Risk Management Entity for Businesses Evaluating Business Uses and - - PowerPoint PPT Presentation

Captive Insurance Companies: Risk Management Entity for Businesses

Evaluating Business Uses and Legal Risks, Addressing Tax Implications, and Avoiding Regulatory Pitfalls

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

The audio portion of the conference may be accessed via the telephone or by using your computer's

• speakers. Please refer to the instructions emailed to registrants for additional information. If you

have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.

WEDNESDAY, JULY 18, 2012

Presenting a live 90-minute webinar with interactive Q&A

F . Hale Stewart, Owner, The Law Office of Hale Stewart, Houston Jay D. Adkisson, Partner, Riser Adkisson, Newport Beach, Calif.

Sound Quality If you are listening via your computer speakers, please note that the quality of your sound will vary depending on the speed and quality of your internet connection. If the sound quality is not satisfactory and you are listening via your computer speakers, you may listen via the phone: dial 1-866-961-8499 and enter your PIN -when prompted. Otherwise, please send us a chat or e-mail sound@straffordpub.com immediately so we can address the problem. If you dialed in and have any difficulties during the call, press *0 for assistance. Viewing Quality To maximize your screen, press the F11 key on your keyboard. To exit full screen, press the F11 key again.

For CLE purposes, please let us know how many people are listening at your location by completing each of the following steps:

• In the chat box, type (1) your company name and (2) the number of

attendees at your location

• Click the SEND button beside the box

FOR LIVE EVENT ONLY

If you have not printed the conference materials for this program, please complete the following steps:

• Click on the + sign next to “Conference Materials” in the middle of the left-

hand column on your screen.

• Click on the tab labeled “Handouts” that appears, and there you will see a

PDF of the slides for today's program.

• Double click on the PDF and a separate page will open.
• Print the slides by clicking on the printer icon.

A Primer on Captive Insurance And How to Structure Captive Insurance Transactions

• F. Hale Stewart, JD, LLM, CTEP, CWM, CAM

Author of the book U.S. Captive Insurance Law Captiveinsuranceinfo.com 832-330-4101

5

Who Should Form A Captive?

 A company that has an above-average risk profile.  A company or individual with the financial resources to contribute to the captive.  Finally, a company should have a good combination of income and risk

• Ideally, a company should have $3 million in

gross revenue

• But a company that has $1-$3 million may have

enough risk to warrant looking at a captive.

• Please call if you have questions

6

What Companies Are More Likely to Benefit From a Captive

 Doctors and other professionals  Manufacturers  Exporters and Importers  Dry Cleaning  Construction Related Professions

• Contractors
• HVAC
• Plumbing

 Oil and Gas  Hotels, Motels, Restaurants and Inns  Transportation Companies

7

What Are the Benefits of Forming A Captive?

• Custom Insurance Policies

– The Beech Case – Using Individual loss experience in determining insurance rates

• Gives the insured negotiating leverage with third party

insurers

– Third party insurer insures standard risk – The captive underwrites specialty risk

• Captives can be used as wealth transfer vehicles
• Small Insurance Companies are Taxed Advantaged

– 831(b)

8

What Are the Benefits to Forming a Captive, con’t?

• Underneath the insurance and risk

management purposes of a captive insurance company is a great tax arbitrage opportunity.

– In the current year, the insured lowers his taxable income through the payment of insurance premiums. In forming the captive, the insured is most likely insuring a large amount of risk which was previously “self-insured,” meaning the insured paid for losses out of current earnings and savings. – The premiums are placed into a tax-advantaged vehicle – remember that small insurance companies are taxed on their current portfolio income rather than their current earnings. – When the insured sells his captive shares, the transaction is taxed as a capital gains transaction rather than as an ordinary income transaction.

9

What Are the Steps to Forming a Captive?

• After a company decides to form a captive, the

next step is to perform a feasibility study, which has three objectives.

– It provides a blueprint for the entire captive program. – Second, it aids in compliance. – Third, the study can aid in selling important decision-makers within the organization on the plan.

10

What Are the Steps to Forming a Captive?

 The jurisdiction where the captive is being formed must determine if forming the captive is in the jurisdiction’s best interest. To do that, they will consider

• (i) The character, reputation, financial standing and

purposes of the incorporators;

• (ii) The character, reputation, financial responsibility,

insurance experience and business qualifications of the officers and directors; and

• (iii) Such other aspects as the commissioner shall

deem advisable.

