New Uses and Benefits of Captive Insurance-What, Why and How

May 20, 2015

Philip J. Tortorich

+1.312.902.5643

philip.tortorich@kattenlaw.com

Partner

Katten Muchin Rosenman LLP

Kyle Mrotek

+1.262.402.8612

kmrotek@taa-inc.com

Consulting Actuary

The Actuarial Advantage, Inc.

What is a Captive Insurance Company?• 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.

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Basic Captive Structure

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Captive InsuranceCompany

OperatingBusiness

BusinessOwner

Payment of Premium

Issuance of Policies

100% 100%

Why Form a Captive?

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• Improved risk management

• Profit center

• Expanded/customized coverage

• Flexibility

• Access to reinsurance

• Incentive for loss control

• Opportunity to minimize income and transfer taxation

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Source: Wilmington Trust

Financial Benefit-Sample Comparison

Five year accumulated benefit

$2 million

Where is a Captive Formed?

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• States to Consider for Captive Formation, include:− Nevada− Delaware− Utah− Missouri− Vermont− Hawaii

• Offshore Jurisdictions to Consider for Captive Formation, include:− Cayman Islands− Bermuda− British Virgin Islands− Hong Kong

Where is a Captive Formed? (continued)

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• 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 policies issued?− 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?

What Types of Policies Can a Captive Issue?

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• Proper policy design is essential to the success of a captive

• Captives can offer practically all types of insurance

• In general, business owners should not replace their commercially-purchased insurance with self-insurance except in limited circumstances

• 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.− Excess limits over commercial insurance− Fill gaps of commercial insurance exclusions

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• Following are examples of the various types of commercial policies that businesses can investigate:− Antitrust & Unfair Competition− Commercial Vehicle Insurance− Construction and Design Defect− Copyright Infringement− Deceptive Trade Practices− Directors & Officers Liability− Employment Practices− Environmental

− Advertising Liability− Errors & Omissions− Malpractice− Performance Liability− Structural Defects− Title Insurance− Trademark Infringement− Libel & Slander

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

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

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• 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.

11Source: Leon Rives

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• 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− Advertising & Marketing− Antitrust and Unfair Comp.− Business Credit Cover− Business Dirty Tricks− Business Document Forgery− Business Extortion− Business Interruption

− Currency Risks− Delay Start-up− Eminent Domain− Financial Crime− Force Majeur− Foreign Operations− Administrative Delay− Insurance Failure

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

− Product Tampering− Production

Benchmarks− Property Damage− Trade Secrets− Strike & Labor Unrest− Terrorism− Theft− Trade Credit

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• Types of “soft” policies (continued):− Business Reputation− Cargo Consequential Loss− Cash in Transit− Commercial Crime− Commun. Breakdown− Computers: Dissemination− Computers: Loss of Data− Computers: Software− Computers: Virus Loss− Confiscation− Contract Frustration− Copyright Infringement

− Knock-Off Lost Profit− Lawsuit Interruption− Labor Costs− Legal Expenses− Lender Failure− Loss of Key Customer− Loss of Talent− Machinery Breakdown− Market Flooding− Market Risks− Political Risks− Product Launches

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

− Trade Good Will− Patent & Trademark

Infringement− Transit Risk− Unfair Calling of

Guarantees− Weather Risks

What are the Income Tax Benefits of Captive Planning?

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• 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”?

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• In order to achieve the income tax benefits the payments must be for “insurance” and must relate to “insurance contracts”.

• 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.

• 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 Helveringv. Le Gierse. Namely, that insurance has two components:− Risk Shifting; and− Risk Distribution

What is “Insurance”? (continued)

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• 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.

What is the Case Law Regarding Captives?

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

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

• Kidde Industries, Inc. v. U.S., 40 Fed.Cl. 42 (Ct. Cl. 1997)

• Hospital Corporation of America v. C.I.R., T.C.M. 1997-482 (1997)

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

What are the IRS Rulings Regarding Captives?

• Revenue Ruling 2001-31• Revenue Ruling 2002-89 – Safe Harbor 1• Revenue Ruling 2002-90 – Safe Harbor 2• Revenue Ruling 2002-91• Notice 2003-34• Revenue Ruling 2005-40• Revenue Ruling 2007-47• Revenue Ruling 2008-8• Revenue Procedure 2002-75

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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.

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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.

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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.

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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

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• Purpose− Is a captive insurance company right for

your company?− If yes, how to pursue optimally?

• Content− Financial evaluation− Operational evaluation− Actuarial analysis

Captive Feasibility Overview

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• Basic Results− Actuarially fair premium− Projection of loss and loss expense

Captive Feasibility

Policy Year 2015Coverage Written Premium Ult Loss & Loss Exp

Coverage A $500,000 $325,000

Coverage B $400,000 $260,000

Coverage C $200,000 $130,000

Sum $1,100,000 $715,000

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• Basic Results− Expected Scenario Loss Payout

Captive Feasibility (continued)

Loss and Loss Expense Payout

Policy Year

Written Premium

Ult Loss & Loss Exp 2015 2016 2017 2018 2019

2015 1,100,000 715,000 500,500 107,250 71,500 35,750 0 2016 1,122,000 729,300 510,510 109,395 72,930 36,465 2017 1,144,000 743,600 520,520 111,540 74,360 2018 1,167,000 758,550 530,985 113,783 2019 1,190,000 773,500 541,450

Sum 5,723,000 3,719,950 500,500 617,760 701,415 751,205 766,058 25

• Basic Results− Adverse Scenario Loss Payout

Captive Feasibility (continued)

Loss and Loss Expense Payout

Policy Year

Written Premium

Ult Loss & Loss Exp 2015 2016 2017 2018 2019

2015 1,100,000 715,000 500,500 107,250 71,500 35,750 0 2016 1,122,000 729,300 510,510 109,395 72,930 36,465 2017 1,144,000 743,600 520,520 111,540 74,360 2018 1,167,000 1,750,000 1,750,000 02019 1,190,000 773,500 541,450

Sum 5,723,000 4,711,400 500,500 617,760 701,415 1,970,220 652,27526

• Additional Results− Pro Forma Financials− Evaluate Capitalization

Captive Feasibility (continued)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

YE '15 YE '16 YE '17 YE '18 YE '19

NPW:Surplus (Exp)

NPW:Surplus (Adv)

Res:Surplus (Exp)

Res:Surplus (Adv)

PY 2018 adverse loss increases solvency ratios

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Growth in Captive Insurance

-4%

-2%

0%

2%

4%

6%

8%

10%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Captive Counts vs US GDP

Captives

US GDP

Source: Business Insurance, World Bank28

Growth in Captive Insurance

0

1000

2000

3000

4000

5000

6000

7000

8000

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Number of Captive Insurers

Source: Business Insurance29

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.

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