Captive 101-Back to the Basics Sean Rider, Willis Global Captive Practice Scott Spencer, Stevens & Lee Moderator: Anne Marie Towle, Willis Global Captive Practice
Presentation Topics Captive Primer Feasibility Study Legal & Tax Considerations Incorporation Contact Information 2
CAPTIVE BASICS PRIMER 3
Primer: the Basics What is a captive? A limited purpose, licensed insurance company, the main business purpose of which is to insure the risks of the captive s owners A risk assumption vehicle An insurance or reinsurance company Specifically established to insure or reinsure the risks of its parent or associated third parties 4
Primer: the Basics HIGH Self-Insured Trust Complete assumption of risk with limited regulation Single Parent Captive Complete assumption of risk Subject to Regulatory Oversight Group Captive Pooling of Risk with Participants subject to Corporate Governance Deductible Policy Significant/complete risk assumption in exchange for deductible credit Retro Policy Assumption of limited risk in exchange for potential return premium Deferred pay-in premium LOW Guaranteed Cost Complete transfer of risk Commercial insurance with no deductible HIGH Financial Control 5
Primer: Factors Driving Captive Growth The unwillingness/inability of insurers to provide cost effective insurance The need for new capacity for certain risks The drive control to frictional and non-loss costs Lack of confidence in the traditional markets ability to differentiate and provide stable protection The enhanced focus on loss prevention and intelligent claims handling The opportunity to implement efficient intergenerational wealth transfer The opportunity to take risk and profit positions in affiliate business The opportunity to see favorable risk management, wealth and tax outcomes 6
Primer: Lines of Business TRADITIONAL EXPANDED EMERGING Workers Compensation Auto Liability General Liability Professional and Products Liability Director and Officer Liability Employment Practices Liability Environmental Liability Product or Service Extended Warranty Property and Business Interruption EE Benefits Terrorism (TRIA) Shipping Coverage Title and Private Mortgage Insurance Equipment Maintenance Construction Exposures Trade Credit Risk Cyber-Risk Managed Care Errors and Omissions Self-Insured Medical Stop- Loss (non-erisa) Reputation/Brand/Loss of Income Risks Intellectual Property (patent, trademark, copyright) Product Recall Coverage Medicare Fraud and Abuse Insurance Lease Residual Value Risk Punitive Damages Coverage International Kidnapping Protection 7
Primer: Types of Captive Utilization Retained Risk Finance Risk Transfer Rate Arbitrage Access to Capacity Entrepreneurial Utilizations Infrastructure for providing transparency, validation, and rationalization of retained risk positions Enhancing risk management efforts Accelerating tax treatment of deductible liabilities Reinsurance market cost of risk transfer is less than commercial retail cost of risk transfer Better use of capital to retain risk than transfer it Managing total cost of risk Federal programs (TRIA) Reinsurance capacity, which may not be otherwise accessible in commercial retail market (trade credit risk, +10 yr pollutions risks) Franchisee programs Consumer facing insurance programs (warranty, service contract, point of sale insurances, etc) Affiliate business (vendors, VAPs, distributors, etc) Agency captives 3 rd party business 8
Primer: Deductible Reimbursement Programs How do they Work? The insured continues to purchase deductible insurance programs from the commercial market; The insured then purchases a deductible reimbursement program from their captive, paying a premium equivalent to their loss picks under the commercial deductible program; In the commercial deductible program, the insured will be required to post a security instrument of some sort, it is possible, upon negotiating with the carrier, that the premiums that the insured pays to the captive be used to secure the insured s liabilities under the commercial deductible program. Risk Transfer Program (Excess Insurance over Deductible) Insured s Deductible Fits into the deductible layer Deductible Reimbursement Program (provided by the Captive) (Aggregate Stop Loss) 9
Primer: Captive Facilities Equity Captive Facility Segregated Captive Facility Segregated Captive Facility Facility Owner Facility Owner Cell 1 (Group) Equity Captive (SP) Insured 1 Beneficial Owner 1 Insured Insured pays premiums and submits claims Captive- pays operational service providers, collect premiums, pays claims, dividends profits Shareholder provides capital and surpluses, and collects dividends Insured 2 Cell 2 (SP) Beneficial Owner 2 10
CAPTIVE BASICS FEASIBILITY STUDY 11
Feasibility Study A Feasibility Project typically has six main components: Information Gathering General Framework Actuarial Analysis Domicile Analysis Tax and Legal Analysis Pro Forma Financial Statements 12
