captive insurance presentation pdf

Captive Insurance Companies: The Next Estate Planning Frontier

© 2013 - All Rights Reserved - Philip J. Tortorich

October 21, 2013

Philip J. Tortorich+1.312.902.5643philip.tortorich@kattenlaw.comPartnerKatten Muchin Rosenman LLP

1 © 2013 - All Rights Reserved - Philip J. Tortorich

What is a Captive Insurance Company?

A captive insurance company is an entity which provides insurance coverage to a related group of businesses.

It is a true insurance company that requires an insurance license in the designated jurisdiction, proper accounting for reserves and surplus, issues policies and settles claims.

A captive generally provides property and casualty insurance. Only in very limited circumstances is it possible for a captive to issue a life insurance policy.


Basic Captive Structure

Captive InsuranceCompany

OperatingBusiness

BusinessOwner

Payment of Premium

Issuance of Policies

100% 100%


Why Form a Captive?

Every business has some level of “self-insurance”. Self-insurance includes the ability to pay deductibles, payment in excess of coverage limits by commercial providers, and payment of claims for types of loss that are not covered (“exclusions”).

A captive provides a means to address these self-insured risks in an economically tax-efficient manner.

As a separate business, the captive has the potential to be a profit-center for the business owner. As such, mitigating losses is an incentive to creating a captive. Commercial insurance does not provide such an incentive – if a business’ claims are lower than the industry average, the business is not generally rewarded for the lower claim history. With a captive, low claims continues to benefit the overall business owner and consequently encourages the implementation of risk mitigation techniques.


Why Form a Captive? (continued)

The captive provides a more flexible environment in the design of the insurance policies it issues. Policy design is a critical component of the formation of a captive. Unlike commercial insurance, premium payments can be front-loaded, if desired, can vary over time, can be refunded if claims are lower than expected. In addition, the types of coverage itself can be more specifically designed for each operating business as will be discussed below.

By forming a captive, the business owner is given access to the reinsurance markets. Purchasing coverage from a reinsurance company can create an arbitrage between the premiums paid to the captive and the amount the captive pays for the reinsurance – it is like buying insurance coverage at a discount. This is generally only open to larger captives.

Additionally, the captive provides an opportunity to minimize income and transfer taxation as discussed below.


Where is a Captive Formed?

Captive insurance companies can be formed domestically or offshore. Many states are passing captive legislation and are beginning to compete with foreign jurisdictions for the captive business. It is the surge of state laws and the more definitive guidance by the IRS that is believed by some to account for the increase in interest to form captives.

The more competitive nature of forming captives has driven the cost down so that a large subset of business owners can reasonably afford to form and administer a captive insurance company and achieve all of its attendant tax benefits.


Where is a Captive Formed? (continued)

States to Consider for Captive Formation, include:

• Texas • Vermont

• Delaware • Hawaii

• Utah • Nevada

• North Carolina

Offshore Jurisdictions to Consider for Captive Formation, include:

• Cayman Islands

• Bermuda

• British Virgin Islands

• Hong Kong



In considering in which jurisdiction to form a captive, there are several factors to consider, namely:

• What is the premium tax, if any?

• What assets can be considered for reserve purposes – i.e., “permitted assets”?

• How long has the jurisdiction been issuing captive licenses?

• Will the insured need a “Certificate of Insurance” for any of the policies issued by the captive?

• What are the annual meeting requirements of the jurisdiction?

• What are the restrictions, if any, on the types of permitted investments?

• What are the fees for the initial application to obtain the insurance license?

• What are the capitalization requirements?

• What reporting is required by the captive?

• Do the principals have to meet with the Insurance Commissioner in the jurisdiction before obtaining a license?



Until the recent proliferation of states which have captive legislation, most captives were formed in offshore jurisdictions. Now, the increased competition has made staying onshore very attractive.

Benefits of being onshore:

• No foreign entity tax reporting

• Reportedly fewer audits and inquiries

• Depending on the types of policies, it may be required

• Convenient location



However, there are still significant benefits that can be achieved by forming a captive offshore:

Such benefits include:

• Less administrative bureaucracy

• Lower capitalization requirements

• More lenient “permitted asset” definitions

• Greater asset protection features

• Access to foreign investments

• Lower premium taxes, if any.


What Types of Policies Can a Captive Issue?

As suggested above, proper policy design is essential to the success of a captive insurance company.

Captives can offer practically all types of insurance with the exceptions of life insurance and workers compensation insurance.

Generally, we do not suggest that a business owner replace their commercially-purchased insurance with self-insurance except in very limited circumstances where the cost of the commercial insurance is drastically too expensive in comparison to a long, established low claim history by the business.

Rather, the captive can offer policies which protect against the potential to pay the deductibles on the commercial insurance. This will allow the business to increase its deductibles as high the commercial insurer will allow – thereby lowering the cost of the commercial insurance.


