Fundamentals of Captive Insurance Companies

Transcription

1 Fundamentals of Captive Insurance Companies Bridgebay Consulting & Northern Trust Company Corporate Treasurers Seminar Tuesday, March 22, 2005 Hyatt Regency San Francisco Airport Thomas M. Jones, Partner 312/

2 What is a Captive? A limited purpose, licensed insurance company, the main business purpose of which is to insure the risks of the captive s owners

3 What are the Advantages of a Captive? Reduce/stabilize cost of risk funding Provide customized coverage Put focus on proactive risk management; create a team approach with physicians, including unified defense of lawsuits Permit access to reinsurance markets

4 Types of Captives Single-owner Group Association Agency Rent-a-captive Segregated account (cell) captives Captive pools Risk retention groups

5 Structural/Regulatory Issues Form (stock/mutual/reciprocal); Federal Risk Retention Group? State insurance laws Securities registration exemption/antifraud disclosure Federal and state tax considerations Other legal considerations (e.g., Medicare fraud and abuse) Management/governance (directors and committees) Coverage and policy questions

6 Why an Alternative to Commercial Insurance? You want to control your destiny You know your risks better than any underwriter You do not want to be rated based on others and industry losses Off the shelf insurance programs do not suit your companies circumstances

7 Possible Drawbacks of a Captive Administration Increased administrative burdens unbundled services Delegation to outside service providers Learning curve for acquisition of insurance expertise Dealing with regulatory authorities, forms and filings with domicile and IRS Financial Volatility of reinsurance market Capital commitment Limited exit strategies: run-off or loss portfolion transfer

8 Possible Drawbacks of a Captive Feasibility Study Analysis of Owners Risk Profile and Financial Condition Financial Analysis Legal Research Actuarial Projections Tax Projections Domicile Options Comparisons Insurance issues analysis

9 Convince Senior Management Long term commitment (at least 5 years) Set strategic goals, objectives and capitalization Consolidate / manage risk with financial program Stabilize risk management portfolio Less vulnerable to price fluctuations and market restrictions Must meet in person with captive regulators Should have an up-front strategy for withdrawal

10 Domicile Selection Factors Recognized Domicile T axes Regulatory Infrastructure Perception Premium & Excise Taxes Income Taxes Ownership Structure Coverages Capitalization Options Ease of Accessibility Operating Flexibility Service Providers-Quality & Cost Tax Haven Issues Corporate Governance Shareholder Rights Status

11 Estimated Number of Active Captives 2004 Business Insurance Magazine (3/07/05) Vermont 524 Tennessee 4 British Columbia 13 Hawaii 147 Colorado 10 Cayman 694 Ireland 214 Isle of Man 175 Jersey 13 Guernsey 410 South Carolina 114 Luxembourg 219 Singapore 57 Georgia 14 Gibraltar 12 Bermuda 1,150 Switzerland 50 Vanuatu 18 Curacao Bahamas 19 (Netherlands Antilles) 18 Turks & Caicos 164 U.S. Virgin Islands 7 British Virgin Islands 350 Barbados 257 Mauritius 13

12 Taxation of Captives The key tax question: Will it be treated as insurance for tax purposes?

13 Why Insurance Matters? Tax deduction for premiums paid to captive by policyholder Favorable insurance tax treatment of captive (deduction for discounted insurance reserves, unearned premiums) Offshore CFC captives - Subpart F income Domestic captives - direct federal income tax Offshore captives Federal Excise Tax on insurance premiums Possible IRC Sec. 953(d) onshore tax election

14 Tax Definition of Insurance To find insurance, the IRS and the courts have historically required the presence of both risk shifting and risk distribution The first criterion connotes the transfer of the risk to separate party The second mandates that enough independent risks are being pooled to invoke the actuarial law of large numbers

15 Tax Definition of Insurance No statutory or regulatory definition of insurance - only cases and rulings A gray area existed between 1 and 31 insureds, but a rule of thumb is that more than several unrelated insureds pooling risk should create insurance Case law has further liberalized the tax definition of insurance Unrelated Risk at least 30% of premium from 3 rd parties Brother/Sister Risk substantial risk of captive s siblings

