captive insurance session... · 2014-06-03 · business and can be supported. 14. have claims....

IASA 86TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

CAPTIVE INSURANCE

Session #406

Panelists

Brian Kilbane, Senior Manager

Dixon Hughes Goodman LLP

Insurance Services Group

225 Peachtree Street NE, Suite 600

Atlanta, GA 30303

404-575-8954

[email protected]

Douglas W. Stein, Partner

Strategic Law LLC

5909 Peachtree-Dunwoody Road NE

Suite 800

Atlanta, GA 30328

770-804-4888

[email protected]

Aaron Maguire, Partner

Dixon Hughes Goodman LLP

Insurance Services Group

225 Peachtree Street NE, Suite 600

Atlanta, GA 30303

404-575-8960

[email protected]

Agenda

Captive Insurance Primer

Captive Structures

Captive Benefits and Risks

State of the Captive Industry

Do’s and Don’t’s

Q&A


What is a captive insurance company?

Why do companies create them?

• What are the benefits?

Where can I create a captive?


Company

Self-

Insured

Company

Third Party

Insurer

Company

Captive

Third Party

Reinsurer

Captive Insurance Primer – Reasons to Form a Captive

• Tax Benefits

• Retain Premium Dollars

• Estate Planning

• Claim Control

• Flexibility

• Access Reinsurance Market

• Reduce Costs

• Retain Underwriting Profit

Minimize Insurance

Cost

Control Risk

Improve Cash Flow

Accumulate Wealth


Source: Business Insurance “Captive domiciles see growth as insurer formation options increase”, March 16, 2014

Bermuda Cayman Islands Vermont Guernsey Utah Delaware

Series1 831 759 588 344 342 298

0

100

200

300

400

500

600

700

800

900

Nu

mb

er

of

Cap

tiv

es

2013 Captives by Domicile

Captive Structures

Single Parent Captive

Section 831(b) Captive – “Micro Captive”

Group Captive

Rent-a-Captive

Risk Retention Groups (RRGs)

Single Parent Captive

Holding

Company

Captive Subsidiary

A

Subsidiary

B

Subsidiary

C

Subsidiary

D

Premiums Claims

Claimants

Section 831(b) – “Micro Captive”

Premiums (Total premium revenue less than $1.2 million. Only

taxed on investment income. Underwriting results not subject to

income tax)

Claims

Holding

Company

Captive Subsidiary

A

Subsidiary

B

Subsidiary

C

Subsidiary

D

Claimants

Section 831(b) – Wealth Transfer Strategy

Shareholder

Family Trust

1

Shareholder

Family Trust

2

Premiums Claims

Shareholder

Family Trust

3

Shareholder

Family Trust

4

Captive 1 Captive 2 Captive 3 Captive 4

Subs A&B Subs C&D Subs E&F Subs G&H

Each heir has own 831(b) captive, which can accumulate up to $1.2 million in tax free premium

revenue, PER YEAR….less any claims/admin costs.

Claimants

Group Captive

Company

A

Group

Captive

Subsidiary 1 Subsidiary 2 Subsidiary 1 Subsidiary 2

Premiums Claims

Company

B

Claimants

Rent-a-Captive

Rent-a-Captive Facility

Fronting

Company

Participant

A

Participant

B

Participant

C

Participant

D

Premiums Claims Sponsor

Companies

Claimants

Risk Retention Groups (RRG)

Created from Liability Risk Retention Act of 1986 to help

obtain liability insurance that was unavailable or

unaffordable due to the “liability crisis.”

RRGs are liability insurance companies that are owned by

its members.

Pre-empts state regulation, easier to operate nationally.

Similar to group captives, but different regulations.

Medical malpractice is most popular use.


PREFACE

Captives are appropriate and beneficial

structures that can truly add value to a company

if they have the right fact pattern and the

rules/regulations are followed.

