Captives The ABC s. What Is a Captive Insurer? Definition of a Captive. Active Captives by Domicile: Year End 2006.

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1 October 30, 2007 Captives The ABC s What Is a Captive Insurer? Definition of a Captive Licensed insurance company in domicile of incorporation May insure or reinsure the risks of its owner or chosen unrelated parties Located offshore or onshore Regulated under special captive legislation Regulated by domicile regulators only Not regulated by other state insurance departments Nonadmitted insurer Not permitted to write workers compensation (WC) and auto liability on a direct basis (may reinsure) Marsh 2 Active Captives by Domicile: Year End 2006 US % Switzerland, 48, 1% New York, 39, 1% ROW % Utah, 30, 1% Singapore, 60, 1% Total: % Other US domiciles, 79, District of Columbia, 70, 2% 1% Arizona, 74, 1% Rest of the world, 150, 3% Nevada, 97, 2% Bermuda, 989, 20% South Carolina, 146, 3% Dublin, 154, 3% Hawaii, 160, 3% Isle of Man, 161, 3% Turks & Caicos, 169, 3% Cayman, 740, 15% Luxembourg, 208, 4% Barbados, 235, 5% Guernsey, 381, 8% British Virgin Island, 383, 8% Vermont, 563, 11% Marsh Source: Business Insurance March 12,

2 Types of Captives Single-parent (pure) captive Group or association captive Heterogeneous (Mixed/Dissimilar) Homogeneous (Same) Rent-a-captive Protected cells / segregated cells / segregated portfolios / sponsored captives Risk-retention group (U.S. domiciles) Reciprocal risk-retention groups Branch captives 831(b) (Qualified Small Insurance Company) Marsh 4 Financial Benefits of a Captive Access to reinsurance markets Cashflow and investment income Eliminates the cost of insurance company profit and overhead Stabilize or enable allocations and budgeting processes among business units Tax benefits, if properly structured No state income tax on investment income, captive net income Estate Planning/Wealth Transfer Marsh 5 Operational Benefits of a Captive Difference in view of loss expectancy vs. peers Provides a vehicle for specialized coverage and/or customized forms Avoids the cyclicality of traditional market Bargaining strength Stabilize or enable allocations and budgeting processes Consistent approach to the organization s overall risk philosophy Method to repatriate foreign capital Group or association companies facing large firm risk challenges Marsh 6

3 Potential Obstacles of a Captive Sarb Ox and Financial Controls Cashflow Commitment, i.e., capitalization, operating costs, premium tax, Federal Excise Tax, direct placement tax Federal Tax Treatment Humana Ruling or Third Party Business Sept IRS Regulation Proposal Long Term Commitment Risk Management Commitment (Safety, Loss Control, Claims) Proper Organizational Structure Nonprofit, LLC, etc. Parent Company Buy In Potential Adverse Underwriting Results Actuarial Certification of Loss Reserves Availability of Data Marsh 7 Example of Policies Issued by Captives TRADITIONAL Property and DIC Business Interruption (BI) and Contingent BI General / Auto Liability Products Liability and Completed Operations Workers Compensation Crime E&O Liability Transit / Cargo Basket Coverage Aggregate Stop-loss Auto Physical Damage Contractors All Risk Reinsurance ADVANCED Trade Receivables Pollution / Waste Site Remediation Products Recall Political Risk Supply Chain Interruption Intellectual Property Cat Exposure (DIC side-car) International Units: Retention Buy-Down Cyber Risks M&A Coverage Gaps Legal Defense Expense Mortgage Impairment CUSTOMER / EMPLOYEE Joint-Venture Partners Warranties Liquidated Damages Service Re-work / Product Replacement ERISA / non-erisa Credit Life Personal Lines Trip Travel Employee Relocation International Employee Benefits Pure Third Party Risk (Offshore) Marsh 8 Where Do We Go From Here? Insurance is a business essential Captives and other ART options are important, profitable and essential to business. Of the 1,500 largest global companies, half do not own a captive Potential for new domestic growth is strong Potential for onshore redomestication is equally as attractive Challenges: Keep laws, taxes and regulatory attitude comparable to those of offshore and oversees jurisdictions Marsh 9

4 Structuring a Captive Program The Captive s Service Team Client Actuary Banker Department of Insurance Insurance Brokers Captive Manager Auditor Claim Administrators Consultants: Tax, Employee Benefits Investment Advisors Legal Counsel Marsh 11 Structuring a Captive Program (millions) $100 Example of How a Captive Fits Within a Typical Commercial Insurance Program Policy Limit (not to scale) $50 $7 Workers Compensation Excess Liability Excess Liability Property Insurance (second layer) Umbrella Liability Property Insurance $2 Employers Auto General Layer of risk (first layer) Liability Liability Liability insured or reinsured $0 Deductible Deductible Deductible Deductible by a captive Coverage Marsh 12