16 Tax Caveats The captive must establish: Presence of risk distribution That the captive should be respected as a separate and distinct taxable entity, e.g., it is not a sham IRS refers to its new approach as a facts and circumstances test

17 Non-Sham Status IRS Facts and Circumstances Approach Looks to: Valid non-tax business purpose Adequate capitalization (maximum 5:1 premium/surplus ratio recommended) No parental support agreements Limited loan backs of captive assets to parent or affiliates ( circularity of cash flow ) Formation of captive in other than a weakly or nonregulated offshore domicile Captive operates on an arm s length basis in a manner similar to that of commercial insurers

18 U.S. Taxation of Onshore Captives Subject to tax on worldwide income Deduction for discounted loss and 80 percent unearned premium reserves when calculating taxable underwriting and investment income If captive is at least 80 percent owned (voting power and value) by a U.S. corporation, must be included in the federal consolidated income tax return of the parent also true for offshore captive electing to be subject to U.S. tax

19 Onshore Versus Offshore Federal Tax Considerations Offshore captive tax issues include: Imputed federal income tax on controlled foreign corporations (Subpart F/CFCs) Related party insurance income (RPII) Branch profits tax Federal withholding tax Federal excise tax

20 Federal Excise Tax - The Basics Applies to premiums paid to foreign insurers/reinsurers covering U.S. risks 4 percent on direct property & casualty policies 1 percent on life policies and all reinsurance Withheld and remitted (quarterly on IRS Form 720) by payer of premium If not a deductible insurance premium, then FET N/A - Rev. Rul Also N/A if onshore tax election is made or tax treaty applies (Bermuda and Barbados N/A)

21 Making a Section 953(d) Election Section 953(d) allows certain foreign corporations to elect to be treated as a U.S. corporation In order to qualify to make this election, the foreign corporation must -- be a CFC (under the regular rules or the RPII rules), qualify as an insurance company under Subchapter L comply with regulations to ensure that it pays its U.S. taxes, and make an election to have Section 953(d) apply and to waive all U.S. treaty benefits The election is valid for the year made and for every year thereafter unless revoked with the consent of the Secretary In order to make election, foreign corporation must waive right to Treaty benefits

22 Making a Section 953(d) Election Advantages of Election Can join the U.S. consolidated return Will not be subject to any insurance excise taxes Can avoid application of branch profits tax Can hold meetings and conduct business in the U.S. Can invest in U.S. property Can avoid U.S. withholding tax costs on cross-border payments (e.g., interest on loan from CFC to shareholder)

23 State Taxation Of Captives Direct placement taxes on premiums generally no state tax on net income of an insurance company Also called: direct procurement taxes self procurement taxes taxes on independently procured insurance 35 states Most apply to captives Statutes preserve right of insureds to place insurance outside state -- an exception to doing business requirement Tax imposed on transaction where in-state customer deals directly with non-admitted insurance company; no regulation, just tax

24 U.S. Federal Income Taxation of Insurance Company s Income U.S. PE/Branch Profits Tax Exposure Ability to Use Losses in U.S. Return Vermont Corporation Net income taxed at 35% with Subch L benefits in consolidated return No U.S. PE/branch profits tax exposure. See box below re U.S. activities Losses can be used in U.S. consolidated return Bermuda Corporation with Section 953(d) Election Net income taxed at 35% with Subch L benefits in consolidated return No U.S. PE/branch profits tax exposure. Can conduct U.S. activities (but need to comply with state insurance statutes) Losses cannot be used in U.S. consolidated return because of DCL rules; can be carried forward or back to be used against income of 953(d) company Bermuda Corporation with No Section 953(d) Election 6 Net income taxed at 35% under Sub F rules with Subch L benefits U.S. PE/branch profits tax exposure (can be managed by limiting U.S. activities to passive reimbursing of paid claims) Net losses of insurance company cannot be used in U.S. consolidated return; can be carried forward to reduce future E&P though

