captives Almost anyone can be an owner Shareholders eligible for profits Domiciled (almost) anywhere Most require a front to issue policy Can (re)insure most lines Heterogeneous or not Regulated by domicile 22 11
Group Captive Structure Group Captive formed to pool premiums from several independent insureds. Allows insurance to be tailored precisely to the needs of the group. Can provide substantial insurance savings. Provides a focal point for Risk Management and Loss Control. 23 Growing Segment Cell Captives Originally started in Channel Islands/offshore/UK domiciles. Single legal entity with core or general assets Cell election can be: incorporated which has its own FEIN, or: protected which assimilates with ownership of cell company Series LLC (or cell ) master LLC wherein series or cells can be created functioning similar to incorporated cells. Comparably lower capital, cost and resources required. Can be owned by parent, association, group, agency insurer or others and be rented to 3rd parties. Extremely popular with private and SME businesses. 24 12
Incorporated Cells/Series Cells Cell walls higher and thicker than PC. Own Board of Directors or use existing PCC Board. Own FEIN and tax filing. Inter cell agreements permitted. Can enter into own reinsurance and vendor contracts. Auditing, associated costs can be reduced/shared. 25 Captives for the Middle Market An enormously powerful financial planning tool for owners of middle market companies. It facilitates cost effective and efficient risk financing. Fastest growing business segment using captives are the Small and Medium Sized Business (SMB). 99% percent of all independent businesses employ fewer than 500 people. Small (up to 100 employees) and Medium sized (up to 500). Increasing use of captives to manage risk, control insurance costs, create wealth and use pre tax premium dollars to fund future liabilities. Source: Marsh Survey Group 26 13
Taxation of Captives Insurance companies can establish reserves and deduct them from taxable profits. Ordinary companies cannot do this. Premium payable to a captive should (subject to conditions) be tax deductible by insured. Small captives benefit from generous tax treatment under IRC S.831(b) (and S.501(c)(15)). Captive is tax efficient; building contingency fund using pre tax dollars. 27 Insurer of Tax Purposes The captive must be an insurer for tax purposes. There are three key tests: Must operate as an insurance company in a commonly accepted manner Must carry out the business of insurance. More than 50% of revenue coming from insurance premiums. It must demonstrate risk shifting and risk distribution pooling of risk. 28 14
Risk Pooling To be considered an insurance company for tax purposes, a captive must be able to demonstrate risk distribution. By participating in a risk pool, a portion of the captive s risk will be reinsured by a reinsurance company. The reinsurance company charges a fee to cover administrative expenses equivalent to a percentage of the premium ceded to the pool annually. This arrangement reduces volatility and allows the captive to be an insurer for tax purposes. 29 Federal Taxation of Captives (1941) Supreme Court opined on insurance : Historically and commonly insurance involves risk shifting and risk distribution. Captives are typically taxed as C corporations. Captive owners and IRS have historically battled over tax issues. Over the years safe harbor provisions have been established. Helvering v. Le Gierse (1941) Risk Distribution Risk Shifting Revenue Ruling 92 93 Revenue Ruling 2002 89 Revenue Ruling 2002 90 Revenue Ruling 2002 91 Revenue Ruling 2005 40 Revenue Ruling 2008 8 Revenue Ruling 2009 26 is it an insurance company for tax purposes 30 15
Insurance Company* or Sham Captives insure and manage risk so they must qualify as an insurance company to obtain primary benefits of (1) premiums paid into it as bona fide business expenses (for policyholder) and (2) reserving. Business purpose not solely a tax planning. Require an adequate amount of capital. Arms length calculation of premiums Risk shifting and risk distribution. Real risks with real possibility of loss. Pay claims. Managed and regulated as an insurance company. *The IRS does NOT define insurance. 31 IRC Section 831(b) Non life insurers with annual premium income not exceeding $1.2m pay income tax on investment income ONLY Underwriting profits are NOT subject to income tax 32 16
Risk Shifting and Risk Distribution Revenue Ruling 2002 89 Parent Company Shareholder #2 Adding 50% unrelated risk (3 rd party) creates risk shifting and risk distribution. Majority of Premium Majority of Risk Captive #1 Lacks sufficient risk distribution or transfer so premiums paid are NOT deductible. Attorney Auditor Actuary Adjuster Agent Accountant Professional Team 34 17
Select a Good Captive Manager Qualified industry professionals; CPA, CIC, ARe, ACII, ARM. Acts as eyes and ears for regulators. Virtual employee of the captive and performs accounting, financial reporting, banking, annual reports and filings. Reinsurance and fronting support/negotiations and wording. Underwriting, policy issuance, binding coverage, investment oversight and other services upon consideration. 35 Formation Timeline Feasibility Study 30 to 90 days. Determine type of cover, limits, funding. Financial pro forma (Cash flow, Balance Sheet, Income). Capitalization strategy. Domicile analysis. Business plan. Submitted Application 30 to 60 days. Implementation 30 days. Summary: As little as 90 days or as much as 1+ year 36 18
Formation Process Step 1 Step 2 Step 3 Step 4 Feasibility study Appointment of key parties Ownership structure Capital Application process captive name type directors officers 37 Formation Considerations Long term commitment (5+ years). Capitalization requirements. Operating costs. Opportunity cost. Potential adverse underwriting results. Time commitment from management. May be subject to state self procurement taxes. IRS challenges to insurance company status. 38 19
Estimated Costs of Forming a Captive Feasibility Study/Business Plan $8,000 $100,000 Captive Consultant $10,000 and up Legal $5,000 $8,000 Total $23,000 $100,000+ 39 Pre feasibility Strategy Session Gather loss data, premium, policy counts for prior 5 years. Multi year financial and loss pro forma; (1) Expected (2) Adverse and (3) Years 1 3, 5 Ownership structure including tax analysis. Where to domicile captive. Capitalize owned captive or PC. Business plan (why is the captive/rrg being formed). 40 20
Domicile Selection Where and Why Corporate personal preference. (In) Stability of regulators. Capitalization and surplus requirements vary. Offshore or US (gap is closing). Access to local domicile service providers. Premium taxes (some or none). Captive statutes (when last updated?). Relationship of captive insurance association w/ regulators. 41 Estimated Costs of Running a Captive Captive/RRG Manager $20,000 $50,000+ Audit (Subject to a minimum) $12,000 $20,000 Actuary $5,000+ Attorney (Domicile) $5,000 $10,000+ Adjuster/Third Party Administrator (%age of GWP) $10,000 Government Fees & Taxes $1,000 $10,000+ Total $53,000 $100,000+ 42 21