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Fundamentals of CaptiveInsurance Companies

Fundamentals of CaptiveFundamentals of CaptiveInsurance CompaniesInsurance Companies

Bridgebay Consulting & Northern Trust Company

Corporate Treasurers’ SeminarTuesday, March 22, 2005

Hyatt Regency San Francisco Airport

Thomas M. Jones, Partner312/984-7536

[email protected]

©2005 McDermott Will & Emery LLP. All Rights Reserved.

A limited purpose, licensed insurance company, the main business purpose of which is to insure the risks of the captive’s owners

What is a Captive?What is a Captive?What is a Captive?


Reduce/stabilize cost of risk funding

Provide customized coverage

Put focus on proactive risk management; create a team approach with physicians, including unified defense of lawsuits

Permit access to reinsurance markets

What are the Advantages of a Captive?What are the Advantages of a Captive?What are the Advantages of a Captive?


Single-owner

Group

Association

Agency

Rent-a-captive

Segregated account (cell) captives

Captive pools

Risk retention groups

Types of CaptivesTypes of CaptivesTypes of Captives


Form (stock/mutual/reciprocal); Federal Risk Retention Group?

State insurance laws

Securities registration exemption/antifraud disclosure

Federal and state tax considerations

Other legal considerations (e.g., Medicare fraud and abuse)

Management/governance (directors and committees)

Coverage and policy questions

Structural/Regulatory IssuesStructural/Regulatory IssuesStructural/Regulatory Issues


You want to control your destiny

You know your risks better than any underwriter

You do not want to be rated based on others and industry losses

Off the shelf insurance programs do not suit your companies circumstances

Why an Alternative to Commercial Insurance?Why an Alternative to Commercial Insurance?Why an Alternative to Commercial Insurance?


AdministrationIncreased administrative burdens – unbundled servicesDelegation to outside service providersLearning curve for acquisition of insurance expertiseDealing with regulatory authorities, forms and filings with domicile and IRS

FinancialVolatility of reinsurance marketCapital commitmentLimited exit strategies: run-off or loss portfolion transfer

Possible Drawbacks of a CaptivePossible Drawbacks of a CaptivePossible Drawbacks of a Captive


Feasibility Study

Analysis of Owners Risk Profile and Financial Condition

Financial Analysis

Legal Research

Actuarial Projections

Tax Projections

Domicile Options

Comparisons

Insurance issues analysis

Possible Drawbacks of a CaptivePossible Drawbacks of a CaptivePossible Drawbacks of a Captive


Long term commitment (at least 5 years)

Set strategic goals, objectives and capitalization

Consolidate / manage risk with financial program

Stabilize risk management portfolio

Less vulnerable to price fluctuations and market restrictions

Must meet in person with captive regulators

Should have an up-front strategy for withdrawal

Convince Senior Management Convince Senior Management Convince Senior Management


axesT Premium & Excise Taxes

Recognized Domicile

Income Taxes

egulatoryROwnership Structure

Coverages

Capitalization Options

nfrastructureIEase of Accessibility

Operating Flexibility

Service Providers-Quality & Cost

erceptionP“Tax Haven” IssuesCorporate GovernanceShareholder Rights Status

Domicile Selection FactorsDomicile Selection FactorsDomicile Selection Factors


Hawaii 147

British Columbia 13

Colorado 10

Ireland 214 Isle of Man 175

Jersey 13Guernsey 410

Luxembourg 219

Gibraltar 12

Mauritius 13

Bermuda 1,150

U.S. Virgin Islands 7British Virgin Islands 350

Barbados 257

Curacao(Netherlands

Antilles)18Turks &

Caicos 164

Cayman 694

Bahamas 19

Vermont 524

Tennessee 4

Georgia 14

SouthCarolina 114 Singapore 57

Vanuatu 18

Switzerland 50

Estimated Number of Active Captives2004 – Business Insurance Magazine (3/07/05)

Estimated Number of Active CaptivesEstimated Number of Active Captives2004 2004 –– Business Insurance Magazine (3/07/05)Business Insurance Magazine (3/07/05)


The key tax question:

Will it be treated as“insurance” for tax purposes?