11

What Are the Steps in Forming a Captive, con’t

• Next, the applicant must make a formal application to
• pen an insurance company. The application must

typically contain the following information

– (A) The amount and description of its assets relative to the risks to be assumed; – (B) The adequacy of the expertise, experience, and character

• f the person or persons who will manage it;

– (C) The overall soundness of its plan of operation; – (D) The adequacy of the loss-prevention programs of its parent, member organizations, or industrial insureds, as applicable; and – (E) Other factors considered relevant by the commissioner in ascertaining whether the proposed captive insurance company will be able to meet its policy obligations

• Finally, there is the issue of original capital and

surplus.

12

Running the Captive

• Domicile manager
• Legal counsel
• Accounting/Audit
• Actuarial Services
• Investment manager

13

Shutting Down the Captive

 In most states, one of the following seven reasons will allow a state regulator to shut down a captive:

• 1. Insolvency or impairment of capital and surplus.
• 2. Refusal or failure to submit an annual report … or any other

report or statement required by law or by lawful order of the director.

• 3. Failure to comply with the provisions of its own articles of

incorporation, bylaws or other organizational document.

• 4. Failure to submit to an examination or any legal obligation

related to the examination.

• 5. Refusal or failure to pay the cost of an examination.
• 6. Use of methods that, although not otherwise specifically

prohibited by law, render its operation hazardous or its condition unsound with respect to the public or to its policyholders.

• 7. Failure otherwise to comply with the captive statute.

14

The IRS Fought Captive Insurance For Nearly 30 Years

• They used three arguments

– The Economic Family – Nexus of Contracts – Assignment of Income

• No Court Accepted Any of the IRS’

arguments

15

Safe Harbor Guidance, Part I

• Under Harper, a captive must comply with a

three prong test: – (1) whether the arrangement involves the existence of “insurance risk”; – (2) whether there was both risk shifting and risk distribution; and – (3) whether the arrangement was for “insurance” in its commonly accepted sense.

• The duck test – does the company “walk

and talk” like an insurance company?

16

Safe Harbor Guidance, Part II

 The IRS has issued several Revenue Rulings that

provide further safe harbor guidance

 A captive must derive at least 50% of its insurance

revenue from a non-parent.

• Harper lowers this amount to 30%
• This is accomplished through reinsurance

 Or, a captive must have at least 12 subsidiaries in

• rder to have sufficient risk distribution.

17

Private Letter Rulings, or, the Ultimate Safe Harbor

• A Private Letter Ruling (or PLR) is "issued for a

fee upon a taxpayer's request and describes how the IRS will treat a proposed transaction for tax purposes."

• Private Letter Rulings create certainty – we

know how the IRS will view a specific transaction

18

Staying Within the Law; Captive Insurance and Anti-Avoidance Law

19

What is Anti-Avoidance Law?

• Generally, anti-avoidance law is a series of

common law doctrines that prevent a taxpayer from manipulating the tax code and/or transactions in such a way as to bastardize congressional intent.

• For example, a corporate reorganization is a

tax-free event. Therefore, taxpayers will try to make a transaction look like a reorganization when in fact it is not.

20

For Example

• A corporate reorganization must meet the

following requirements:

– There must be a plan of reorganization – The plan must meet the continuity of interest and business enterprise tests. – There must be a sound business purpose (the business purpose test).

• If a “reorganization” does not meet these

requirements, a court can strip the taxpayers of their tax-free treatment.

21

But, There is a Tension Within the Law

• On one hand, taxpayers cannot manipulate

the code in a way not intended or contemplated by the underlying statute.

• On the other hand, taxpayers are allowed to

plan their transactions from a tax perspective to minimize the rate of taxation.

22

Therefore, Remember the Following Two Rules.

• In General, a Taxpayer who is a party to any transaction must be

able to demonstrate: – there is a genuine multiple-party transaction – with economic substance that is – compelled or encouraged by business or regulatory realities, – that is imbued with tax-independent considerations, and – that is not shaped solely by tax-avoidance features to which meaningless labels are attached.

• This documentation must occur before the transaction is

complete.

• Think “duty of care”
• Occam's razor (or Ockham's razor), is the meta-theoretical

principle that "entities must not be multiplied beyond necessity" (entia non sunt multiplicanda praeter necessitatem) and the conclusion thereof, that the simplest solution is usually the correct one.