5 Captive Structures Marsh 13 Fronted vs. Direct Writing Captives Reinsure when you: need admitted insurance policies need to meet proof-offinancial-responsibility laws (property landlords; Products liability retailers) have security issues (A.M. Best Rating) are providing insurance to unrelated parties Direct write: in all other instances Marsh 14 Structuring a Captive Program Typical Deductible Program Direct, Captive Indemnification Program (3) Losses (3) Losses S I T N A S N U D R A E R R D (1) Premium (2) Policy I N S U R E D (A) Premium Indemnification (B) Policy (C) Invoice (D) Reimburse C A P T I V E (4)Reimburse Deductible Losses Captive program has no impact to current deductible program s insurer relationship Marsh 15

6 Group Captives Group Captive Characteristics A group captive is a legal entity in which its shareholders are owners and insureds sharing in the participation of insuring and reinsuring its risks. Types of group captives Member-owned/equity group captives Agency-owned captives Association-owned captives Marsh 17 Group Captive Characteristics (continued) Lines typically covered include: General liability Including products liability Workers compensation Auto liability Other coverages can include: Commercial property Business income Directors and officers Professional liability Employment practices liability Employee benefits (non-erisa) Marsh 18

7 Group Captive Criteria Should be considered when: Paying disproportionate premium vs. perceived risk Interested in assuming (or currently taking) a level of risk Candidates have: Sound financials Good safety and loss control programs Commitment to claim avoidance and handling Better-than-average loss experience Best-in-class risk for industry group Willing to share best practices Marsh 19 Group Captive Benefits Advantages over guaranteed cost: Group captives enable mid-size companies to manage risk like a Fortune 500. Captive members have a large impact on the total cost of their risk. Potential Return Management can be outsourced. Marsh 20 Group Captive Benefits (continued) High-quality selection of membership Premiums determined by members losses Superior loss control Shared fixed costs Creation of an asset if favorable loss experience Return of profits (may affect desired tax treatment) Investment income Control over market swings Estate planning tool for company owners Marsh 21

8 Traditional Insurance Placement Fixed Costs 40-50% Profits and Paid Losses 50-60% Fixed Insurance company overhead, taxes, reinsurance cost, commission Profits and Investment Income Underwriting profit and investment income accrued by insurance company and/or insurer Marsh 22 Captive Solutions Placement Fixed Costs Reins. Costs Profits and Paid Losses 65-70% Fixed Fronting policy Taxes Captive management Claims management Loss control Filings/Certificates/ Profits and Investment Income Accrued by group captive Reinsurance Transfers catastrophic losses Caps cumulative losses Policy Administration Marsh 23 Differences Between Single-Parent Captives and Group Captives A / B risk-sharing structures Structure is intended to limit risk sharing in frequency layer. Risk sharing is intended for severity layer once actuarial loses are exhausted. Member participation by committee Increased emphasis to manage/control losses Expectation for member referrals Participation in captive governance Marsh 24

9 Why Do Group Captives Fail? Inadequate and overly broad business plans Ineffective management and loss control Lack of commitment from the members Lack of security and relationship with a quality fronting company and reinsurer Risk sharing losses exceeding expectations Marsh 25 Captives and Taxation Captive Tax Treatment Income tax implications were the historic driver Tax treatment remains an important economic element in the financial equation Investment Company Payments to captive non-tax-deductible Captive does not have income No tax deduction for loss reserves Claims are not tax-deductible until paid Insurance Company for Federal Income Tax Purposes Premium payments are tax-deductible (over the policy coverage period) Captive has income Captive has deduction for loss reserves on discounted basis Position supported through precedent setting case law and revenue rulings Marsh 27

10 Perspective of Insurance by IRS Dates back to a 1941 case titled Helvering v. Legierse U.S. Supreme court held that, Historically and commonly insurance involves risk shifting and risk distribution; and must be in existence of a business purpose. Marsh 28 Supporting Favorable Tax Treatment Evolution of precedent setting case law (captive owners victorious!) Captive maintains brother-sister relationship with other operating subsidiaries (minimum of 7 subsidiaries) of parent holding company insured by the captive (Cases: Humana, HCA, and Kidde) Or Captive writes unrelated risk equal to or greater than 30% of the captive s total writings (Cases: Harper Group, Amerco, Odeco and Sears/Allstate) Marsh 29 Supporting Favorable Tax Treatment Brother-Sister Approach Parent Sub Sub Sub Sub Sub Sub Sub Captive Not tax-deductible Tax-deductible (Note: subsidiaries and captives must be legal C-Corporations) Marsh 30

