October 22, 2009

Arthur D. Perschetz, EsquireKilpatrick Stockton LLP

SEGREGATED CELL CAPTIVES

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Overview

• What is a Cell Captive

• What’s in a Name

• Where in the World

• Who Uses Cells

• The District of Columbia Law

• Differences

• The Incorporated Cell

• The Protected Cell RRG

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What is a Cell Captive

• Cell captives provide a means to isolate specific risks within a single corporate entity

• Exist in numerous domiciles

• Cell captive has general assets and cell assets

• Cell assets are identifiable assets segregated from other assets of the company for purposes of creditor protection

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What is a Cell Captive (cont’d)

• Cell assets can only be used to satisfy creditors’ claims with respect to a particular protected cell

• Protected cell captive may form one or more protected cells to insure individual risks of independent insureds

• Captive maintains core capital base and each protected cell has additional capital provided by the individual or group using that cell

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What’s in a Name

Variously known as:

• Protected Cell Company• Segregated Cell Company• Incorporated Cell Captive• Segregated Accounts Company• Sponsored Captive Insurance Company• Segregated Portfolio Company• Special Purpose Vehicle• Special Purpose Financial Captive

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Where in the World – Cell Domiciles

Gibraltar Arizona DubaiGuernsey Delaware MauritusIsle of Man District of Columbia NamibiaJersey Hawaii South AfricaMalta Iowa GuamAnguilla Kentucky VanatauBahamas MontanaBarbados NevadaBritish Virgin Islands OklahomaCayman South CarolinaSt. Lucia Utah

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Who Uses Cell Captives

Most of Today’s Cell Growth is Profit Center Focused

• Insurance Company Owned

• Insurance Producer Owned

• Associations

• Entrepreneurs

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Cell Advantages

• Less expensive to:

• Organize• Capitalize• Cost Sharing of Service Providers

• Turn Key Operation

• Rapid Implementation

• Use someone else’s capital

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District of Columbia Captive Law:Philosophy

• Relatively low capitalization

• Flexible laws

• Designed to encourage both small and large captives

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District of Columbia Law:Differences From Other Domiciles

• Capital Requirements

• Limitations on Business

• Sponsor

• Corporate Structure

• Core Liability

• Cell to Cell Agreements

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District of Columbia Captive Law:Key Points – Apply to All Captives

• Any form of business entity

• Any investments approved by Commissioner

• Any reinsurance approved by Commissioner

• Favorable U.S. Branch provision

• Best practices

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District of Columbia Captive Law:Cells and Cell Companies

• Meaningful legal description of the relationship between core and cell and cell and cell in DC law

• Two Types of Cell Companies• Protected Cell Companies (PCC)• Incorporated Cell Companies (ICC)

• Two Types of Cells• Protected Cells (PC) – defined legal characteristics• Incorporated Cells (IC) – own legal identity

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District of Columbia Captive Law:Relationship of Cells to Core

DC law clearly defines the relationship of each type of cell to core

• Incorporated Protected Cell means a protected cell that is established as a corporation or other legal entity from the protected cell captive insurer of which it is a part

• Protected Cell means a separate account established and maintained by a protected cell captive insurer

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District of Columbia Captive Law:Advantages

• Agreements between cells specifically permitted

• A Protected Cell of a PCC may enter into an agreement with the PCC or a cell of the PCC that shall be enforceable as if each cell of the PCC were a separate legal entity

• Protected Cell (PC and IC) may transfer from one protected cell captive to another

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District of Columbia Captive Law:Advantages (cont’d)

• Existing captive insurer may become a protected cell of a protected cell captive

• A protected cell may leave protected cell captive and become a stand alone captive

• A PCC may issue one or more classes or series of securities for one or more cells – proceeds to cell

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District of Columbia Captive Law:Incorporated Cells

Benefits of Incorporated Cell Captive

• Cell walls higher and thicker than PC

• Own FEIN and tax filing

• Each cell may have own directors and officers

• Inter cell agreements specifically permitted

• Each cell treated as a captive insurer for purposes of the Act

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Other Examples of Incorporated Cell Companies