23

There are 5 Anti-Avoidance Rules

• Substance over form
• The Sham Transaction
• Business Purpose
• Economic Substance
• The Step Transaction

24

Substance Over Form

• In these circumstances, the facts speak for

themselves and are susceptible of but one

• interpretation. The whole undertaking, though

conducted according to the terms of subdivision (B), was in fact an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else.….. To hold

• therwise would be to exalt artifice above reality

and to deprive the statutory provision in question

• f all serious purpose.

25

Sham Transaction

• “[i]t is well established that a transaction

entered into solely for the purpose of tax reduction (the Goldstein prong) and which has no economic or commercial objective to support it (the Knetsch prong) is a sham and without effect for Federal income tax purposes.”

26

The Business Purpose Test

• “[I]n construing words of a tax statute which

describe commercial or industrial transactions we are to understand them to refer to transactions entered upon for commercial or industrial purposes and not to include transactions entered upon for no other motive but to escape taxation.”

27

The Economic Substance Doctrine

• Prong One: The transaction is rationally

related to a useful non-tax business purpose that is plausible in light of the taxpayer’s conduct and economic situation

• Prong Two: the transaction results in a

meaningful and appreciable enhancement in the net economic position of the taxpayer

• ther than to reduce tax.

28

The Step Transaction Doctrine

• A given result at the end of a straight path is not made a different result

because reached by following a devious path.

• The mutual-interdependence test finds that the step-transaction doctrine

applies where individual transactions were “so interdependent that the legal relationship created by one transaction would have been fruitless without a completion of the series. The relationship between the steps, rather than their “end result,” is examined.

• In the end results test, “purportedly, separate transactions will be

amalgamated into a single transaction when it appears that they are really component parts of a single transaction intended from the outset to be taken for the purpose of reaching the ultimate result.” Put another way, “Separate steps will also be integrated if they are a part of a single scheme designed to achieve a single result.”

29

Therefore, Remember the Following Two Rules.

• In General, a Taxpayer who is a party to any transaction must be able to

demonstrate:

– there is a genuine multiple-party transaction – with economic substance that is – compelled or encouraged by business or regulatory realities, – that is imbued with tax-independent considerations, and – that is not shaped solely by tax-avoidance features to which meaningless labels are attached.

• This documentation must occur before the transaction is complete.
• Occam's razor (or Ockham's razor), is the meta-theoretical principle that

"entities must not be multiplied beyond necessity" (entia non sunt multiplicanda praeter necessitatem) and the conclusion thereof, that the simplest solution is usually the correct one.

30

Captive Insurance Companies and Closely-Held Insurance Companies

Jay Adkisson

Riser Adkisson LLP

R i s e r A d k i s s o n L L P

Direct Office: 949-200-7773 E-Mail: jay@risad.com Supporting documentation at: www.captiveinsurancecompanies.com

31

Background

• Author of Adkisson’s Captive Insurance

Companies

• Partner in the law firm of Riser

Adkisson LLP with offices in Newport Beach, CA

• Former partner of a captive insurance

consulting firm (US) and licensed captive manager (BVI) from 1998 to 2003

• Current Chair of ABA’s Committee on

Captive Insurance

• Expert witness to U.S. Senate Finance

Committee

32

Onshore or Offshore?

• Historically, captives were formed offshore for tax

and regulatory reasons

• Most captives are formed in the US today
• Vermont, South Carolina, Hawaii, Utah, Nevada

and others attract captives

• No need for offshore or “hide the ball” -planning

with captives is fully above-board

33

The Modern Captive Sector

• Captive insurance arrangements have boomed in

popularity during the last five years

• Part of overall trend of alternative risk

management

• Captive markets have become efficient
• Nearly all major corporations have captives

34

Who Has A Captive?

Parent Captive Exxon-Mobil Ancon Insurance Company Archer Daniels Midland Agrinational Insurance Company Verizon Exchange Indemnity Company AT&T Gateway Rivers Insurance Company University of Michigan Veritas Insurance Company Phillips Petroleum Sooner Insurance Company Starwood Hotels Westel Insurance Company Johnson & Johnson Middlesex Assurance Company CBS Corporation Central Fidelity Insurance Company Boeing Astro Ltd.

