Changing Regulatory Landscape of Captive Insurance Companies

Transcription

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2 Changing Regulatory Landscape of Captive Insurance Companies Session #105

3 Presenters Brian Kilbane, Senior Manager Dixon Hughes Goodman LLP DHG Insurance 225 Peachtree Street NE, Suite 600 Atlanta, GA Doug Stein, Partner Strategic Law, LLC 5909 Peachtree-Dunwoody Road NE Suite 800 Atlanta, GA Eric Halter, President Patriot Captive Management, Inc. 27 Hospital Road PO Box Grand Cayman, KY

4 Legal Disclaimer The information contained in this presentation is intended to afford general guidelines on matters of interest. The application and impact of tax laws can vary widely, based upon specific or unique facts involved. Accordingly, the information in this presentation is not intended to serve as legal, accounting, or tax advice. Users are encouraged to consult with their own professional advisors for advice concerning specific matters in this presentation before making any decision and DHG, Strategic Law, and Patriot National disclaims any responsibility for positions taken by taxpayers in their individual cases or for any misunderstanding on the part of users. 4

5 Agenda Captive Insurance Primer Captive Structures Captive Benefits and Risks State of the Captive Industry Buyers Guide Do s and Don ts 5

6 Captive Insurance Primer What is a captive insurance company? Why do companies create them? What are the benefits? Where can I create a captive? 6

7 Captive Insurance Primer Company Company Company Self- Insured Third Party Insurer Captive Third Party Reinsurer 7

8 Captive Insurance Primer- Reasons to Form a Captive Reduce Costs Retain Underwriting Profit Minimize Insurance Cost Control Risk Claim Control Flexibility Access Reinsurance Market Accumulate Wealth Improve Cash Flow Estate Planning Tax Benefits Retain Premium Dollars 8

9 Captive Structures 9

10 Types of Captives Single-Parent Captive - Insures the risks of related companies. The most common form of Captive. Group / Association Captive - Insures the risks of companies in an industry group, franchise, or other association. A group Captive can share the risk among several participants and spread the fixed cost of the Captive among many members. 10

11 Types of Captives Segregated Portfolio Captive/Protected Cell - Segregated Portfolio Captives (SPC) enables users to legally segregate their assets and liabilities within a separate vehicle, or cell. This allows many cells to be created within the same Captive. Most jurisdictions now allow cell Captive structures. Micro-captive (Electing 831(b) Tax Treatment) - A captive that provides insurance covering enterprise risk which is limited to $1,200,000 of annual premium. Taxes are deferred, based on IRC 831(b) and 834 legislation requiring taxes to be paid on the annual investment income generated from the held assets. 11

12 Captive Type Illustration 12

13 Basic Captive Diagram This is the most basic Captive arrangement, where a business pays insurance premiums directly to a Captive. 13

14 Captive with Fronting Insurer In this Captive arrangement, there is a licensed insurance company that allows the Captive use of its paper, that writes the insurance for the business, and then reinsures some or all of the risks (along with the premiums) to the Captive. This arrangement is used in workers compensation. 14

15 Group Captive In a group captive, several businesses in the same industry, association or franchise each pay insurance premiums to the group captive, which pools the premiums and losses. Generally, each group member is an owner in the captive. This allows insurance to be tailored precisely to the needs of the group, and can provide substantial insurance savings. 15

16 Segregated Portfolio Structure Insurance Company, Inc. ----Core Captive---- Cell Captive Cell Captive Cell Captive Cell Captive Cell Captive Cell Captive Cell A Cell B Cell C Cell D Cell E Cell F Premiums Insured Business B Insured Business D Insured Business F 16

17 Captive Benefits and Risks Preface Captives are appropriate and beneficial structures that can truly add value to a company if they have the right fact pattern and the rules/regulations are followed. However, there are risks to watch out for to ensure company s aren t putting themselves in unnecessary risk. 17

18 Captive Benefits and Risks Benefits Reduction in insurance costs Premiums priced on own risk vs. pool of insureds (premium stability) Incentive and reward for good risk management Retention of underwriting profits Obtaining insurance on risks that are unavailable or cost prohibitive Medical malpractice, professional liability, aircraft Access to reinsurance markets Wealth management strategy Federal income tax advantages 18

19 Captive Benefits and Risk Risks Insurance policy must have a risk of loss Possibility that this can be a net loss arrangement Deductibles need to allow for risk of loss Insurance policy must have an insurable risk Premiums must have a relationship to the risk being insured Actuarially determined IRS rules are very complex 19

20 Captives Benefits and Risks Risks Beware of discovering/creating insurable risks Terrorism Cyber liability Loss of key customer/supplier/employee Environmental liability Patent infringement Must be a true risk that can be insured Fully understanding initial and ongoing administrative costs 20