What Types of Policies Can a Captive Issue? (continued)

In addition, the captive can issue a policy for coverage over the limits established by the commercial insurance. In fact, the captive can even limit its exposure to a certain level, if desired.

The business can purchase a policy from the captive which covers the exclusions of the commercial insurance.

All of these policies which the captive provides completes the whole picture of the commercial insurance, makes it more affordable, but does not replace it.



Following are examples of the various types of commercial policies that businesses can investigate:

• Antitrust & Unfair Competition • Advertising Liability

• Commercial Vehicle Insurance • Errors & Omissions

• Construction and Design Defect • Malpractice

• Copyright Infringement – • Performance Claims Against Liability

• Deceptive Trade Practices • Structural Defects

• Directors & Officers Liability • Title Insurance

• Employment Practices • Trademark Infringement

• Environmental • Libel & Slander



In addition to rounding out the commercial coverage, captives can also provide “softer” coverage where the claimant will be the business itself and not a third party.

This type of coverage is particularly attractive in a captive setting since the result is that the overall economic family retains the funds. However, moving the funds from the captive back to the operating business in payment of the claim shifts the money away from the tax-favored entity. It is important for the business to implement risk mitigation methods in order to limit the claims even from these “softer” policies.



There are many types of these “softer” policies than can be considered by the business. Jay Adkisson does a good job of referencing a number of these types of policies in his book “Captive Insurance Companies”. Included in these types of polices are:

• Administrative Action • Currency Risks • Product Tampering

• Advertising & Marketing • Delay Start-Up • Production Benchmarks

• Antitrust and Unfair Comp. • Eminent Domain • Property Damage

• Business Credit Cover • Financial Crime • Trade Secrets

• Business Dirty Tricks • Force Majeur • Strike and Labor Unrest

• Business Document Forgery • Foreign Operations • Terrorism

• Business Extortion • Administrative Delay • Theft

• Business Interruption • Insurance Failure • Trade Credit



Types of “soft” policies (continued):• Business Reputation • Knock-Off Lost Profit • Trade Good Will

• Cargo Consequential Loss • Lawsuit Interruption • Patent & Trademark Infringement

• Cash In Transit • Labor Costs • Transit Risk

• Commercial Crime • Legal Expenses • Unfair Calling of Guarantees

• Commun. Breakdown • Lender Failure • Weather Risks

• Computers: Dissemination • Loss of Key Customer

• Computers: Loss of Data • Loss of Talent

• Computers: Software • Machinery Breakdown

• Computers: Virus Loss • Market Flooding

• Confiscation • Market Risks

• Contract Frustration • Political Risk

• Copyright Infringement • Product Launches



Without question, practically every business is being operated with a certain level of self-insurance, even against third party claimants. Any claim that is not covered poses a risk to the future continuation of the business.

A captive insurance company provides a means by which the business owner can acknowledge the existence of a particular risk for his business and take proactive steps to insure against that risk in a tax-efficient manner.

Also, from a psychological perspective, the mere exercise of investigating a business’ risk profile as compared against its current commercial coverage will usually create an incentive for the business owner to implement risk mitigation techniques to lessen the possibility of claims that were previously self-insured.


What are the Income Tax Benefits of Captive Planning?

Tax Benefits to Operating Businesses:• Ability to achieve Section 162 or Section 212 deductions for the payment

of premiums to the captive.

Tax Benefits to Captive Insurance Company:• Ability to reduce gross income by amounts accrued for future potential

losses (i.e., reserves).

• Ability for smaller captives to elect 831(b) status which exempts all income (other than investment income) from taxation at the captive level.

Tax Benefits to Owner of Captive• Ability to monitor captive reserves and receive distributions from the

captive at capital gain rates when the reserves can no longer be maintained. If the captive makes an 831(b) election, then no income would be picked up by the captive other than the investment income.


What is “Insurance”?

In order to achieve the income tax benefits the payments must be for “insurance” and must relate to “insurance contracts”. The following slides explain these requirements in more detail.

Anyone can form a captive and have the captive insure risks from operating businesses. However, that does not necessarily mean that the structure implemented will result in any income tax efficiencies. The remainder of this presentation assumes that the business owner desires more than a mere loss control vehicle.

In order for the captive to provide any income tax efficiencies, the captive must provide “insurance” under the Internal Revenue Code.

Interestingly enough, the terms “insurance” and “insurance contract” are not defined in the Internal Revenue Code. Rather, the IRS and Courts look to the “definition” of insurance provided by the Supreme Court in Helvering v. Le Gierse. Namely, that insurance has two components:

• Risk Shifting; and

• Risk Distribution


What is “Insurance”? (continued)

Risk Shifting

• Requires that an operating business shift the risk of loss away from itself to another entity.