• REIT• Entrepreneurial• Insures Real Estate Investment Trusts• Cell formed as LLC

• Life Insurer• Formed by insurer• Cells owned by agents provide agency incentive• Cells also available to insureds• Cell formed as corporation

• Commercial Program• Formed by property – owner manager• Cell for own property• Cell for joint ventures• Cell for third parties

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Other Examples of Incorporated Cell Companies (cont’d)

• Commercial Insurer• Owner traditional insurance company• Cells owned by agents• Quota share reinsurance• Fronted by admitted company

• Commercial Program• Formed by owner of various facilities• Cell for owned facilities• Provide and manage cells for other non-owned facilities

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The Protected Cell RRG

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Segregated Cell RRG - Basic

RRGMembers all homogenous

GLCell

D&OCell

XSLiability Cell

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Segregated Cell RRG - Alternative

Health Care System

Cell 1Staff Doctors

Cell 2Low Risk Doctors

Cell 3Higher Risk

Doctors

LLC

Cell 4Health Care

System

RRG

Hospital Class A MemberCells Class B Members

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Segregated Cell RRG – Actually Licenses andRegistered in Most States

Delivery CompanyRRG

Cell 2Delivery Company

Cell 4Risk Sharing

Cell 3Delivery Company

Cell 1Delivery Company

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Segregated Cell RRG – An Alternative

RRG

PCCOwned by Member 1, 2, 3

Member Cell 1

Member Cell 2

Member Cell 3

Member 1 Insured

Member 2 Insured

Member 3 Insured

Policy Reinsurance

October 22, 2009

Arthur D. Perschetz, EsquireKilpatrick Stockton LLP

Suite 900607 14th Street

Washington, DC 20005202.508.5871 – Telephone

aperschetz@kilpatrickstockton.com

www.mwe.com

Boston Brussels Chicago Düsseldorf Houston London Los Angeles Miami Milan Munich New York Orange County Rome San Diego Silicon Valley Washington, D.C.

Strategic alliance with MWE China Law Offices (Shanghai)

© 2009 McDermott Will & Emery LLP. McDermott operates its practice through separate legal entities in each of the countries where it has offices. This communication may be considered attorney advertising.Previous results are not a guarantee of future outcome. The following legal entities are collectively referred to as "McDermott Will & Emery," "McDermott" or "the Firm": McDermott Will & Emery LLP, McDermott Will &Emery/Stanbrook LLP, McDermott Will & Emery Rechtsanwälte Steuerberater LLP, MWE Steuerberatungsgesellschaft mbH, McDermott Will & Emery Studio Legale Associato and McDermott Will & Emery UK LLP.These entities coordinate their activities through service agreements. This communication may be considered advertising under the rules regulating the legal profession.

Recent IRS Cell Captive GuidanceTom Jones, Partner McDermott Will & Emery LLP227 West Monroe StreetChicago, Illinois 60606(312) 984-7536(312) 984-2097tjones@mwe.com

Captive Insurance Council of the District of ColumbiaEighth Annual Conference

The DC DifferenceL’Enfant Plaza Hotel

Washington, DCOctober 21 - 22, 2009

www.mwe.com 26

IRS 2009-10 Priority Guidance Plan

Released 9/10/08 – Captive related matters listed:

“Guidance on the classification of certain cell captive insurance arrangements. Previous guidance was published in Notice 2008-19.”

“Revenue ruling providing guidance on reinsurance arrangements entered into with a single ceding company.”

