Captive Insurance AICPA Real Estate and Construction Conference 12/9/16 www.montpelieradvisors.com Presented by: Kevin Atkinson, Founder 1
SEMINAR TOPICS Captives for Risk Financing Enterprise Risk Captive (831b) Taxation of Captives and Recent Developments Captive Best Practices
OUR PHILOSPHY Integrated Solution Objectivity Do no harm Do it right Hire the best advisors Business not product
COLLABORATIVE APPROACH RISK ACTUARY LEGAL CLIENT CAPTIVE TEAM CPA/LEGAL CPA FINANCIAL INSURANCE MANAGER Montpelier is your trusted captive team leader.
WHAT IS A CAPTIVE FOR? Business owners and risk 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 commercialmarket The questions cannot properly be answered without first identifying risks within the business
THE CAPTIVE MARKETPLACE Current State: Estimated 7,000 Captives worldwide; estimated 3,000 small captives $50 billion in annual premiums Originally, 90% of Fortune 500 companies owned captives Over 50% of major US Corporations have captives 35+ US States now have passed captive legislation Middle Market Increase since 2001 IRS Revenue Rulings creating safe harbors have opened the door for expansion as well as more cost efficient structures and service offerings Captive Types: Pure, Group, Association, Agency, Rent-a-Captive, Protected Cells, Diversified Captive, Special Purpose
COMMERCIALLY PURCHASED INURANCE Workers Comp Auto Liability General Liability Property, Umbrella, etc Legal Expense Employment Practices Administrative Actions Business Interruption Intellectual Property Directors & Officers Loss of Client Reputational Risk Product Recall Supply Chain Risks Cyber Liability Regulatory Changes Buried Risks
FOCUS: MIDDLE MARKET A captive insurance company is an enormously powerful financial planning tool for owners of middle market companies. It facilitates cost-effective and efficient risk financing, and has the potential to provide benefits in the medium term amounting to literally millions of dollars.
ENTERPRISE RISK CAPTIVE Property and casualty insurance company (C-Corp) with annual premium not exceeding $2.2m ($1.2m for 2016) qualifies to make election under IRC S.831(b) and meets diversification requirements of the 2015 PATH Act and notice requirements of IRS Notice 2016-66 Taxed only on investment earnings. Underwriting profits are not subject to income tax Distributions are return of capital and taxed at capital gains
CANDIDATES BUSINESS PROFILE Businesses desiring to explore alternative risk transfer solutions to finance risks currently retained Available cash flow to pay annual premiums to the insurance company of at least $400,000 Identifiable uninsured or self insured risks that can actuarially be quantified Privately held companies Greater than $20 million in gross revenues IDEAL INDUSTRIES Professional Services Firms General Contractors Government Contractors Manufacturers Service Companies Transportation/Distribution Auto dealers/equipment Dealers Real Estate Development and Management Manufacturers Reps
CASE STUDIES Construction Contractor Roofing Contractor Revenues $29,000,000 $25,000,000 # of States 3 30+ # of Employees 220 26 Use of Subcontractors Limited 15 to 17 Crews (multiple individuals per crew) Premium Range Up to $1,100,000 Up to $1,200,000 Premium Funded $998,396 $937,389 Coverages Administrative Actions Administrative Actions Cyber Risk Cyber Risk Reputational Damage Reputational Damage Wrongful Acts including Pollution Gaps Wrongful Acts (including D&O, E&O, Fiduciary Gap) Work Stoppage Work Stoppage Legislative or regulatory change Legislative or regulatory change Litigation Expenses Litigation Expenses Tax audit legal defense expense Tax audit legal defense expense Loss of Key Employee Loss of Key Client/Account Loss of Key Employee Contingent Business Interruption Loss of Key Client/Account Uncollected Receivables Loss of Key Supplier Contingent Business Interruption Express or Implied Warranties
IDENTIFYING RETAINED RISK QUESTIONS TO ASK What does the business do? How does it doit? What environments exist? Regulatory, supply chain, distribution channels? What makes the business go? What keeps the owners up atnight? SELF INSURED RISKS RISKS NOT COMMONLY INSURED POLICY DEDUCTIBLE CUSTOMIZED COVERAGE HIDDEN RISKS UNIQUE RISKS DIFFICULT OR COSTLY TO INSURE POLICY EXCLUSIONS