Taxation of CaptivesTaxation of CaptivesTaxation of Captives


Why “Insurance” Matters?Why Why ““InsuranceInsurance”” Matters?Matters?

Tax deduction for premiums paid to captive by policyholder

Favorable insurance tax treatment of captive (deduction for discounted insurance reserves, unearned premiums)

Offshore CFC captives - Subpart F income

Domestic captives - direct federal income tax

Offshore captivesFederal Excise Tax on insurance premiums

Possible IRC Sec. 953(d) onshore tax election


Tax Definition of “Insurance”Tax Definition of Tax Definition of ““InsuranceInsurance””

To find insurance, the IRS and the courts have historically required the presence of both risk shifting and risk distribution

The first criterion connotes the transfer of the risk to separate party

The second mandates that enough independent risks are being pooled to invoke the “actuarial law of large numbers”


Tax Definition of “Insurance”Tax Definition of Tax Definition of ““InsuranceInsurance””

No statutory or regulatory definition of “insurance”- only cases and rulings

A gray area existed between 1 and 31 insureds, but a rule of thumb is that “more than several”unrelated insureds pooling risk should create insurance

Case law has further liberalized the tax definition of insurance

Unrelated Risk – at least 30% of premium from 3rd parties

Brother/Sister Risk – substantial risk of captive’s siblings


Tax CaveatsTax CaveatsTax Caveats

The captive must establish:

Presence of risk distribution

That the captive should be respected as a separate and distinct taxable entity, e.g., it is not a sham

IRS refers to its new approach as a “facts and circumstances” test


Non-Sham StatusNonNon--Sham StatusSham Status

IRS Facts and Circumstances Approach Looks to:Valid non-tax business purpose

Adequate capitalization (maximum 5:1 premium/surplus ratio recommended)

No parental support agreements

Limited loan backs of captive assets to parent or affiliates (“circularity of cash flow”)

Formation of captive in other than a weakly or non-regulated offshore domicile

Captive operates on an arm’s length basis in a manner similar to that of commercial insurers


Subject to tax on worldwide income

Deduction for discounted loss and 80 percent unearned premium reserves when calculating taxable underwriting and investment income

If captive is at least 80 percent owned (voting power and value) by a U.S. corporation, must be included in the federal consolidated income tax return of the parent—also true for offshore captive electing to be subject to U.S. tax

U.S. Taxation of Onshore CaptivesU.S. Taxation of Onshore CaptivesU.S. Taxation of Onshore Captives


Onshore Versus OffshoreFederal Tax Considerations

Onshore Versus OffshoreOnshore Versus OffshoreFederal Tax ConsiderationsFederal Tax Considerations

Offshore captive tax issues include:

Imputed federal income tax on controlled foreign corporations (Subpart F/CFCs)

Related party insurance income (RPII)

Branch profits tax

Federal withholding tax

Federal excise tax


Federal Excise Tax - The Basics Federal Excise Tax Federal Excise Tax -- The Basics The Basics

Applies to premiums paid to foreign insurers/reinsurers covering U.S. risks

4 percent on “direct” property & casualty policies

1 percent on life policies and all reinsurance

Withheld and remitted (quarterly on IRS Form 720) by payer of premium

If not a deductible “insurance” premium, then FET N/A - Rev. Rul. 78-277

Also N/A if onshore tax election is made or tax treaty applies (Bermuda and Barbados N/A)


Making a Section 953(d) ElectionMaking a Section 953(d) ElectionMaking a Section 953(d) Election

Section 953(d) allows certain foreign corporations to elect to be treated as a U.S. corporation

In order to qualify to make this election, the foreign corporation must --

be a CFC (under the regular rules or the RPII rules),

qualify as an insurance company under Subchapter L

comply with regulations to ensure that it pays its U.S. taxes, and

make an election to have Section 953(d) apply and to waive all U.S. treaty benefits

The election is valid for the year made and for every year thereafter unless revoked with the consent of the Secretary

In order to make election, foreign corporation must waive right to Treaty benefits


Making a Section 953(d) ElectionMaking a Section 953(d) ElectionMaking a Section 953(d) Election

Advantages of Election

Can join the U.S. consolidated return

Will not be subject to any insurance excise taxes

Can avoid application of branch profits tax

Can hold meetings and conduct business in the U.S.