However, there are risks to watch out for to

ensure company’s aren’t putting themselves in

unnecessary risk….


Benefits

• Reduction in insurance costs

• Premiums priced on own risk vs. pool of insureds

• Obtaining insurance on risks that are unavailable or cost prohibitive

• Medical malpractice, professional liability, aircraft

• Access to reinsurance markets

• Wealth management strategy

• Federal income tax advantages

Buyer Beware Captive Benefits and Risks

Income tax benefit example:

Self-Insurance Third Party Insurance Captive Insurance

$ Tax

Deductible? $

Tax

Deductible? $

Tax

Deductible?

Year 1

Pay Premium N/A NO $1,000,000 YES $750,000 YES*

Reserves $500,000 NO N/A NO $500,000 YES

Year 2

Pay Claim $500,000 YES N/A NO $500,000 NO

*Under 831(b), premium revenue (less than $1.2 million) can elect

underwriting income/loss not subject to tax.


Risks

• Insurance policy must have a risk of loss

• Possibility that this can be a net loss arrangement

• Deductibles need to allow for risk of loss

• Insurance policy must have an insurable risk

• Premiums must have a relationship to the risk being insured

• Actuarially determined

• IRS rules are very complex


Risks

• Beware of “discovering/creating” insurable risks

• Terrorism

• Cyber liability

• Loss of key customer/supplier/employee

• Environmental liability

• Patent infringement

• Must be a true risk that can be insured

• Fully understanding initial and ongoing administrative costs


IRS Tax Rules

• Must prove that it is a valid insurance company

• Elements of risk shifting and risk distribution

• Risk of loss

Risk Shifting

• Must prove that specific risks are transferred in exchange for a

reasonable premium


Risk Distribution

Risk distribution occurs when particular risks are combined in a pool with other,

independently insured risks. By increasing the total number of independent, randomly

occurring risks that a corporation faces (i.e., by placing risks in a larger pool), the

corporation benefits from the mathematical concept of the law of large numbers in that

the ratio of actual to expected losses tends to approach one.

- Kidde, 40 Fed. Cl. 42 (1997)

• To satisfy this requirement, captive must accept risk from multiple

separate entities


Risk of Loss

Indemnification of the ceding entity against loss or liability relating to insurance

risk in reinsurance of short-duration contracts exists only if both of the following

conditions are met:

a. Significant insurance risk. The reinsurer assumes significant

insurance risk under the reinsured portions of the underlying

insurance contracts. Implicit in this condition is the requirement that

both the amount and timing of the reinsurer's payments depend on

and directly vary with the amount and timing of claims settled under

the reinsured contracts.

b. Significant loss. It is reasonably possible that the reinsurer may

realize a significant loss from the transaction.

- Accounting Standards Codification 944-20-15-41 (previously FAS 113, para. 9)


IRS “Safe Harbor” Rulings

• Parent-subsidiary arrangement

• At least 50% of the premium in captive relates to unrelated third party risk

• Brother-sister relationships

• Must have significant volume of homogenous risks

• No subsidiary should account for more than 15% of total insured risk ( at

least 7 companies).

Tax Evaluation of Onshore vs. Offshore Domiciles

Rent A Center V. Comm’r Tax Case

Created a Captive to reduce its costs, improve efficiency,

obtain unavailable coverage, and provide accountability

and transparency.

Feasibility study prepared proved value of captive and

determined proper funding.

Costs actually reduced

26


Parent guarantee made to the captive to ensure claims will

be paid.

Sought permission to treated tax assets as business assets

Accounting was properly maintained and annual audits

were properly conducted

27


IRS Arguments

• Sham Transaction

• Impermissible circular flow of funds

• Premium to surplus ratios were inappropriate

• Not a bona fide insurance company

28


Court Findings

• Payments were deductible payments because the captive was bona

fide

• Real risk

29


CONCLUSION

As long as these risks are properly considered and

addressed, a captive insurance program can provide a lot of

benefit to a company.