25 Ability to Use U.S. Tax Treaties 1 Federal Excise Tax on Premiums Ability to Loan to U.S. Borrowers Vermont Corporation Can take advantage of U.S. tax treaties No FET on premiums; but note IRS cascading theory No withholding tax on interest imputed or paid Bermuda Corporation with Section 953(d) Election Can take position that U.S. tax treaties (other than U.S.- Bermuda Treaty) 4 are available No FET on premiums; but not IRS cascading theory No withholding tax on interest imputed or paid Bermuda Corporation with No Section 953(d) Election 6 Cannot take advantage of U.S. tax treaties no Bermuda tax treaties other than with U.S. exist Life and P&C reinsurance - 1% FET; P&C direct - 4% FET; but note IRS cascading theory 30% withholding tax on interest imputed or paid (portfolio exemption N/A)

26 State Tax Issues Tax Consequences of Not Being Insurance Company for Federal Purposes 2 Non-Tax Issues Vermont Corporation No VT income tax; small VT premium tax 3 ; plus taxes below See footnote 1 Incremental regulatory burden (?) Bermuda Corporation with Section 953(d) Election If fronted, normal premium taxes due. If unfronted, likely NYS premium tax on NY risk; must check other states Section 953(d) election is invalid. As a result, potential PE/branch profits tax exposure for prior years; also, potential Section 367(a) issues on outbound transfer of assets 5 Still must operate offshore to avoid state insurance statutes restricting activities of unauthorized insurers Bermuda Corporation with No Section 953(d) Election 6 If fronted, normal premium taxes due. If unfronted, likely NYS premium tax on NY risk; must check other states Cannot carry froward net losses to offset net Subpart F income in future years; lose Bermuda Treaty PE protection; no FET Greater Bermuda management role

27 1 A separate analysis would be needed with respect to non-u.s. withholding taxes on payments to the insurance company and other potential foreign tax issues. 2 In all cases, if the corporation is not an insurance company, payments to it will not be treated as deductible premiums and different rules will apply for purposes of computing its taxable income (i.e., no deduction for estimated loss reserves will be allowed). 3 The Vermont premium tax rates are: Direct premiums -.38% on the first $20 million;.28% on the next $20 million;.19% on the next $20 million; and.072% over $60 million. Reinsurance premiums -.214% on the first $20 million;.143% on the next $20 million;.048% on the next $20 million; and.024% over $60 million. Minimum annual tax: $7,500; maximum annual tax: $200,000. No credit is granted for premium taxes paid to other states.

28 4 Section 953(d)(3) provides that if a foreign insurance company makes a Section 953(d) election it must agree to waive all rights to all U.S. treaties. There is no published guidance as to how to interpret this broadly drafted language. We understand that 953(d) companies generally take the position that this waiver only limits their ability to claim the benefits of any treaty between the U.S. and their country of residence (i.e., in this case, Bermuda), not U.S. treaties with other countries which they might be able to benefit from as a Section 953(d) company. 5 When a Section 953(d) election ends, the corporation is deemed to have transferred all of its assets as of the first day of the subsequent taxable year from a U.S. corporation to a foreign corporation in an outbound Section 354 exchange. See Section 953(d)(5). 6 Parent must file an IRS Form 5471 with respect to the Bermuda corporation. In addition, the Bermuda corporation should make a protective Form 1120F filing to preserve its ability to be taxed on a net rather than a gross basis if it is found on audit to have a U.S. PE/branch. See Treas. Reg. Section

29 Captive Insurance The Corporate Treasurers Seminar Derick White, CPA, CFE Director of Captive Insurance Department of Banking, Insurance, Securities and Health Care Administration State of Vermont Presented by Timothy Padovese President & CEO OMIC

30 What is a Captive? 8 formalized self-insurance insurance 8licensed in a state (or country) 8a a regulated insurance company with a limited license

31 Why form a Captive? 8Control cost 8Incentive to management to reduce, eliminate losses 8 to implement effective loss control programs 8 to cooperate with claim administration 8 to reduce or eliminate losses 8Retain investment income

32 Why not just self insure? 8 A Captive Insurance Company can: 8 provide evidence of insurance 8 provide access to reinsurers 8 provide security

33 Types of Captives 8Pure 8Industrial insured 8Association 8Risk retention groups 8Discussion on OMIC 8Sponsored (rent-a-captives) 8Branch 8Reciprocal