21 Captive Benefits and Risks IRS Tax Rules Must prove that it is a valid insurance company Elements of risk shifting and risk distribution Risk of loss Risk Shifting Must prove that specific risks are transferred in exchange for a reasonable premium 21

22 Rent A Center V. Comm r Created a Captive to reduce its costs, improve efficiency, obtain unavailable coverage, and provide accountability and transparency. Feasibility study prepared proved value of captive and determined proper funding. Costs actually reduced 22

23 Rent A Center V. Comm r Parent guarantee made to the captive to ensure claims will be paid. Sought permission to treat tax assets as business assets Accounting was properly maintained and annual audits were properly conducted 23

24 Rent A Center V. Comm r IRS Arguments Sham Transaction Impermissible circular flow of funds Premium to surplus ratios were inappropriate Not a bona fide insurance company 24

25 Rent A Center V. Comm r Court Findings Payments were deductible payments because the captive was bona fide Real risk 25

26 Securitas Securitas (SHI) is a publically traded company in the security business SHI has no employees, and no vehicles during the time in question Protectors is Vermont captive which SHI acquired during it s buying spree in the US 26

27 Securitas Insurance is second largest expense for SHI In 2000, the market hardened and raised the cost of insurance Parent guaranteed debt of insurance company IRS denied all deductions except those related to claims and reinsurance paid 27

28 Securitas 4 prong test for insurance for tax purposes arrangement must involve insurable risks; the arrangement must shift the risk of loss to the insurer the insurer must distribute the risks among its policyholders the arrangement must be insurance in the commonly accepted sense 28

29 Securitas Risk Shifting Court uses the balance sheet approach Look only at the insured's assets to determine whether the insured divested itself of the adverse economic consequences IRS argues the parent guaranty undermines risk shifting Court notes that the guaranty was offered for reasons unrelated to captive (e.g., preserve the 501(c)(15) 29

30 Securitas Risk Distribution Risk distribution when it pools a large enough collection of unrelated risks, those that are not generally affected by the same circumstance or event Court notes that the pooling of exposures that brings about the risk distribution - who owns the exposures is not crucial 30

31 Securitas Tax Court commented on the following factors that are commonly accepted as insurance: the insurer was organized, operated, and regulated as an insurance company the insurer was adequately capitalized the insurance policies were valid and binding the premiums were reasonable the premiums were paid and the losses were satisfied 31

32 Captive Benefits and Risks IRS Safe Harbor Ruling Parent-subsidiary arrangement At least 50% of the premium in captive relates to unrelated third party risk Brother-sister relationships Must have significant volume of homogenous risks No subsidiary should account for more than 15% of total insured risk At least 12 companies, well distributed risks is safe Could go as low as 7 companies relatively evenly distributed risks. However, should ensure great documentation for demonstrating risk distribution 32

33 Captive Benefits and Risks IRS Safe Harbor Ruling May 28, 2014 comments from Sheryl Flum, branch chief, IRS Office of Chief Counsel Rulings should not construed as safe harbors. IRS abandoned economic theory family, looks at specific facts and circumstances Policies written must truly reflect the risks. Unsure if IRS would consider pricing by actuaries more persuasive than pricing by an insurance underwriter. 33

34 Captive Benefits and Risks IRS Dirty Dozen Tax Scams for 2015 Filing Season On February 3, 2015, IRS released IR including captive insurance as an area where there are abusive tax structures promoters assist with creating and selling to the entities often times poorly drafted insurance binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant premiums, while maintaining their economical commercial coverage with traditional insurers Premiums are close to $1.2 million Underwriting and actuarial substantiation or missing or insufficient 34

35 IRS Red Flags 1. Materials emphasizing the income tax goals of the captive insurance arrangement. The IRS will evaluate whether such materials emphasize premium deductions as opposed to insurance needs. 2. The realistic probability of coverage applying to the business. If the likelihood of the insurable event happening is low, the IRS believes the cost of coverage should likewise be low. To illustrate, there would be little need for hurricane coverage in a land locked area or earthquake coverage where there is no fault line within hundreds of miles. 3. Reverse engineering the amount of premiums to equal exactly the $1.2 million exemption amount to the penny. The IRS believes certain taxpayers are exploiting this advantage by signing up for premiums exactly at the $1.2 million level. 4. An impermissible circular flow of funds where the premium monies, either through loans or distributions, ultimately end up in the hands of the business or a closely related party. The IRS has a history of suspicion over the circular flow of funds. Source: IRS Increases Scrutiny of Captive Insurance Red Flags from the IRS Playbook by Josh Ungerman; Forbes.com 3/7/