Information Needed Financial Analysis Overview of subject business, including number of employees; Corporate structural, tax, and organizational information; Corporate financials; Current insurance program details for all lines under consideration: these may include insurance policies, certificates of coverage and exposures Projected loss information for all lines under consideration, including any actuarial or risk analytics recently performed; Loss history for at least the last 5 years including large loss detail for all lines under consideration; Historical exposures; Data related to growth plans, expansion (related to exposure basis) and any expected circumstances which may impact risk; In addition to data, company will need to commit the time and engagement of key stakeholders into this process. 13
General Framework Captive Basics Risk Taking Structural Options and Scenarios Domicile Decision making Financing Options Coverage Requirements Marketing Initiatives / Options Additional Ancillary Uses 14
Actuarial Analysis Loss Forecasts Rate Making Working with regulators towards approval 15
Pro Formas Projections Financial Analysis Various loss scenarios Various attachment points Various reinsurance structures Prospective pro forma financial statements 5 year prospective financial statements Actuarially determined payout patterns Expected incorporation and ongoing expenses Investment modeling Surplus and capital contributions 16
Domicile Onshore: (over 35 States): Vermont Hawaii South Carolina New York District of Columbia Arizona Nevada Utah Montana Puerto Rico U.S. Virgin Islands Offshore: Bermuda Cayman Islands British Virgin Islands Barbados Turks & Caicos Channel Islands (Guernsey/Jersey) Ireland Gibraltar Isle of Man 17
Domicile Domicile decision metrics: Capitalization and surplus requirements Receptiveness of regulatory environment Quality of local infrastructure Availability of expertise Stability of regulatory environment Flexibility as respects investment portfolio Ease of doing business in a suitably regulated environment Experience in business under consideration Efficient financial outcomes: tax, wealth, investment etc. 18
Costs Basic Captive Costs Costs Captive Low High Phase One: Feasibility Study Actuarial Study 10,000 25,000 Legal and Tax advice 5,000 20,000 Analysis/Coordination and General Consulting 20,000 45,000 35,000 90,000 Phase Two: Captive Implementation Domicile License and Registration Fees 300 7,000 Lawyers Fees for Docs & Incorp 10,000 25,000 Management Fee for Incorporation 7,500 10,000 Actuarial Certification (if required) 10,000 25,000 Other Disbursements 2,000 3,000 29,800 70,000 Phase Three: Ongoing Operations Annual Government Fees 300 15,000 Lawyers, Secretarial and Directors Fees 3,000 10,000 Audit Fee 20,000 45,000 Actuarial Fees 10,000 25,000 Management Fee 30,000 125,000 Accrual for 3 year examination 5,000 15,000 Miscellaneous (meeting, software, stationary, etc.) 5,000 10,000 Travel 5,000 25,000 Premium / Federal Excise Tax varies varies 78,300 270,000 Initial Capitalization Single Parent 250,000 1,000,000 19
Timeline Timeline (weeks) Phase One: Feasibility Study short long Actuarial Study - 6 Legal and Tax advice 2 6 Coordination and General Consulting 4 10 Overall 5 12 Phase Two: Captive Implementation Develop Business Plan 2 3 Complete Application 2 4 Develop Legal Documents 2 4 Incorporate Company 1 1 Capitalize Company 1 2 Seek Insurance License 3 6 Complete all contracts 2 2 Overall 6 16 20
CAPTIVE BASICS LEGAL AND TAX CONSIDERATIONS 21
Legal and Tax Considerations Choice of Entity Mutual Reciprocal Stock Company Segregated Facilities Tax Planning Insurance Company Classification Available Elections Premium / Surplus Lines Taxes Choice of Ownership Direct Ownership Holding Companies Family Wealth Planning Compliance Issues Doing business in subject business jurisdictions 22
Legal Topic 1 CHOICE OF ENTITY 23
Choice of Entity This is the threshold question: What type of entity should we use? Often the answer is clear: A single parent captive rules out the mutual or reciprocal form, and may often rule out an SPC structure Leaving one with a simple stock corporation A group program has many choices available to it depending on the owners goals 24
Choice of Entity Reciprocals popular on shore, especially for groups where strong central administration is desired (attorney-in-fact) or for groups of tax-exempt organizations Mutuals work well for large groups of doctors Stock companies have flexibility regarding control, allocations of income, etc. Counsel and your captive consultant will work with the client to evaluate and select the best form under the circumstances 25
Legal Topic 2 TAX PLANNING 26
What Are We Planning For? We are planning so the captive is classified as an insurance company for federal income tax purposes Normally, a taxpayer is not permitted a deduction for self-insured risks until a claim is paid. A taxpayer is permitted to deduct insurance premiums when paid to a properly structured captive A captive classified as an insurance company for tax purposes is entitled to deduct reserves incurred (before paid) thus deferring income recognition A small insurance company (Section 831(b)) is not required to pay tax on its underwriting profit; only its investment income $1.2 million in gross written premium 27