35

Definition

Captive Insurance Company (“Captive”) An insurance company that is formed by the parent company to underwrite the insurance needs of the parent’s other subsidiaries

36

PAYS PREMIUMS

OPERATING BUSINESS

“Pure” Captive Insurance

COMMON OWNER INSURANCE COMPANY

UNDERWRITES RISKS AND PAYS CLAIMS TAKES CURRENT DEDUCTION FOR PREMIUMS PAID

37

Traditional Insurance

OPERATING BUSINESS Business Owner INSURANCE COMPANY Shareholders Profits ASSUME RISK PREMIUMS

38

Traditional Insurance

INSURANCE COMPANY Shareholders REINSURANCE COMPANY Shareholders Profits PREMIUMS ASSUME RISK

39

Traditional Insurance

OPERATING BUSINESS Business Owner INSURANCE COMPANY Shareholders REINSURANCE COMPANY Shareholders Profits Profits PREMIUMS PREMIUMS ASSUME RISK ASSUME RISK

40

The Captive Difference

OPERATING BUSINESS Business Owner Captive Insurance Company REINSURANCE COMPANY Shareholders Profits Profits PREMIUMS PREMIUMS ASSUME RISK ASSUME RISK

41

Insurance Sold by Captive

• Do not increase overall risk profile
• Do not replace bad covered risks
• Cover currently uncovered risks

– Deductibles – Exclusions – Losses – Liability: Litigation Expense Only

42

The Risk Universe

All the Risks

• f the

Business

43

The Risk Universe

General Liability Workers Compensation Fire Accident

Currently Covered Risks

44

The Risk Universe

General Liability Workers Compensation Fire Accident Deductibles Exclusions Product Liability Environmental Intellectual Property Flood, Wind, Earthquakes EPL and Overtime Regulatory Actions

45

The Risk Universe

Deductibles Exclusions Product Liability Environmental Intellectual Property Flood, Wind, Earthquakes EPL and Overtime Regulatory Actions

46

Increased Deductible Program

Deductible $0 to $1M Insurance $1M to $10M Premium $200K Without Captive Captive insures $0 to $3M Premium $250K Insurance $3M to $10M Premium $50K With Captive

47

Captives: Limitations

• Captives can offer insurance to only:

– Other businesses of the common owner – Other insurance companies (by selling reinsurance)

• Captives cannot offer insurance to third-

parties, such as employees

• For workers compensation or health

insurance, a “fronting” arrangement must be used.

48

Employees

Captive

Fronting Arrangement

Workers Compensation -- Healthcare

Fronting Carrier

Business Owner

Premiums Directly Insures Employees and Handles Claims Reinsures Fronting Carrier and provides Letter of Credit

49

Employees

Captive

Fronting Arrangement

Workers Compensation -- Healthcare

Fronting Carrier

Business Owner

Premiums Directly Insures Employees and Handles Claims When policies expire, Captive receives the underwriting profits

50

Deductibility of Premiums

• Definition of Insurance (LaGierse)

– Risk Shifting – Risk Distribution

51

Risk Shifting

• Bona Fide Insurance Arrangement

– Policy Binding on Captive – Captive Will Pay Claims

• Adequate Capitalization

– Premiums Do Not Exceed 5x Capital – Set by Actuaries – Approved by Commissioner

52

Risk Pools

• Some Pools Exist Just To Provide Third-Party

Insurance

– Promoted as “Low Risk” Pools – Few or No Claims

• Problems

– Low Risk = Low Premiums – Attract Undue Attention – Opportunity for IRS to Blow Up Many Captives at Once

• “Pools Are For Fools”

53

Cell Captives

• Rev. Ruling 2008-8

54

12+ Insureds

• Rev.Rulings 2002-90 & 2005-40
• 12+ Taxpayers
• No Disregarded Entities
• No More Than 15% From 1 Insured
• Contrast Case Law: 8 Insureds

55

Small Captives

• 831(b) Election – Tax the captive’s non-premium income
• nly

– The election is filed with the captive’s first tax return

• No tax on up to $1.2 million in total premiums annually
• Thus, the captive can receive up to $1.2 million in

premiums per year but pay no taxes on that money

56

The 831(b) Election

OWNER OPERATING BUSINESS INSURANCE COMPANY DEDUCTION FOR PREMIUMS PAID CAPTIVE PAYS NO TAXES ON PREMIUMS RECEIVED < $1.2M >