“Guidance concerning the classification of series LLCs and cell companies under §7701.”

www.mwe.com 27

Key Tax Considerations of the Cell Captive

Who is the taxpayer?– Entire company

– Each cell viewed separately

– The sponsor organization or the participant

At what level is the determination of “insurance” status made?– Entire company level

– Cell level

– The sponsor organization or the participant level

www.mwe.com 28

Cell Companies: Rev. Rul. 2008-8

No Insured except for XNo guarantee of Cell X obligationsAdequate capitalNo loansAnnual policy

Adequate capitalNo subsidiary < 5% nor >15%No loansNo guarantees by Y or Y1 → Y12 of Cell Y obligationsNo other insurance contractsHomogeneous riskAnnual policy

General Account

Cell X Cell YX

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Y

1

Preferred Shares

Insurance Policy Insurance Policy Covering Brother/Sister

Group

www.mwe.com 29

Cell Companies: Rev. Rul. 2008-8

Look to existing rules; apply on cellular basis

– Risk shifting

– Risk distribution

Arrangement between X and Cell X akin to a parent and wholly-owned subsidiary under Rev. Ruls. 2002-89 & 2005-40

Arrangement between Y and Cell Y characterized as brother/sister insurance under Rev. Rul. 2002-90

Should have been a 3rd situation in which Cell Z owned by Z wrote over 50% unrelated risk with holding of insurance under Rev. Rul. 2002-8926

www.mwe.com 30

Cell Companies: IRS Notice 2008-19

Proposed Guidance

Cell of a PCC would be treated as an insurance company separate fromany other entity if:

– Assets and liabilities are legally segregated

– Based on facts and circumstances cell would be classified as an insurance company taxable under IRC § 816(a) or § 831(c)

Tax Effect– Elections at cell level

– Cell must apply for FEIN if subject to U.S. tax jurisdiction

– Cell activities not taken into account in characterizing PCC’s “general account” (core)

– Cell (or parent, if consolidated) responsible for filing returns and paying tax

– PCC does not include income items with respect to cell

www.mwe.com 31

To implement this guidance, taxpayer comment requested by 5/5/08 regarding:– Transitional rules

– Reporting, if any, necessary to ensure PCC has needed information

– Special rules regarding foreign entities (including CFCs)

– Treatment of PCCs and cells under consolidated return rules

– How to handle segregated arrangements not involving insurance

Note explicitly states no inference should be inferred as to tax status of PCC core or its non-insurance cells

Effective date would be for tax years beginning more than 12 months after this guidance is finalized

Cell Companies: IRS Notice 2008-19

www.mwe.com 32

Chief Counsel Advice 200849013

Offshore cell captive that made an onshore tax election

Wholly owned by a mutual with numerous unrelated policyholder/member-owners

IRS assumed each cell is a separate taxpayer

Each cell was tied to a specific mutual member via a participation agreement

Held Cell 1 qualifies under the brother-sister test – IRS agent was wrong to aggregate 1st & 2nd tier subs

No IRS conclusion on aggregate analysis versus by lines of business because IRS position on homogeneity issue remains unclear as of the CCA release date (12/5/08)

www.mwe.com 33

Latest Development – ICC’s

ICC = Incorporated Cell Company

Originated in Jersey (not New Jersey)

Adopted by the District of Columbia (only onshore)

By statute, each cell is a distinct legal entity and can have its own governing body

Addresses cell participants’ demand for governance input where core owners don’t want to share their power

www.mwe.com 34

Latest Development – ICC’s

Difficult to characterize legal relationship between core and its ICs – not a parent/subsidiary (but contracts between and among ICs clearly are valid)

Tax status is clearer – each IC is a separate taxpayer, likely ineligible to file a consolidated federal tax return (# of tax returns = # of ICs + 1 for the “core”)

Insolvency law status also is clearer – each IC is a separate juridical person; usual rules to apply creditor hierarchy only within each separate IC

www.mwe.com 35

Questions

Presented to:Captive Insurance Council of the District of

Columbia8th Annual Conference

Presented by:

Glenn Saslow, CPAAudit Partner, Saslow Lufkin & Buggy, LLP

October 22, 2009

CELL CAPTIVE CAPTIVE ACCOUNTING

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Cell Captive Financial Reporting

Cell Structure is unique under U.S. GAAP and International Accounting Standards No specific authoritative literature availablePossibility of inconsistent reportingFinancial statement user needs may not be met (regulator, owner/participant, lender, investor, rating agency)