Can invest in U.S. property

Can avoid U.S. withholding tax costs on cross-border payments (e.g., interest on loan from CFC to shareholder)


State Taxation Of CaptivesState Taxation Of CaptivesState Taxation Of Captives

Direct placement taxes on premiums – generally no state tax on net income of an insurance company

Also called:– direct procurement taxes

– self procurement taxes

– taxes on independently procured insurance

35 states

Most apply to captives

Statutes preserve right of insureds to place insurance outside state -- an exception to “doing business” requirement

Tax imposed on transaction where in-state customer deals directly with non-admitted insurance company; no regulation, just tax


U.S. Federal Income Taxation of Insurance Company’s Income

U.S. PE/Branch Profits Tax Exposure

Ability to Use Losses in U.S. Return

Vermont Corporation Net income taxed at 35% with Subch L benefits in consolidated return

No U.S. PE/branch profits tax exposure. See box below re U.S. activities

Losses can be used in U.S. consolidated return

Bermuda Corporation with Section 953(d) Election

Net income taxed at 35% with Subch L benefits in consolidated return

No U.S. PE/branch profits tax exposure. Can conduct U.S. activities (but need to comply with state insurance statutes)

Losses cannot be used in U.S. consolidated return because of DCL rules; can be carried forward or back to be used against income of 953(d) company

Bermuda Corporation with No Section 953(d) Election6

Net income taxed at 35% under Sub F rules with Subch L benefits

U.S. PE/branch profits tax exposure (can be managed by limiting U.S. activities to passive reimbursing of paid claims)

Net losses of insurance company cannot be used in U.S. consolidated return; can be carried forward to reduce future E&P though


Ability to Use U.S. Tax Treaties1

Federal Excise Tax on Premiums

Ability to Loan to U.S. Borrowers

Vermont Corporation Can take advantage of U.S. tax treaties

No FET on premiums; but note IRS “cascading” theory

No withholding tax on interest imputed or paid


Can take position that U.S. tax treaties (other than U.S.-Bermuda Treaty)4 are available

No FET on premiums; but not IRS “cascading” theory

No withholding tax on interest imputed or paid


Cannot take advantage of U.S. tax treaties—no Bermuda tax treaties other than with U.S. exist

Life and P&C reinsurance - 1% FET; P&C direct - 4% FET; but note IRS “cascading” theory

30% withholding tax on interest imputed or paid (portfolio exemption N/A)


State Tax Issues Tax Consequences of Not Being Insurance Company for Federal Purposes2

Non-Tax Issues

Vermont Corporation No VT income tax; small VT premium tax3; plus taxes below

See footnote 1 Incremental regulatory burden (?)


If fronted, normal premium taxes due. If unfronted, likely NYS premium tax on NY risk; must check other states

Section 953(d) election is invalid. As a result, potential PE/branch profits tax exposure for prior years; also, potential Section 367(a) issues on outbound transfer of assets5

Still must operate offshore to avoid state insurance statutes restricting activities of unauthorized insurers


If fronted, normal premium taxes due. If unfronted, likely NYS premium tax on NY risk; must check other states

Cannot carry froward net losses to offset net Subpart F income in future years; lose Bermuda Treaty PE protection; no FET

Greater Bermuda management role


1 A separate analysis would be needed with respect to non-U.S. withholding taxes on payments to the insurance company and other potential foreign tax issues.

2 In all cases, if the corporation is not an insurance company, payments to it will not be treated as deductible premiums and different rules will apply for purposes of computing its taxable income (i.e., no deduction for estimated loss reserves will be allowed).

3 The Vermont premium tax rates are: Direct premiums - .38% on the first $20 million; .28% on the next $20 million; .19% on the next $20 million; and .072% over $60 million. Reinsurance premiums - .214% on the first $20 million; .143% on the next $20 million; .048% on the next $20 million; and .024% over $60 million. Minimum annual tax: $7,500; maximum annual tax: $200,000. No credit is granted for premium taxes paid to other states.