Vast majority of Fortune 500 firms already have captives

Market is focused on middle-market companies and

individual business owners

• Significant growth in the use of 831(b)

• Creating a cottage industry of law firms/consulting firms to push

captive insurance strategies for middle-market companies


Heightened scrutiny from state insurance regulators

• Potential abuse by some life insurance companies using captives to “hide”

liabilities.

The Principles-Based Reserving Implementation Task Force is responsible for

addressing whether any additional regulation should be instituted for captive

insurance companies.

Primarily relates to insurer-owned life insurance captives with Regulation XXX

and/or AXXX business.

•However, any decisions on captive regulation would likely impact all captives in

some manner.

State departments with significant life insurers domiciled in their states are for

more regulation.

State departments with significant captive industries are not in favor of more

regulation.


• Some proposed additional regulations include:

•Requiring insurer-owned captives to be accredited as a multi-

state insurer, which would essentially require them to adhere to

the same NAIC accreditation guidelines as standard insurance

companies.

•Captives would have to hold hard assets equal to principles-

based reserving (PBR) levels and then hold assets or securities

approved by the state to support the remainder of the reserves,

with added disclosures.

• The primary reason to hold PBR reserves is that it is believed the

incentive to create the captive in the first place would go away.

• However, there is debate if that would really occur.


Heightened scrutiny from IRS

• Intentional and unintentional misapplication of tax rules for captives.


Don’t

1. Allow your attorney, accountant, etc. or anyone related to them, to be your

captive administrator.

2. Buy a significant amount of life insurance in your captive. It is not made for it.

3. Believe the sales pitch of people that “do” 100’s of captives annually.

4. Think of this as advanced estate planning. It isn’t. It’s an insurance company.

5. Walk away from the person who emphasizes the income or estate tax benefits.

You should run!

6. Get too fancy with the captives investments. They should be mostly liquid.

7. Get involved in a captive if the person has slick materials. Usually they are

selling a product.

8. Think of insurance as a secondary item. It MUST be the primary purpose of

the captive.

9. Buy terrorism or kidnapping insurance unless there is a provable need for it.

10. Be limited in jurisdictions. There are more captives offshore than onshore.

11. Write exactly $1.2MM of insurance.


Do

1. Keep in mind these are complicated structures.

2. Have a good idea of the upfront and annual costs.

3. Have each professional do what they do best. They should rarely do more than

one task.

4. Have all your professionals know what they need to do at each point.

5. Discuss in detail how claims are made and paid.

6. Have an actuarial letter from a reputable actuary who is licensed in the

relevant jurisdiction.

7. Get annual audits of the captive’s financials.

8. Make certain all elections are timely made.

9. Make certain you have insurance policies and they are well written.

10. Make certain you run the captive like an insurance company. It should look

like one at all times.

11. Use risk pools only when absolutely necessary. (Note they rarely are).


Do (cont’d)

12. If you use a risk pool, make certain you include your proportionate income as

premium income.

13. Have confirmation that the insurance being purchased makes sense for the

business and can be supported.

14. Have claims. Insurance companies have them all the time; so should your

captive.

15. REMEMBER, this is about insurance and not estate planning or asset

protection. Those goals are, at best, secondary.


Run for the Hills –

1. Captives with a large percentage of income spent on life insurance.

2. Captives with terrorism or kidnapping insurance.

3. Captives with no actuarial studies.

4. Captives with no insurance policies.

5. Poorly written policies or internally inconsistent terms.

6. Captives with few or no claims.

7. Many reinsurance pools with few or no claims.

8. Captives in which the insurance probably will not qualify as insurance.

9. Multiple 831(b) captives acting as reinsurance for a single captive.

10. Captives with investment portfolios totally inconsistent with the types of

policies they are issuing.

IASA 86TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

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captive insurance session... · 2014-06-03 · business and can be supported. 14. have claims....

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