• Any claim covered by the policy will not further affect the insured once the premium is paid for the coverage.

Risk Distribution

• Requires that the captive distribute its risk among several insureds.

• Works off the statistical law of large numbers.



Based on the foregoing, it is clear to see that an operating business which creates a subsidiary captive insurance company that provides insurance for its parent will not qualify as “insurance” for IRS purposes.

In this case, there is neither risk shifting nor risk distribution.

Consequently, even though there is likely insurance coverage from a business perspective, there are no attendant tax benefits to either the operating business or the captive.



Moreover, even if you utilize the basic captive structure illustrated earlier, without more, that structure will also not provide the anticipated tax benefits.

This is because there is no risk distribution among the captive.

Case law and IRS Revenue Rulings have addressed these issues and have provided some “safe harbors” that business owners can use as guidelines in establishing their own captive.


What is the Case Law Regarding Captives?

Humana Inc. v. C.I.R., 881 F.2d 247 (6th Cir. 1989)

• Parent creates subsidiary captive.

• Parent makes payments to captive, 7 subsidiaries makes payments to captive.

• Parent’s payments to captive are NOT deductible.

• 7 subsidiaries’ payments to captive are deductible.

Harper Group v. C.I.R., 96 T.C. 45 (1991), aff'd, 979 F.2d 1341 (9th Cir. 1992)

• 2 subsidiaries and customers of another subsidiary make payments to a captive. The 2 subsidiaries’ payments constitute 70% of the total premiums, the customers’ (i.e., third parties’) payments constitute the remaining 30% of the total premiums to the captive.

• The payments are deductible by all of the insureds. There is sufficient risk shifting and risk distribution.


What is the Case Law Regarding Captives? (continued)

Kidde Industries, Inc. v. U.S., 40 Fed.Cl. 42 (Ct. Cl. 1997)• Approximately 100 subsidiaries make payments to a captive. The captive

reinsured the risk with reinsurance companies. During a period of time during the arrangement, the reinsurance companies issued an indemnity agreement.

• Payments are deductible except for during the period the indemnity agreement is in force.

Hospital Corporation of America v. C.I.R., T.C.M. 1997-482 (1997)• Over 100 subsidiaries make payments to a captive. Payments are deductible.

• However, workers’ compensation insurance covered by indemnification agreement by the captive parent is not “insurance” and therefore premium payments are not deductible.

United Parcel Service v. C.I.R., 254 F.3d 1014 (11th Cir. 2001)


What is the Case Law Regarding Captives? (continued)

Other Captive Cases:

• Gulf Oil Corp v. C.I.R., 914 F.2d 396 (3rd Cir. 1990)

• AMERCO, Inc. v. C.I.R., 979 F.2d 162 (9th Cir. 1992)

• Sears, Roebuck and Co. v. C.I.R., 972 F.2d 858 (7th Cir. 1992)

• Ocean Drilling & Exploration Co. v. U.S., 988 F.2d 1135 (Fed. Cir. 1993)

• Malone & Hyde, Inc. v. C.I.R., 62 F.3d 835 (6th Cir. 1995)


What are the IRS Rulings Regarding Captives?

Revenue Ruling 2001-31• IRS states that the “economic family” doctrine will no longer be applied to

captives.

• However, captives can be challenged on the particular “facts and circumstances” of each case.

Revenue Ruling 2002-89 – Safe Harbor 1 (see chart on page 28) • A parent-captive situation where the parent only comprises 50% of the

total insurance of the captive and the other 50% consists of third party risk will constitute “insurance”.

• A parent-captive situation where the parent consists of 90% of the total insurance of the captive and the other 10% consists of third party risk will NOT constitute “insurance” as between the parent and the captive


What are the IRS Rulings Regarding Captives? (continued)

Revenue Ruling 2002-90 – Safe Harbor 2 (see chart on page 28)• Parent creates subsidiary captive. Parent has 12 separately recognized

subsidiaries that make payments to the captive (i.e., brother-sister organization). No one subsidiary constitutes more than 15% nor less than 5% of the total insurance. The arrangement constitutes “insurance”.

Revenue Ruling 2002-91• Addresses group captive insurance arrangements not discussed in this

presentation.

Notice 2003-34

Revenue Ruling 2005-40• Essentially same as Revenue Ruling 2002-90, but clarifies that

disregarded entities do not count in determining if there is sufficient risk shifting.


What are the IRS Rulings Regarding Captives? (continued)

Revenue Ruling 2007-47• Clarifies that insurance must have a risk transfer. In this arrangement, the

operating business knew for certain that payments would need to be made in the future. The business attempted to create a captive and have the captive insure against the future risk. However, because the payments were certain this was determined to be a financing arrangement rather than insurance.

Revenue Ruling 2008-8• Involves protected cell companies (PCCs). A PCC is cheaper to administer

because it is merely a separate “cell” under a master captive where the cell covers the risks of the related entities of a particular participant.