4 Section 953(d)(3) provides that if a foreign insurance company makes a Section 953(d) election it must agree to waive all rights to all U.S. treaties. There is no published guidance as to how to interpret this broadly drafted language. We understand that 953(d) companies generally take the position that this waiver only limits their ability to claim the benefits of any treaty between the U.S. and their country of residence (i.e., in this case, Bermuda), not U.S. treaties with other countries which they might be able to benefit from as a Section 953(d) company.

5 When a Section 953(d) election ends, the corporation is deemed to have transferred all of its assets as of the first day of the subsequent taxable year from a U.S. corporation to a foreign corporation in an outbound Section 354 exchange. See Section 953(d)(5).

6 Parent must file an IRS Form 5471 with respect to the Bermuda corporation. In addition, the Bermuda corporation should make a protective Form 1120F filing to preserve its ability to be taxed on a net rather than a gross basis if it is found on audit to have a U.S. PE/branch. See Treas. Reg. Section 1.882-4.

Captive InsuranceCaptive InsuranceThe Corporate TreasurersThe Corporate Treasurers’’ SeminarSeminar

Derick White, CPA, CFE

Director of Captive Insurance

Department of Banking, Insurance, Securities and Health Care Administration

State of Vermont

Presented by Timothy Padovese

President & CEO OMIC

What is a Captive?What is a Captive?

88““formalized selfformalized self--insuranceinsurance””88licensed in a state (or country)licensed in a state (or country)88a regulated insurance a regulated insurance

company with a limited licensecompany with a limited license

Why form a Captive?Why form a Captive?

88Control costControl cost88Incentive to management to reduce, Incentive to management to reduce,

eliminate losseseliminate losses88 to implement effective loss control to implement effective loss control

programsprograms88 to cooperate with claim administrationto cooperate with claim administration88 to reduce or eliminate lossesto reduce or eliminate losses

88Retain investment incomeRetain investment income

Why not just self insure?Why not just self insure?

88 A Captive Insurance Company can:A Captive Insurance Company can:88 provide evidence of insuranceprovide evidence of insurance88 provide access to reinsurersprovide access to reinsurers88 provide securityprovide security

Types of CaptivesTypes of Captives

88PurePure88Industrial insuredIndustrial insured88AssociationAssociation88Risk retention groupsRisk retention groups88Discussion on OMICDiscussion on OMIC88Sponsored (rentSponsored (rent--aa--captives)captives)88BranchBranch88ReciprocalReciprocal

Some Coverages Currently Some Coverages Currently Written with CaptivesWritten with Captives

88General LiabilityGeneral Liability88Professional Professional

LiabilityLiability88Workers CompWorkers Comp88Auto LiabilityAuto Liability88Auto Physical Auto Physical

DamageDamage88PropertyProperty88Business Business

InterruptionInterruption88Marine & CargoMarine & Cargo88D&OD&O

88Environmental Environmental ImpairmentImpairment88CreditCredit88Product LiabilityProduct Liability88Political/War RiskPolitical/War Risk88AviationAviation88StrikeStrike88Employee BenefitsEmployee Benefits88TRIATRIA

How To Form A CaptiveHow To Form A Captive

88Preliminary EvaluationPreliminary Evaluation88 current programcurrent program88 ultimate loss estimateultimate loss estimate88 risk retention levelsrisk retention levels88 expense loading to arrive at expense loading to arrive at

premiumspremiums88 loss payloss pay--out patternsout patterns88 domicile considerationsdomicile considerations

Domicile ConsiderationsDomicile Considerations

88premium, capital and surplus premium, capital and surplus requirementsrequirements88registration costsregistration costs88other incorporation and service feesother incorporation and service fees88investment restrictionsinvestment restrictions88permissible insureds and coveragepermissible insureds and coverage88availability and quality of availability and quality of

professional/business servicesprofessional/business services

Domicile ConsiderationsDomicile Considerations

88acceptance by reinsurers and acceptance by reinsurers and fronting companiesfronting companies88distance, accessibility and ease distance, accessibility and ease

of travelof travel88ease of communicationsease of communications88regulatory flexibilityregulatory flexibility88world image/political stabilityworld image/political stability