34 Some Coverages Currently Written with Captives 8General Liability 8Professional Liability 8Workers Comp 8Auto Liability 8Auto Physical Damage 8Property 8Business Interruption 8Marine & Cargo 8D&O 8Environmental Impairment 8Credit 8Product Liability 8Political/War Risk 8Aviation 8Strike 8Employee Benefits 8TRIA

35 How To Form A Captive 8Preliminary Evaluation 8 current program 8 ultimate loss estimate 8 risk retention levels 8 expense loading to arrive at premiums 8 loss pay-out patterns 8 domicile considerations

36 Domicile Considerations 8premium, capital and surplus requirements 8registration costs 8other incorporation and service fees 8investment restrictions 8permissible insureds and coverage 8availability and quality of professional/business services

37 Domicile Considerations 8acceptance by reinsurers and fronting companies 8distance, accessibility and ease of travel 8ease of communications 8regulatory flexibility 8world image/political stability

38 Vermont s s Captive Industry Profile 8numbers (over 700 licensed companies) 8management firms (10 active) 8service providers (CPA s, banks, actuaries, attorneys) 8Vermont Captive Insurance Association

39 Total Number of Vermont Captive Licenses Issued

40 Vermont s s Legislative History Vermont s s captive statute passed by legislature Risk Retention Act adopted Employee Benefits allowed Premium Tax reduced Premium Tax reduced again Reciprocal Captives permitted Sponsored & Branch Captives permitted Premium tax reduced General re-write of statute

41 Vermont The Premier Captive Domicile 8Cooperation (governor,legislature,regulators, industry) 8Stable Environment 8Dedicated Staff 8Firm but Flexible

42 State of Vermont Captive Insurance VT Department of Banking, Insurance, Securities & Health Care Administration 89 Main Street, Drawer 20 Montpelier, VT (802)

43 Why Hawaii The Premier Captive Insurance Domicile of the Pacific The Corporate Treasurers Seminar Presented by: Lisa Kremer, Managing Director Enterprise Risk Management San Francisco, CA on behalf of Hawaii Captive Insurance Council

44 History of the Industry in Hawaii Act 253 established Hawaii as a captive domicile on July 1, 1987 Hawaii has grown to become 2 nd largest onshore domicile First domicile to allow the formation of not-for-profit captives 176* captives licensed to date Number of ACTIVE captives in Hawaii has DOUBLED since 2000 (74 vs. 147*) * Year End 2004 Statistics

45 Hawaii Captive Classes Class and Description Class 1: Pure captive that writes business only as a reinsurer. Class 2: Pure captive that writes business as a direct writer and/or reinsurer. Class 3: Risk retention group or Association captive Class 4: Leased captive facility (protected cell) Class 5: Reinsurance captive at the discretion of the Insurance Commissioner. Minimum Capital Requirement * $100,000 $250,000 $500,000 Risk Retention Group $750,000 Association Captive $1,000,000 Discretion of Insurance Commissioner *Additional capital/surplus may be required depending upon the lines of coverage written, retentions with the captive, financial position of the parent, loss payout patterns and/or other criteria established by the State of Hawaii Insurance Division.

46 Taxation of Hawaii Captives No minimum tax requirement Graduated premium tax $0-25 Million $25-50 Million $50 Million+ 0.25% 0.15% 0.05% Premium tax applies to gross written or assumed premium and is not subject to double taxation. No double taxation Hawaii premium tax is only assessed on premiums upon which no premium tax is otherwise paid during the year (HRS 431:19-16).

47 Other Hawaii Requirements Annual meeting in Hawaii Meeting can take place on any Hawaiian island or in Hawaiian waters One board member must be a Hawaii resident Normally role filled by a service provider Captives subject to triennial exam

48 Hawaii Infrastructure Hawaii has a dedicated Captive Branch within the State Insurance Division Experienced captive service providers with offices in Hawaii Captive managers, accountants, financial institutions, attorneys, and third party administrators Hawaii Captive Insurance Council offers educational and networking opportunities to owners and service providers Multi-cultural workforce Many people speak multiple languages

49 Visit Hawaii to learn more Hawaii Captive Insurance Council Forum November 2005 in Kapalua, Maui RIMS 2006 April 2006 in Honolulu Online at