11 Recent Captive Tax Developments Brother-Sister approach Revenue ruling involved a brother-sister captive arrangement with a minimum of 12 subsidiaries (within all levels of subtiers) whereby captive premiums were tax deductible Revenue ruling stated that no one insured subsidiary accounted for more than 15% of the company s risks supporting the existence of risk distribution More defined position of the IRS for captive owners Marsh 31 Supporting Favorable Tax Treatment Third-Party Writings Approach Unrelated Risk 30% (Minimum) Related Risk 70% (Maximum) For every $1 of premium for related risk, a captive insurer needs $.30 of unrelated risk premium Marsh 32 Recent Captive Tax Developments Third-party writings approach Revenue ruling involved a captive arrangement whereby greater than 50 percent of the risks underwritten was from third parties; thereby, premiums paid by the parent were treated as tax deductible More defined position of the IRS for captive owners Historical case law supports premiums paid to insurance subsidiaries that wrote greater than 30% outside business should be deductible While IRS position clear, it seeks to limit the flexibility of captive owners IRS Regulation Proposal of Sept. 28, 2007 Challenges Brother-Sister allocation of 15% per subsidiary Equal footing to self-insurance Marsh 33

12 Sources of Third-Party Business Employee benefits Risk swapping with other captives Reinsurance pools (*) Group captives Extended warranties (if no embedded values) Private mortgage insurance Credit life Joint-venture partner risks Suppliers / contractors / lessees (*) Pools are typically non-entities but contractual agreements. Marsh (b) Mini Captives Election available to captives that qualify as insurers for tax purposes Files federal taxes benefiting from section 831(b) of the US Tax Law Can make election if net written premiums for the taxable year do not exceed $1,200,000 Result: underwriting income is effectively taxed at a 0% rate Ideal for low-frequency/high-severity losses (e.g., products liability) Less ideal for WC (premiums approximate losses and therefore low or no underwriting profit) Marsh 35 Captives and Estate Planning Applies for family-owned, privately held captives Goal surrounds ability to transfer wealth in the form of captive underwriting profits whereby the captive is owned by the family heirs Estate tax savings potentially optimized when captive insures low-frequency / high-severity risks, which tends to produce more significant underwriting profits Crawford Fittings precedent setting case Marsh 36

13 Domicile Discussion Active Captives by Domicile: Year End 2006 US % Switzerland, 48, 1% New York, 39, 1% ROW % Utah, 30, 1% Singapore, 60, 1% Total: % Other US domiciles, 79, District of Columbia, 70, 2% 1% Arizona, 74, 1% Rest of the world, 150, 3% Nevada, 97, 2% Bermuda, 989, 20% South Carolina, 146, 3% Dublin, 154, 3% Hawaii, 160, 3% Isle of Man, 161, 3% Turks & Caicos, 169, 3% Cayman, 740, 15% Luxembourg, 208, 4% Barbados, 235, 5% Guernsey, 381, 8% British Virgin Island, 383, 8% Vermont, 563, 11% Marsh Source: Business Insurance March 12, Choosing a Captive Domicile Issues to consider Parent ownership structure Premium taxes Captive income taxation Ability to provide intercompany loans to parent Restricted classes of business Incorporation/annual operating costs Capitalization requirements Options Investment restrictions Regulatory attitudes Infrastructure Marsh 39

14 Differentiators Among Captive Domiciles Taxes Federal excise Premium Ease of travel Perception and reputation Friendly regulation Source of risk Related European Union United States Rest of world Unrelated Marsh 40 Sample Domicile Comparison Onshore Offshore Operating Costs Estimated $100,000 Estimated $100,000 Premium Taxes Capitalization Infrastructure.40% First $20 million subject to a maximum of $100,000 (SC) or $200,000 (VT) $250,000 Statutory Minimum Capital and Surplus Typically 4-5:1 premium to capital ratio for casualty risks Efficient and stable None (by electing to treat the captive as US taxpayer per the 953(d) election, no federal excise tax is imposed) $120,000 Statutory Minimum Capital and Surplus Typically 5:1 premium to capital ratio for casualty risks Can be less stable than onshore Permitted Business Regulatory Attitudes Parent related and controlled third party including U.S. employee benefits Prior approval for changes in business plan state insurance department anxious to build new business Any risks except U.S. employee benefits and TRIEA No prior approval required for changes in business plan Marsh 41 Trends in Domicile Selection U.S. for-profit clients tend to form U.S. captives. New domiciles seldom cannibalize old domiciles. New domiciles are emerging: Kentucky Ohio New Jersey Alabama Missouri European countries Marsh 42

