Catch the Ins and Outs of Micro-Captives · 2. Section 1.822-8(c)(2) (ii) defines “general...

14thAnnual Executive Educational Conference

Catch the Ins and Outs of

Micro-Captives

September 17, 2013

Anne Marie Towle: Senior Captive Consultant, Willis Global Captive PracticeDaniel J. Kusaila: Partner, Saslow Lufkin & Buggy, LLPChaz Lavelle: Partner, Bingham Greenebaum Doll LLP


b) Captives

831(b) Captives

Scoping the risks

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Workers’ Compensation Auto Liability General Liability Professional and Products

Liability Director and Officer

Liability Employment Practices

Liability Environmental Liability Product or Service

Extended Warranty Property and Business

Interruption

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Types of Risks

Self-Insured Medical Stop-Loss (non-ERISA)

Reputation/Brand/Loss of Income Risks

Intellectual Property (patent, trademark, copyright)

Product Recall Coverage Medicare “Fraud and

Abuse” Insurance Lease Residual Value Risk Punitive Damages Coverage International Kidnapping

Protection

EMERGINGTRADITIONAL

EE Benefits Terrorism (TRIA) Shipping Coverage Title and Private Mortgage

Insurance Equipment Maintenance Construction Exposures Trade Credit Risk Cyber-Risk Managed Care Errors and

Omissions

EXPANDED

14thAnnual Executive Educational Conference4

Small Insurance Company Optimization

• Low Frequency, high severity types of risks• Endless possibilities• Examples include:

– Cyber– Cargo– Crime– Pollution– Professional– Business Interruption– Reputational Risk– Property


Company XYZ Captive §831(b)

A B C D E F

Insuran ce Poli cy

Risk & Premium

Shareholders

1 – Shar eholders e ach con tribute capital to the §831 (b)capti ve;2 – Company XYZ pa ys t he cap tive a pr emi um which includes the losses , exce ss premiums (if appli cable) and taxe s;3 – The ca ptiv e Issues an insurance pol icy to Company XYZ4 – Company XYZ submits cl ai ms t o the capt ive , who settle s t hem; and5 – Ca ptiv e reimbur ses Company XYZ for t he losses

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2

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5

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Common Structure Options for §831(b) Captives


Common Structure Options for §831(b) Captives

Company XYZ Captive 831(b)

A B C D E F

Insurance Policies

Risk & Premium

Shareholders

Captive 831(b)Captive 831(b)Captive 831(b)

Captive 831(b)Captive §831(b)

1 – Shareholders contribute capital to their in divid ual §831(b)captive;2 – C ompany XYZ p ays each capt ive a premium whic h includes the losses, excess premiums (if applicable) and taxes associated wit h that captive’s insurance o ffer ing;3 – Each captive Issues an insurance pol icy to Company XYZ4 – C ompany XYZ submit claims to th e capt ives, wh o set tle them; and5 – C apt ives reimburse Company XYZ for the losses

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Captive Structural & Services

Optimization

Captive Feasibility

Kick-Off

Phase 1: Initial

Analysis

Phase 2: Formal

Feasibility Study

> Development of Strategic Plan> Identification of optimal structure> Identification of the Revenue Streams in near and long term

> Identification of Stakeholders > Road mapping project timeline and deliverables> Discussion of initial parameters and dynamics

> Information requirements > Data collection and aggregation > Data analysis > Development of initial program schematics > Initial analysis review

> Tax and Legal Advice > Actuarial Analysis > Fronting and Reinsurance > Optimal Program Design > Domicile Review> Feasibility Report, Pro-Forma Financials, and Recommendations

Captive Formation

Captive Operations

> Implementation of Captive Facility> Implementation of Insurance Program> Initial Subscription

> Ongoing Captive Management> Program Administration> Ongoing Captive Utilization Consulting> Marketing> Risk and Loss Control> Audit> Actuarial> Legal

CaptIve

Process


b) Captives

831(b) Captives

831(b) Captives

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Small Corporations can “elect” to be taxed on their taxableinvestment income.

Must meet the tax qualifications to be taxed as an insurance company in order to make the election.

Alternative Tax for Small Insurance Companies831(b) Captives

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What is Small?

