The Purpose of a Captive Captives vs. Traditional Insurance - - PowerPoint PPT Presentation

• The Purpose of a Captive
• Captives vs. Traditional Insurance
• Structuring a Captive
• Determining the Feasibility and Goals of a Captive
• Domicile Selection
• Partner Selection
• Operating a Captive
• Captive Advantages

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• Greater Control over Claims
• Increased Coverage
• Underwriting Flexibility
• Access Reinsurance Market
• Incentive for Loss Control
• Reduced Insurance Costs
• Pricing Stability
• Purchase Based on Need
• Tax Benefits
• Investment Income
• Capture Underwriting Profit
• Improved Claims Review and

Processing

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Risk Management Minimize Costs and Maximize Profits Coverage for Your Changing Needs Complement Estate or Business Planning Strategies

• Design the captive with risk management as the primary focus, for valid business

purpose

• Adhere to IRS Revenue Rulings and all available guidance including requirements for

Risk Shifting and Risk Distribution

• Assure that the captive is operated as a bona fide property & casualty insurance

company in accordance with the accepted business plan and a reasonable investment plan

• Underwrite policies that offer meaningful coverage at appropriate premium levels
• Avoid structures that are “too good to be true” in order to generate predictable results

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Company Independent Distributor Front for Company Captive Program

Insurance Premium Insurance Policy

Captive X

12.5% Quota Share

Trust X

Purchase Warranty Reinsurance Premium Underwriting Profit Reduced Product Cost = Cost of Warranty

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Primary Insurer

(front)

Captive 1:

Owned by Trust #1

Captive 2:

Owned by Trust #2

Captive 4*:

Owned by Trust #4

Captive 7*:

Owned by Trust #7

Captive 6*:

Owned by Trust #6

Captive 5*:

Owned by Trust #5

Captive 3:

Owned by Trust #3

Captive 8*:

Owned by Trust #8 Each Captive receives $926,375 share of Premium Each Captive receives $926,375 share of Premium Each Captive pays quota share of Claims

• Feasibility Studies

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• Premium payments made by the operating company allow the client to further manage

business risk and should be tax-deductible as ordinary and necessary business expenses

• Captives which make an election under IRC Section 831(b) collect annual premiums of

$1.2MM or less and are entitled to attractive tax benefits

• Premiums received by the captive are tax-exempt under the annual $1.2MM premium

test

• Captive underwriting profits and surplus accumulation are also tax-exempt; only

investment income is taxable annually

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• Considerations:

– Responsiveness of Regulator – Availability of service providers – Capital requirements – Investment restrictions – Underwriting restrictions – Tax rates

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Captive Manager Legal Counsel Financial Advisor Tax Counsel Audit Firm Actuarial Firm

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• Accounting consolidation

– Timing of Audit – Cost considerations

• Captive Manager
• Self-Managed Captives

• Company: Large manufacturer with large retentions on GL

program

• Problem: GL carrier wanted $100K to front the program, plus

$2.5 million in collateral. The company needed insurance policy evidence to satisfy customer contractual requirements

• Solution: Established a captive, costing $60,000/year to run.

Issue certificates. “Collateral” is lent back to the parent corporation

• Results: $40,000/year in savings, $2.5 million improved

liquidity

• Company: Engineering firm with Marine Services subsidiary
• Problem: Captive was previously established to provide certificates

for professional liability similar to Example #1. During the marine renewal, negotiations with the hull underwriter were not going well. Large premium increases were proposed for the vessel fleet, despite a favorable loss ratio

• Solution: The company calculated a loss pick to place the program

with their captive. They told the commercial underwriters to renew within $10,000 of the loss pick, “or we are putting it into the captive”. A quote within the requested range magically appeared the next day.

• Results: The program was renewed, saving well over $100,000

• Company: Large chemical manufacturer
• Problem: Wanted to reduce variability in self-insured losses

from year to year and quarter to quarter.

• Solution: Joined a group captive to insure its deductibles,

including a substantial new retention in the credit risk program

• Results: $2 million of variability removed; $1.5 million of

premium saved on credit risk; $35,000 savings for GL fronting fees

• Company: Privately owned home builder
• Problem: Profitable company, but taking risks, ie no product

liability or warranty coverage was purchased – “it’s too expensive and we’ve never had a claim”

• Solution: Set up a captive owned by the family to insure these

risks with a premium just over $1 million per year. Took an 831(b) election.

• Results: Now, they have $5 million in assets to pay for a

problem if one arises (after 4 years), while saving the owner about $350,000 per year in income taxes

• Company: US-based multi-national – post bankruptcy
• Problem: Huge US tax loss carry forwards – aka “NOLs”. Post bankruptcy,

they had virtually no US operations, and a limited ability to use up the US

• NOLs. Foreign operations are still profitable, paying income tax to foreign

governments at an average tax rate of 23.5%. Balance sheet showed warranty reserves of over $50 million

• Solution: Set up a US domiciled captive subsidiary
• insure all uninsured risks
• charge premium to local sub’s P&L
• Make reasonable return in US sub
• Results: Removed $50 million in liability from the balance sheet. Saved over

$10 million a year in taxes. Used up a portion of the NOLs, which would have

• therwise expired as useless.

• Company: Larger retailer with over 300 franchisee owners
• Problem: Franchisee spending significant premiums via

separate programs for GL, Property, WC, and some benefits programs

• Solution: Company sponsored a captive solution to provide

a turnkey insurance solution, in some cases, behind a front company for regulatory compliance

• Results: This program not only saves franchisees

significant premium (and time), the program also generates

• ver $10 million annually in profit for the franchisor

• Company: A private equity firm with over 70 portfolio companies
• Problem: Company wanted to utilize a combined D&O program for

the firm, as well as its portfolio companies. While this program would save $2 million per year, the required SIR was too high for the individual companies, so it was unattractive

• Solution: A captive was formed to buy down the deductibles for the

portfolio companies to tolerable levels

• Results: $2 million saved, and deductibles cut in half for the portfolio

companies

• Revenue Ruling 78-338 – The Internal Revenue Service held that a Group Captive Insurance Company - where

no shareholder’s individual risk exceeded 5% of the total risks of the captive - had sufficient risk shifting and risk distribution

• Revenue Ruling 2001-31 - The Internal Revenue Service abandoned its “economic family theory” with respect to

captive insurance transactions

• Revenue Ruling 2002-89 – Provides a safe harbor determination for risk shifting if a captive has more than 50%

unrelated business risk

• Revenue Ruling 2002-90 – Reviews Brother and Sister Operating Subsidiaries and establishes the Rule of 12 for

safe harbor purposes

• Revenue Ruling 2002-91 – If the liability of each company is no more than 15% of total risks insured by the

captive, significant Risk Shifting and Risk Distribution exists

• Revenue Notice 2004-65 – The service stated that 831(b) no longer should be identified as “listed transactions” for

purposes of disclosure, registration, and list maintenance requirements

• Revenue Ruling 2005-40 – Reviewed cases in which the captive underwrote a significant amount of third party

risks, risk distribution and risk shifting were found to be present, even when the captive insurance companies that were wholly owned, or nearly wholly owned by its insured’s

• Revenue Ruling 2008-8 – This ruling explains how arrangements between an individual cell and its owner are

analyzed for purposes of determining whether there is adequate risk shifting and risk distribution to constitute insurance

• Proposed Regulations – Initial Draft (REG–119921–09) – On September 14, 2010, the Treasury proposed that

domestic series organizations (typically a series limited liability company – Series LLC) would be treated as a separate entity formed under local law and general tax principles 20