ACTUARIAL RISK PRICING Actuaries should NOT price loss exposures that do not represent real insurance risk. Rigorous methods and assumptions develop expected loss estimates for each coverage. Insurance must Reflect a shift of both economic loss and timing of payments Represent a material risk (statistically) of a material loss Actuarial Methods utilize Pricing from public information Rate filings for similar coverage Past claims history Reinsurance techniques when little public data exists Actuarial Reports must Comply with the highest actuarial standards and be easily reviewable by other actuaries and regulators
BUILDING A BALANCE SHEET $$$ $$ $ Statement of Investment Policy Approved by Regulator Preservation of capital Liquidity Assets typically held by insurance companies Distributions and loans approved by regulator not infringing on liquid reserves
THE BUSINESS TRANSACTION
STRUCTURE
TAXATION OF CAPTIVES Insurance companies can establish reserves and deduct them from taxableprofits Ordinary companies cannot do this Premium payable to a captive should(subject to conditions) be tax deductible byinsured Small captives benefit from generous tax treatment under IRCS.831(b) Captive is tax efficient; building contingency fund using pre-tax dollars
Risk Shifting Risk Distribution INSURANCE ACCORDING TO THE IRS Fortuitous Risk Shifting Transfer Risk Of Economic Loss Risk Distribution Law of Large Numbers; Pooling Fortuitous Uncertainty; General sense Commonly Accepted Commonly Accepted Operates as Insurance Company
RISK SHIFTING The insurance is determined with an underwriting and actuarial analysis that conforms to insurance industry standards The insurance payments are made consistently with the schedule in the insurance contract The insurance payments are agreed to by the insured and captive comparing the amounts of the payments to payments that would be made under alternative insurance arrangements providing the same or similar coverage Issue policies or binders in a timely manner consistent with industry standards Policies with clear language as to an occurrence event
RISK DISTRIBUTION CRITERIA Two key IRS revenue rulings provide the framework for micro-captives meeting risk distribution Rev. Ruling 2002-90 Rev. Ruling 2002-89 Brother-Sister Test Must have 12 subsidiaries (i.e. brother-sister companies) to meet safe harbor Each subsidiary should represent no less than 5% but no more than 15% of total captive risk Case law lowered number of brother-sister companies to 6 Pooling Requires more than 50% of risk derived from unrelated third parties Case law requires only 30% third party risk Most Micro- Captives Use Pooling
P O O L P O O L POOLING CONCEPT Captive & Risk Premium to Pool Captive & Risk Premium from Pool Captive Risk After Pooling Captive 1 Captive 2 Captive 3 Captive 4 Captive 5 Captive 6 Captive 7 Captive 8 Captive 9 0 Captive 10 1 Captive 11 2 Captive 12 3 Captive 13 4 Captive 14 5 Captive 15 6 Captive 16 7 Captive 17 8 Captive 18 9 Captive 19 0 Captive 20 You walk into a pool room with your own risk Once you are involved your risk becomes mixed with others Your captive has your risk and others risks; others have your risk
PATH ACT: CHANGES TO 831B LAW First change since 1986; Changes take effect in 2017; no grandfathering Increased premium limit from $1.2m in 2016 to $2.2m in 2017 and indexed for inflation Added a diversification requirement Risk Diversification Test- no more than 20% of premiums from one policy holder OR Ownership Test- Lineal descendants or spouse of business owner(s) do NOT, directly or indirectly through a trust, family limited partnership, business entity, etc., own more than 2% in their insurance company than they own in their business
INDUSTRY RESPONSE Industry seeking clarity: SIIA and Industry Associations Letter to IRS October 2016 Captive Managers must decide on pooling structure they will offer 51% Pooling Structure---Captives Must Meet Ownership Test 80% Pooling Structure---Captives Meet Risk Diversification Test and Freedom of Choice for Ownership 51% & 80% Pooling Structure--- 51% and Meet Ownership Test 80% and Ownership Freedom of Choice Observation: Not all pooling structures are created equal Meeting Ownership Test needs to be evaluated carefully especially with multiple insureds and complex business ownership structures