VermontVermont’’s Captive s Captive Industry ProfileIndustry Profile

88numbers (over 700 licensed numbers (over 700 licensed companies)companies)88management firms (10 active)management firms (10 active)88service providers (CPAservice providers (CPA’’s, banks, s, banks,

actuaries, attorneys)actuaries, attorneys)88Vermont Captive Insurance Vermont Captive Insurance

AssociationAssociation

Total Number of Vermont Total Number of Vermont Captive Licenses IssuedCaptive Licenses Issued

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

717

VermontVermont’’s Legislative s Legislative History History

881981 Vermont1981 Vermont’’s captive statute passed by s captive statute passed by legislaturelegislature

881986 Risk Retention Act adopted1986 Risk Retention Act adopted881993 Employee Benefits allowed1993 Employee Benefits allowed881994 Premium Tax reduced1994 Premium Tax reduced881995 Premium Tax reduced again1995 Premium Tax reduced again881997 Reciprocal Captives permitted1997 Reciprocal Captives permitted881999 Sponsored & Branch Captives 1999 Sponsored & Branch Captives

permittedpermitted882003 Premium tax reduced2003 Premium tax reduced

General reGeneral re--write of statutewrite of statute

VermontVermont……The Premier Captive DomicileThe Premier Captive Domicile

88Cooperation Cooperation (governor,legislature,regulators,(governor,legislature,regulators,industry)industry)88Stable EnvironmentStable Environment88Dedicated StaffDedicated Staff88Firm but FlexibleFirm but Flexible

www.bishca.state.vt.us

State of VermontCaptive Insurance

VT Department of Banking, Insurance,Securities & HealthCare Administration

89 Main Street, Drawer 20Montpelier, VT 05620-3101

(802) 828-3304

Why HawaiiThe Premier Captive Insurance Domicile of the Pacific

The Corporate Treasurers’ Seminar

Presented by:

Lisa Kremer, Managing DirectorEnterprise Risk Management

San Francisco, CAon behalf of

Hawaii Captive Insurance Council

History of the Industry in Hawaii

• Act 253 established Hawaii as a captive domicile on July 1, 1987

• Hawaii has grown to become 2nd largest onshore domicile

• First domicile to allow the formation of not-for-profit captives

• 176* captives licensed to date• Number of ACTIVE captives in Hawaii has DOUBLED

since 2000 (74 vs. 147*)

* Year End 2004 Statistics

Hawaii Captive Classes

Discretion of Insurance Commissioner

Class 5: Reinsurance captive at the discretion of the Insurance Commissioner.

$1,000,000Class 4: Leased captive facility (protected cell)

$500,000 Risk Retention Group$750,000 Association Captive

Class 3: Risk retention group or Association captive

$250,000Class 2: Pure captive that writes business as a direct writer and/or reinsurer.

$100,000Class 1: Pure captive that writes business only as a reinsurer.

Minimum Capital Requirement *

Class and Description

*Additional capital/surplus may be required depending upon the lines of coverage written, retentions with the captive, financial position of the parent, loss payout patterns and/or other criteria established by the State of Hawaii Insurance Division.

Taxation of Hawaii Captives

• No minimum tax requirement• Graduated premium tax

Premium tax applies to gross written or assumed premium and is not subject to double taxation.

• No double taxation– Hawaii premium tax is only assessed on premiums

“upon which no premium tax is otherwise paid during the year”(HRS§431:19-16).

0.05%$50 Million+

0.15%$25-50 Million

0.25%$0-25 Million

Other Hawaii Requirements

• Annual meeting in Hawaii– Meeting can take place on any Hawaiian island or in

Hawaiian waters• One board member must be a Hawaii resident

– Normally role filled by a service provider• Captives subject to triennial exam

Hawaii Infrastructure

• Hawaii has a dedicated Captive Branch within the State Insurance Division

• Experienced captive service providers with offices in Hawaii

• Captive managers, accountants, financial institutions, attorneys, and third party administrators

• Hawaii Captive Insurance Council offers educational and networking opportunities to owners and service providers

• Multi-cultural workforce• Many people speak multiple languages

Visit Hawaii to learn more

• Hawaii Captive Insurance Council Forum– November 2005 in Kapalua, Maui

• RIMS 2006– April 2006 in Honolulu

• Online at www.hawaiicaptives.com

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