Section 831(b)(2)(A)(i) states that the net written premiums (or, if greater, direct written premiums) for the taxable year do not exceed $1,200,000

Company must elect and can only be revoked by the Commissioner or if the Company fails to

meet the criteria

Alternative Tax for Small Insurance Companies (cont’d.)

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– Net written premiums and direct written premiums are not defined by the Internal Revenue Code or regulations. However, the IRS Manual has determined that the IRS will look to the NAIC definition of these terms.

Direct written premiums = all premiums arising from policies issued by the company as the primary insurance carrier, adjusted for any return or additional premiums arising from endorsements, audits, and retrospective rating plans.

Net written premiums = the sum of direct written premiums plus assumed reinsurance premiums, less ceded reinsurance premiums.


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1. Investment expenses also can include general expenses properly allocable to investment activities.

2. Section 1.822-8(c)(2) (ii) defines “general expenses” to mean “any expense paid or incurred for the benefit of more than one department of the company rather than for the benefit of a particular department thereof.” 1. Auditing Expenses2. Management Fees3. Tax Fees4. Etc.

See Letter Ruling 9609003


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• If general expenses are allocated to investment expenses the deduction is subject to a limitation under IRC 834(c)(2)

• The total deduction cannot exceed the sum of (1) 1/4 of one percent of the mean of the book value of the invested assets held at the beginning and end of the tax year, plus (2) 1/4 of the amount by which taxable investment income (computed without the deduction for investment expenses, tax-exempt interest or dividends received) exceeds 3 3/4 percent of the book value of the mean of the invested assets held at the beginning and end of the tax year

“Small” Insurance Company : 831(b)

Investment Expenses Limitation

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“Small” Insurance Company : 831(b) Investment Expense Limitation (cont’d.)

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Controlled Group:

If there is more than 1 insurance company that is part of a consolidated return or member of a controlled group, the premiums of all insurance companies must be aggregated in order to determine if the $1.2 million threshold has been exceeded.

See Section 831(b)(2)(B)


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1563(f)(5)Brother-sister controlled group definition1563(f)(5)(A)(2)Two or more corporations if 5 or fewer persons who are individuals, estates, or trusts own (within the meaning of subsection (d)(2) stock possessing—

1563(f)(5)(A)(2)(A) at least 80 percent [more than 50% IRC Sec 831(b)(2)(B)] of the total combined voting power of stock or at least 80 percent [more than 50% IRC Sec 831(b)(2)(B)] of the total value of shares of all classes of stock, of each corporation, and

1563(f)(5)(A)(2)(B) more than 50 percent of the total combined voting power of stock or more than 50 percent of the total value of stock of each corporation, taking into account the stock ownership of each such person only to the extent such stock ownership is identical with respect to each such corporation


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Brother/sister controlled group example:


Individuals Red Co Blue Co Green Co

John 45 25 38

Sara 40 30 32

Nick 15 10 20

Unrelated 0 35 10

Total 100 100 100

John, Sara and Nick combined own more than 50% of the stock of each company thus they constitute a brother sister corporation.

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Net Operating Losses:

• Cannot be carried to or from a year in which the company is taxed under Section 831(b)

• Cannot be carried to any taxable year if, between the taxable year from which such loss is being carried and such taxable year, there is an intervening taxable year for which the insurance company was not subject to the tax imposed by subsection (a).


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b) Captives

831(b) Captives

Common Pitfalls

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C CorporationTI: $100,000



831(b) Company$1.2 million of premium

In the above scenario, the 15% tax rate for the 831(b) Company will be stepped up to a 34% tax rate due to the controlled group.

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• Business or Investment Risk rather than insurance risk;• Too much time spent on investments;

• Are you in the business of insurance or investing?

• Premium Credits• Advanced Premium

Other Pitfalls

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Frequently asked Questions:

Once the election is made, can I decide not to make the election due to losses?

Can you flip/flop between 831(b) years and traditional years?

Are the 831(b) captives more vulnerable to IRS scrutiny?

Will Congress increase the premium threshold anytime soon?