NOTICE 2016-66 Issued 11/1/16 Designates 831b captives meeting criteria as a Transaction of Interest IRS recognizes that many Micro-Captive may be legitimate and non-abusive; concerned about abuses and need more information Most 831b captives formed in last 10 years will have to report Reporting by captive, insured and captive/business owners Material advisors also have reporting and maintenance requirements Filing Deadline: 1/30/17 for past years through 2015 Annually with tax return filings 2016 and forward
NOTICE 2016-66 The required disclosures (using IRS Form 8886, Reportable Transaction Disclosure Statement) include but are not limited to the following: A description of all types of coverage provided by the Captive; A description of how the premiums for coverage provided by the Captive were determined; Under what authority the Captive is chartered; A description of any claims paid by the Captive; A description of the assets held by the Captive; A description of the amount and nature of the expected tax treatment and expected tax benefits generated by the transaction.
GETTING IT RIGHT! Genuine business purpose (i.e. risk financing) Regulatory compliance (spirit and law) Insurance in the commonly accepted sense covering real risks relevant to the insured Premiums priced reasonably with actuarial integrity Legitimate pool-actuarial integrity, claims and expectation of claims Claims-make them when event occurs Properly capitalized Appropriate approach to related party loans No investment in life insurance
COMNONLY ASKED QUESTIONS How does one decide how to own their captive? Does the ownership have to be the same as the business? Does the business have to make claims? If a claim occurs, does the business need to make it? Isn't it hard and doesn't it take a long time to shut a small captive down? Is this the only option?
CAPTIVE LEADERSHIP MONTPELIER ADVISORS Montpelier Advisors is an independent boutique firm specializing in the collaborative structuring and focused oversight of captive insurance solutions for middle market companies. We provide thought leadership, strategies, knowledge transfer, and access. The ability to sit down with clients and lay down foundations, develop ideas, and discuss future goals is a rarity throughout the captive industry. Montpelier Advisors navigates the entire lifecycle of your captive with the ability to sense practical alternatives. They add innovation and creative foresight to every situation. You can count on Montpelier Advisors to have you and your company s best interest in mind. KEVIN ATKINSON Founder, Kevin Atkinson, is the innovative leader of Montpelier Advisors. If there is a challenge to overcome or an opportunity to explore, Kevin either has the expertise or has access to the information and relationships to deliver results. Kevin is a firm believer that an integrated, coordinated and focused approach is the key to getting things done right, the first time. Cell: 443 994 2723 katkinson@montpelieradvisors.com www.montpelieradvisors.com Schedule a customized follow up for you and your team!
DISCLAIMERS 1. Montpelier Advisors LLC does not give tax, accounting, regulatory or legal advice to clients. The effectiveness of any of the strategies described will depend a client s individual situationand on a number of complex factors. 2. Clients should consult with their other advisors on the tax, accounting, and legal implications of these proposed strategies before any strategy isimplemented. 3. Any discussion in this presentation relating to tax, regulatory, or legal matters is based upon our understanding as of the date of this presentation. Rules in these areas are constantly changing and are open to varying interpretations. 4. IRS Circular 230 Disclosure. To ensure compliance with requirements imposed by the IRS, we are required to advise you that, unless otherwise expressly indicated, any written tax advice inthis communication (including attachments) is not intended or written by the author to be used by any taxpayer, (i) for the purpose of avoiding penalties that may be imposed on the taxpayer or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication. Montpelier Advisors, LLC For Discussion PurposesOnly. Not for Distribution WithoutApproval.