• A PCC which only covers the risks of one operating business (or any number of disregarded entities) will not qualify as “insurance

Revenue Procedure 2002-75• The IRS will issue Private Letter Rulings on Captives.


IRS Revenue Ruling Structure(“Safe Harbors”)

PREMIUMS

ParentOperatingCompany

CaptiveInsuranceCompany

Third-Party Risk(Purchased from

Reinsurance Companies)

$500,000in premiums

$500,000in premiums

100%owner

CaptiveInsuranceCompany

100%owner

Parent

Subsidiary 1

Subsidiary 2

Subsidiary 3

Subsidiary 4

Subsidiary 6

Subsidiary 7

Subsidiary 8

Subsidiary 9

Subsidiary 10

Subsidiary 11

Subsidiary 12

Subsidiary 5

* No one subsidiary having more than 15% nor less than 5% of the total premiums paid to the captive.


How is Captive Planning a Wealth Transfer Technique?

In the foregoing examples it was assumed that the business owner or parent company owned the captive as a subsidiary entity.

However, if the ownership of the captive is held by a trust for the business owner’s family, then you can effect an effective wealth transfer with very little use of gift tax exemption, if any.

Many of our clients have trusts that already contain significant assets, those trusts could use a portion of the assets to capitalize the captive.

This would create no gift tax situation. If the client does not have a previously funded trust, then there are three options:

• The client can gift the necessary amount to the trust and the trust can use that amount to fund the captive.

• The client loan assets to the trust which the trust can use to capitalize the captive.

• Finally, the client can do a part-gift / part-loan.

In negotiating with the insurance commissioner in the jurisdiction where the captive is formed, it may be possible to have some portion of the required capital satisfied by a letter of credit.


How is Captive Planning a Wealth Transfer Technique? (continued)

Once the captive is properly funded, the trust will own the captive and have the benefit of any of the profits generated by the captive without gift taxation.

The payment of premiums by the operating businesses to the captive should not be considered to be gifts since the payments are determined by actuaries reflecting arms-length premiums for the coverage. It is crucial to have dependable and relatively conservative actuaries on the team to justify the premium amounts.

Finally, there should be no estate tax inclusion if the trust is properly designed.

The trust should also allocate GST-exemption to any gifts to the trust so that the trust can be a long-term dynastic trust for future generations.

Any gifts or allocation of GST-exemption will require the filing of a gift tax return.

On the next slide is a typical captive structure with wealth transfer planning included.


Captive Structure with Wealth Transfer Planning

Captive InsuranceCompany

OperatingBusiness

BusinessOwner

IrrevocableDynasty

Trust

100% ownerUses $200,000 giftto capitalize captive

Depending on entire structuremay need to reinsure risks of

third parties to qualify as insurance for tax purposes

$800,000 premiums

Insurance coverage

Note: Capitalization requirements generally run around ¼ of the anticipated initial premiums, with this percentage going down in offfshore jurisdictions.

$200,000 gift


How is Captive Planning a Wealth Transfer Technique? (continued)

Advanced Planning Considerations:

• Once the captive is operating, the ability to manage reserves at the highest level allows for the continued deferral of taxation on the income of the captive.

• One technique to consider is to purchase a whole life insurance policy with the reserves in order to initially lower the value of the reserves and provide an asset diversification for the reserve bucket. There will be some income tax issues to consider once the insured dies.

• Another planning opportunity is to have the captive lend money to an ILIT and let the ILIT purchase the policy avoiding the income tax issues and maintaining the policy is another dynastic trust.


How is Captive Planning an Asset Protection Vehicle?

Because the captive is a separate entity for all purposes, only its creditors can attach to its assets. For tax purposes, the entity must be a C corporation and consequently will not be considered a disregarded entity even for tax purposes.

The insured companies’ and the owner’s creditors cannot attach the assets of the creditors.

Moreover, the payment of the premiums by the operating businesses to the captive reduce the balance sheet of the operating businesses and reduce the amount of assets that the creditors of the operating business can attach.

The payment of the premiums should not run afoul of the fraudulent conveyance statutes since the payment is for full and adequate consideration. Albeit admittedly aggressive, it may be possible to argue that the payment of premiums to a captive even during a creditor crisis is not a fraudulent conveyance under the same rationale.


CIRCULAR 230 DISCLOSURE: Pursuant to regulations governing practice before the Internal Revenue Service, any tax advice contained herein is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.

Katten Muchin Rosenman LLP Locations

CIRCULAR 230 DISCLOSURE: Pursuant to regulations governing practice before the Internal Revenue Service, any tax advice contained herein is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.

Katten Muchin Rosenman LLP is a limited liability partnership including professional corporations. London: Katten Muchin Rosenman UK LLP.

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