15 Captives - The ABC s Part II Feasibility Study Models and Proformas Key Assumptions Captive Formation Captive Implementation Strategic Reviews Marsh 43 The information contained in this [publication, presentation, etc.] provides only a general overview of subjects covered, is not intended to be taken as advice regarding any individual situation and should not be relied upon as such. Insureds should consult their insurance and legal advisors regarding specific coverage issues. Statements concerning tax, accounting, and legal matters should be understood to be general observations based solely on our experience as insurance brokers and risk consultants and should not be relied upon as tax, accounting, or legal advice, which we are not authorized to provide. All such matters should be reviewed with the client s own qualified tax, accounting, and legal advisors in these areas. Depending upon an organization's facts and circumstances, certain tax or accounting benefits may be associated with this product. Organizations should consult with their tax, accounting, and legal advisors to determine whether such benefits would be applicable. Marsh is part of the family of MMC companies, including Kroll, Guy Carpenter, Putnam Investments, Mercer Human Resource Consulting (including Mercer Health & Benefits, Mercer HR Services, Mercer Investment Consulting, and Mercer Global Investments), and Mercer specialty consulting businesses (including Mercer Management Consulting, Mercer Oliver Wyman, Mercer Delta Organizational Consulting, NERA Economic Consulting, and Lippincott Mercer). This document or any portion of the information it contains may not be copied or reproduced in any form without the permission of Marsh Inc., except that clients of any of the companies of MMC need not obtain such permission when using this report for their internal purposes, as long as this page is included with all such copies or reproductions. Copyright 2007 Marsh Inc. All rights reserved. Marsh 44 Captives The ABC s Thank You! Robert L. Johnson Managing Director Marsh Management Services Inc. Marsh 45

16 October 30, 2007 Captives The ABC s Part II Captives - The ABC s Part II Feasibility Study Models and Proformas Key Assumptions Captive Formation Captive Implementation Strategic Reviews Marsh 47 Forming a Captive Phased Approach Pre-feasibility dialogue: Risk management strategy discussion (targeted coverages, proposed retentions, financing options, impact on risk management / administration) Phase I: Envisioning and financial modeling session with internal stakeholders Phase II: Captive feasibility study and management decision making Phase III: Business plan / incorporation and start-up process Phase IV: Integrate captive with parent s consolidated accounting format. Address legacy policy issues Ongoing: Facilitate board s annual meeting with content planning; address operational strategies / opportunities Marsh 48

17 The Captive Feasibility Process Define objectives Determine advantages/disadvantages Perform actuarial analysis review retention levels Perform NPV / cash flow / pro formas Develop program structure Domicile analysis Ownership issues Tax issues Capitalization and investment policy Implementation Marsh 49 Captive Formation Process Marsh 50 Legal Captive Formation and Operation Marsh 51

18 Strategic Review of Existing Captive 3-5 Year Rule When Is The Last Time You Reviewed The Business Plan? Domicile Laws? Recent Tax Rulings and Trends? What Is The Process? Prioritize the Agenda Include the Internal Team (Risk Management, Tax, Treasury, etc.) Determine Desired Deliverables Test the Expected Results Complete the Project Marsh 52 Captives - The ABC s Part II Emerging Trends Manager Healthcare Industry, Construction Industry, Redomestications, Multiple Captives Owned, Securitizations, Expanded Use of Existing Captive Legal Ownership Structure Flexibility Redomestication of Corporations Audit IRS Proposed Legislation Trickle Down of Sarb Ox Actuarial Continued Interest in Writing 3 rd Party Business Increased Emphasis on Reserve Setting Process Between Annual Reviews Medical Malpractice Improvement Generating Captive Profits Marsh 53 The information contained in this [publication, presentation, etc.] provides only a general overview of subjects covered, is not intended to be taken as advice regarding any individual situation and should not be relied upon as such. Insureds should consult their insurance and legal advisors regarding specific coverage issues. Statements concerning tax, accounting, and legal matters should be understood to be general observations based solely on our experience as insurance brokers and risk consultants and should not be relied upon as tax, accounting, or legal advice, which we are not authorized to provide. All such matters should be reviewed with the client s own qualified tax, accounting, and legal advisors in these areas. Depending upon an organization's facts and circumstances, certain tax or accounting benefits may be associated with this product. Organizations should consult with their tax, accounting, and legal advisors to determine whether such benefits would be applicable. Marsh is part of the family of MMC companies, including Kroll, Guy Carpenter, Putnam Investments, Mercer Human Resource Consulting (including Mercer Health & Benefits, Mercer HR Services, Mercer Investment Consulting, and Mercer Global Investments), and Mercer specialty consulting businesses (including Mercer Management Consulting, Mercer Oliver Wyman, Mercer Delta Organizational Consulting, NERA Economic Consulting, and Lippincott Mercer). This document or any portion of the information it contains may not be copied or reproduced in any form without the permission of Marsh Inc., except that clients of any of the companies of MMC need not obtain such permission when using this report for their internal purposes, as long as this page is included with all such copies or reproductions. Copyright 2007 Marsh Inc. All rights reserved. Marsh 54

19 Captives - The ABC s Part II Thank You! Robert L. Johnson Managing Director Marsh Management Services Inc. Marsh 55