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Cell Captive Financial Reporting

Each protected cell shall be accounted for separately on books and records to reflect:

The financial condition and results of operations of the protected cell net income or lossDividends and distributions to participants

Annually file financial statements of each protected cell with Commissioner

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Protected Cell Presentation Styles

“Columnar” presents separate columns on the face of the statements and in the footnotes for the core (general account) and for each individual protected cell

“Singular” summarizes all segregated portfolio assets, liabilities and equity as single segregated asset and liability balances on the balance sheet with no income statement items being disclosed except for those of the core (general account)

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Annual Audit

Annual Audit by Independent CPADue on or before June 30In accordance with GAAPWhich presentation style is GAAP or STAT ?

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Operations of a Cell Company: Example 1 - GAAP

Involves a Sponsor and Cell

The Cell was created for benefactors other than the Sponsor

Potential deficits arising from investment and underwriting risk of the Cell are recoverable from the Sponsor

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Operations of a Cell Company:Example 1 - GAAP (cont.)

Management fees are paid to the Sponsor with regards to:

Participation Fee - percentage of premium for insurance contracts entered into

Cost of Surplus Fee - maintenance of surplus requirements

Administration Fee - reimbursement for all cost related to the Cells

The Cell operates a line of insurance business and all operations are separately accounted for and all insurance activity is independent of the Sponsor

Effectively separate companies (although the Sponsor’s surplus is at risk for the Cell operations as a “backstop”)

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GAAP Presentation

Total Assets and Liabilities and Capital of the Cell are shown as separate line items on the balance sheet of the Sponsor

Single line items for “asset held for protected cell” and “liabilities and capital held for protected cell”

Revenue, expenses, cash flows and equity activity can be shown in separate columns within the Sponsor’s financial statements or in the footnotes (not required)

Statement of Operations of Cells are not combined with sponsor

To the extent the Cell has an operating deficit and the Sponsor’s capital is at risk - known as a “contingency reserve”

Operations of a Cell Company:Example 1 - GAAP (cont.)

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Contingency ReserveDeficits arising from the underwriting and investment risk of the Cell could ultimately be recoverable from the Sponsor

Contingency Reserves represent the dollar for dollar accumulated deficit and other comprehensive loss of the Cell on a standalone basis

Cell captive laws vary state by state and where the sponsor capital is not “at risk” the concept of a contingency reserve may not exist

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Disclosures Related to GAAP

Clear and concise footnote 1 related to the structure, formation and relationship of the sponsor to the cells and cells to other cells

Option to include consolidating schedules in supplemental schedule

Option to have separate statement of operations, changes in capital and cash flows for the Sponsor and each Cell

Option to have investment footnote for the Sponsor and each Cell

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Disclosures Related to GAAP (cont.)

Insurance activity by each Cell

All related party transactions and fee arrangements occurring between the Sponsor and the cells and also between the cells and other cells

Income tax allocation for the Sponsor and each Cell

Assets and Liabilities of each Cell

Footnote describing the contingency reserve amount and policy

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Alternative GAAP Presentations Accounting for the sponsor and cells will always look through to the substance of the relationship as opposed to the formation or name to arrive at the proper presentation within the financial statements

GAAP Presentations:

Consolidated Sponsor and Cell statements with accompanying consolidating schedules (FIN 46R)

Separate account presentation with sponsor assets not at risk

Separate account presentation with sponsor assets at risk

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STAT Presentation

All Admitted Assets and Liabilities and Capital of the Cells are shown combined within the statutory financial statements

All revenue, expense, cash flows and equity activity is shown combined

All intercompany activity between the Cell and Sponsor is eliminated

No contingency reserve

Operations of a Cell Company:Example 2 – STAT

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Disclosures Related to STATSupplemental schedules showing combining statements related to the statement of admitted assets, liabilities and capital and surplus and statutory statement of operations with eliminating entries

Similar footnotes to GAAP Presentation

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Questions and Comments

Thank you to The Captive Insurance Council of the District of Columbia