57

Termination of Captive

• Liquidate captive and pay long-term capital

gains – Assume this result

58

Definition

Closely-Held Insurance Company (“CHIC”) A captive that is owned by younger family members so as to also accomplish an intergenerational wealth transfer

59

“Pure” Captive Insurance Company

OWNER OPERATING BUSINESS INSURANCE COMPANY DEDUCTION FOR PREMIUMS PAID CAPTIVE PAYS NO TAXES ON PREMIUMS RECEIVED < $1.2M >

60

Closely-Held Insurance Company

OWNER OPERATING BUSINESS INSURANCE COMPANY IRREVOCABLE TRUST FOR CHILDREN DEDUCTION FOR PREMIUMS PAID CAPTIVE PAYS NO TAXES ON PREMIUMS RECEIVED < $1.2M >

61

OWNER OPERATING BUSINESS INSURANCE COMPANY IRREVOCABLE TRUST FOR CHILDREN DEDUCTION FOR PREMIUMS PAID (Not a Gift) CAPTIVE PAYS NO TAXES ON PREMIUMS RECEIVED < $1.2M >

INSIDE ESTATE OUTSIDE ESTATE

62

Captives and Estate Taxes

• Estate Tax Efficiency
• Payment of premiums not a gift
• No unified credit used
• Every premium dollar transferred is a tax-

free transfer outside the estate

63

Attribution Rule for Multiple Captives Children 21 or older are distinct

Dad’s Business Captive #1 Child #1 21 or older Captive #2 Child #2 21 or older Captive #3 Child #3 21 or older

$1.2M each With three captives for three children who are 21 or

• lder up to $3.6M total per year

can be transferred -- $18M / 5 years!

64

Group CHIC

Captive

Business A Business C Business B A LLC B LLC C LLC Trust A’s Kids Trust B’s Kids Trust C’s Kids

Distributions

65

Third-Party Reinsurance

Group Pool A – B – C

Group Captive

Group Captive

Business A Business C Business B

A’s Captive Re B’s Captive Re C’s Captive Re

Reinsures

66

Assets of the Captive

RESERVES

Backs outstanding policy liabilities Deductible when set aside, but taxable upon recapture

SURPLUS

Available to underwrite new policies Not deductible

Combined they constitute the total assets of the captive

67

Reserves – Investments

• Limited by Insurance Commission’s “Permitted

Asset Rules”

• Can invest in new projects, even if closely held,

both as an equity or debt investor

• Can invest in a wide range of investments

subject to certain minimum limitations relating to liquidity and safety

• Life Insurance now drawing IRS scrutiny &

audits (the IRS hates pre-tax life ins.)

68

Surplus – Assets Not Reserves

• Represents captive’s capacity to accept new

risks

• Can be invested in anything without

restriction

– Real Estate, REITs, Raw Land, Strip Malls – Stocks, Bonds, Mutual Funds, Hedge Funds – Life Insurance

69

Loanbacks Not Advised

• A captive can loan money back to the owner or to

insureds

• But this practice is strongly discouraged
• IRS may consider loanbacks a circular transaction just

to avoid taxes

Business Captive

Premiums Loanback

70

Suitability for Captives

• Need to have at least $250K for capital and to

fund long-term liquid reserves

• Ability to pay more than $500K in annual

premiums to captive for at least five years

• Can satisfy risk spreading and risk shifting (or be

structured to)

• Have substantial P/C insurance needs

71

Captive Process

• 1. Feasibility Analysis
• 2. Actuarial Study
• 3. Application for License
• 4. Licensing - Formation
• 5. Capitalization

Completion Time ~ 60 to 90 days

72

Typical Formation Costs (All Inclusive/Turnkey)

• Basic Captive Structure

$80,000

• Annual License Fee/Tax

~$5,500 ====== Total $85,000

73

Annual Maintenance

• License Fees, Premium Taxes or Franchise

Taxes

• Actuarial
• Accounting
• Insurance Manager and Underwriting
• Typical Annual Fees ~ $50,000

74

Contact Information

Jay Adkisson, Partner Riser Adkisson LLP Ph: 949.200.7773 E-Mail: jay@risad.com Practicing in the area of captive insurance companies www.captiveinsurancecompanies.com

75