Establish and Document Your Business Threshold Requirements: Purpose Have a valid and substantial non-tax business purpose Be in the insurance business (assume and share insurance risk) Operated and regulated as an insurance company Generally not insurance for tax purposes: Speculative risk (likelihood is too small) No fortuity (will inevitably occur, but timing is unknown) Business risk Investment risk 28
Key Requirements: Risk transfer Risk distribution Risk transfer requires the transfer of the financial consequences of a loss to another. What is the economic effect of an insured loss? Does the captive have sufficient capital to pay limit losses? Risk distribution means pooling of premiums for sufficient risks to allow the law of large numbers to apply. Does your actuary see a large number of independent risks? Are the risks non-correlated? Evaluate Risk Sharing Are the risks homogeneous or heterogeneous? Are the risks produced from a sufficient number of separate legal entities? 29
Risk Distribution Possibilities Risk distribution may take the form of: Enough outside business, or Brother-sister insurance 30
Safe Harbor: Unrelated Business Example Safe Harbor Revenue Ruling 2002-89 Greater than 50% of homogenous risk exposure is derived from a third party (The Tax Court once said 30% is enough) Parent company/primary shareholders also own 100% of captive Captive Charges arms-length premiums, established by customary rating formulas No parental or related party guarantees made in favor of captive No loans from captive to parent or insured subs 31
Brother-Sister Structure 32
Multiple Brother-Sister Entities There is risk distribution where a captive sells insurance to enough operating subsidiaries (who own no stock in the captive) The IRS believes that a single-member LLC that is disregarded is not an insured (its owner is); but, if the LLC has checked the box to be a corporation, the LLC is the owner. The IRS has also stated that a multi-member LLC is the insured (and that the owners are not the insureds). The IRS further stated that the general partners of a limited partnership is the insured, and not the limited partnership or the limited partners. 33
Safe Harbor: Brother/Sister Safe Harbor Revenue Ruling 2002-90 Holding company owning 100% of 12 affiliated C corporations Holding company also owns 100% of captive All companies file consolidated federal return Captive charges arms-length premiums, established by customary rating formulas None of the subs have liability coverage for less than 5%, nor more than 15% of the total risk insured by captive. No parental or related party guarantees made in favor of the captive No loans from the captive to parent or insured subs 34
Group/Pool Captives Group/Pool Captives Revenue Ruling 2002-91 Unrelated, independent entities each form a wholly owned entity that operates as a captive insurance company Multiple entities participate to achieve risk shifting and distribution Each captive engages in the business of directly insuring non-life risks of its 100% owned affiliated group Each captive will purchase reinsurance policies with respect to its best insured risks from the other captives within the pooled captive structure 35
Elections For small captives, the 831(b) election For non-us captives, the 953(d) election 36
The Practical Side of Taxes Count Legal Entities Work with the Actuaries to understand the allocation of risks, coverages, premiums Evaluate the result against the applicable precedents Adjust if possible Write a memo (or an opinion) Make the elections where applicable 37
Legal Topic 3 CHOICE OF OWNERSHIP 38
Ownership Structure For pure captives...... Usually the parent organization owns the stock of the captive For closely-held businesses...... Ownership driven by premium deductibility and by wealth transfer goals 39
Small Captive Example 40
Wealth Transfer Insured entitled to an ordinary and necessary income tax deduction for premiums paid. Captive Insurance Companies, like all insurance companies, can accrue reserves (i.e., take a current tax deduction for contribution to their reserves). 831(b) Captives are exempt from income tax on premiums received. If a Captive is owned by adult children (over age 21) of the business owner, distributions from the Captive will be taxed to the children at their income tax rates. 41
Example 1: Parent establishes an Irrevocable Trust for children (and grandchildren) Trust owns the Captive as such, accumulated surplus and reserves pass estate tax-free to the Trust Children/Grandchildren Parent Family Trust Capitalize Dividends Business Premiums Insurance Policies 831(b) Captive Investments Assuming a $1,000,000 annual premium, the potential annual tax savings would be as follows: Income tax savings $400,000 Estate tax savings 350,000 Total $750,000 42
Legal Topic 4 REGULATORY 43
Compliance Issues Is the Captive Doing Business outside its domicile? Are Federal Excise Taxes due and is someone paying them? Are State Premium Taxes due and is someone paying them? Fronting insurer Nonadmitted direct-writing captive Self-procurement 44
Incorporation of the Captive Initial approvals and selection of service providers Draft operations plan and financial projections Meet with domicile regulators Submit captive application to regulator Incorporation Certificate of Authority ( COA ) Capitalize Underwriting/Operations begin Other activities/steps subsequent to COA 45