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b) Captives

831(b) Captives

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Renewed Vigor : Same Tests

• The IRS is very active in auditing captive insurance companies. They are auditing for excise tax compliance, whether the arrangement is insurance for Federal income tax purposes, whether the section 501(c)(15) and 831(b) rules have been met, etc. But the tests remain the same


Renewed Vigor :Same Tests (cont’d.)

• To have a valid insurance arrangement, each of the following must be present:1) Insurance Risk2) Risk Shifting – enough capital and no guarantees3) Risk Distribution4) Common Notions of Insurance


Insurance Risk

• A risk (it may occur)• Not an eventuality (it may not occur)• Not an investment risk• Not a business risk


Business Risk

• An insurance risk cannot be a business risk, but drawing the line between the two is often difficult

• CCA 200628018 ruled that an embedded express limited warranty was a business risk and not an insurance risk. The risk was part of the manufacturing process

• It was, to some degree, required by law• It was part of the purchase price of the item• It could not be declined by the purchaser in exchange for a

refund• The insured controlled the manufacturing process so the risk

lacked fortuity


Business Risk (cont’d.)

• By contrast, an extended warranty is an insurance risk. CCA 200631002

• It only arises after the embedded warranty expires• It is purchased separately for a price• It can be accepted or declined• It covers what would be the consumer’s liability, not the

manufacturer’s


PLR 201314020

• Two Obligor companies that sell vehicle service contracts were insurance companies for Federal income tax purposes

• In those states where it is required, each Obligor will purchase a contractual liability policy or obtain a surety bond from an unrelated party

• The arrangements met all the insurance tax tests


PLR 201314020 (cont’d.)

• The Obligor companies will follow the insurance tax treatment• Neither Obligor company was regulated or licensed as an

insurance company• Each Obligor company paid its parent a charge for

administrative and support services• PLR 201229008 involved roadside assistance (towing, flat tire

changes, battery jump starts, fuel and coolant delivery, and lock-out services)


Insurance Risk – PLR 2011149021

• PLR 201149021 – residual value risk is not an insurance risk• This was not insurance in its commonly accepted sense

because it did not cover physical damages, but rather the value of the product vs a target at the lease’s end (a function of supply and demand)

• There was no risk distribution because the same economic conditions that affect resale value would affect all units

• This is currently being litigated


Types of Risks

Self-Insured Medical Stop-Loss (non-ERISA)

Reputation/Brand/Loss of Income Risks

Intellectual Property (patent, trademark, copyright)

Product Recall Coverage Medicare “Fraud and

Abuse” Insurance Lease Residual Value Risk Punitive Damages

Coverage International Kidnapping

Protection

EMERGING

Workers’ Compensation Auto Liability General Liability Professional and

Products Liability Director and Officer

Liability Employment Practices

Liability Environmental Liability Product or Service

Extended Warranty Property and Business

Interruption

TRADITIONAL

EE Benefits Terrorism (TRIA) Shipping Coverage Title and Private

Mortgage Insurance Equipment Maintenance Construction Exposures Trade Credit Risk Cyber-Risk Managed Care Errors

and Omissions

EXPANDED


Investment Risk

• An insurance risk cannot be an investment risk• An investment risk is illustrated by Rev. Rul. 89-96 which is

said to be based on the MGM Las Vegas (current Bally’s) fire of the mid 1980s

• M was insured for 30X of coverage. A fire caused more than 130x of damage. M bought coverage for the 30x to 130x layer for 50x, with all parties anticipating that the 130x level would be exceeded


Investment Risk (cont’d.)

• The Ruling ruled that the insurance company had assumed an investment risk, and not an insurance risk: because the amount to be paid is known, the only unknown was whether the insurance company would earn enough, quickly enough, to make a profit after the payment of claims and expenses


Risk Distribution

• The IRS has litigated with a public company whether there is risk distribution where one insured represents 60-70% of the captive’s premium

• The IRS has questioned some pools


Common Notions of Insurance

• The insurance arrangement should be reasonable and well documented; the parties should comply with the documentation

• Investments– Loan backs– PLRs 201219009-201219011 – involved good pooling arrangements– “Further no opinion is expressed as to the Federal income tax

consequences of the transaction described above if Company makes loans to its affiliated insureds or parties related thereto”

– Life Insurance – the IRS has challenged arrangements where the captive purchased life insurance on the lives of an owner


Questions

37

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