36 IRS Red Flags 5. Lack of adequate risk distribution to be considered an insurance company for tax purposes. This arises where the captive insures only the single business and simply holds the premium monies in the event of a claim. The IRS is very focused on a perceived lack of risk distribution and risk shifting in certain captive arrangements. 6. Failure to obtain an actuarial study supporting the premiums charged by the captive for the insurance. The IRS will examine the underwriting process. 7. Lack of an analysis of the cost and availability of commercial insurance in the non-captive market. The IRS believes that insurance rates far in excess of commercially available rates defy common sense. 8. Materials emphasizing the estate planning benefits of the captive insurance structure. For instance, the IRS will scrutinize a captive insurance company owned by a family limited partnership or irrevocable trusts that benefits the business owners family members. The IRS takes the position that I.R.C. 831(b) was not enacted as an estate planning tool, but to assist taxpayers who want to manage risk. 9. The existence of guarantees. The IRS believes that guarantees may be an indication of inadequate capitalization. 10. Lack of claims history. The IRS believes that no claims may indicate that the insurance pool is insufficient and risk shifting may not exist. 36

37 IRS Red Flags IRS placed captives making the 831(b) on its Dirty Dozen list of tax scams, according to Captive Review. North Carolina senior deputy commissioner Raymond Martinez said, We have a staff actuary who reviews all of the business plans and the feasibility studies. He makes sure that whatever risks are encompassed in the business plan are appropriately priced and there is in fact risk. So as far as we are concerned this is insurance, regardless of what the IRS says. 37

38 Captive Benefits and Risks Conclusion As long as these risks are properly considered and addressed, a captive insurance program can provide a lot of benefit to a company. 38

39 State of the Captive Industry Vast majority of Fortune 500 firms already have captives Market is focused on middle-market companies and individual business owners Significant growth in the use of 831(b) Creating a cottage industry of law firms/consulting firms to push captive insurance strategies for middle-market companies 39

40 NAIC Actions The Principles-Based Reserving Implementation Task Force is responsible for addressing whether any additional regulation should be instituted for captive insurance companies. Primarily relates to insurer-owned life insurance captives with Regulation XXX and/or AXXX business. State departments with significant life insurers domiciled in their states are for more regulation. State departments with significant captive industries are not in favor of more regulation. 40

41 NAIC Actions On November 17, 2014, the PBR Task Force adopted the XXX/AXXX Framework as part of Actuarial Guideline XLVIII (AG 48). Applies to reinsurance ceded to captive insurers, special purpose vehicles, reinsurers that are not eligible to be ceded reinsurers, reinsurers that deviate from STAT/RBC rules, etc. The ceding insurer may only receive credit for reinsurance, if, but only if: The ceding insurer establishes gross reserves, in full, using applicable reserving guidance The ceding insurer satisfies the Primary Security Requirement (i.e., the ceding insurer receives as collateral Primary Security in at least the amount determined pursuant to the Actuarial Method). Portions of the statutory reserve exceeding the Primary Security Requirement may be collateralized by Other Security. At least one party to the financing transaction holds an appropriate RBC cushion. The reinsurance arrangement is approved by the ceding insurer s domestic regulator. 41

42 NAIC Actions Definitions Primary Security Requirement - The ceding insurer would need to receive as collateral (on a funds withheld, trust or modified co-insurance basis) Primary Security in at least the amount determined pursuant to the Actuarial Method. Primary Security Cash and SVO-listed securities meeting certain requirements. Considering whether to include clean, irrevocable, unconditional evergreen LOC s. Actuarial Method VM-20 (i.e. PBR), modified to incorporate changes to mortality tables developed by the AAA, and another modifications suggested by LATF Other Security Any other security to which the NAIC has developed an RBC asset charge RBC Cushion One party would be required to perform the full traditional NAIC methodology. 42

43 NAIC Actions Other Requirements: XXX/AXXX Reinsurance Supplement in the Annual Statements adopted for New note disclosure will be required in the audited financial statements regarding compliance with the XXX/AXXX Reinsurance Framework. Timing and Next Steps: RBC Cushion to be determined: Proposal to increase authorized control level RBS by the cumulative amount of all primary security shortfalls Proposal to create new RBC exhibit showing RBC calculation and TAC for each captive insurer along with the ceding company.» Any cumulative RBC shortfall results in a reduction to the ceding company s TAC. 43

44 NAIC Actions Other Actions: Financial Regulations Standards and Accreditation (F) Committee is drafting proposed amendments to the Part A and Part B Preambles of the Accreditation Program to require the following to be multi-state insurers and subject to Accreditation: Captives assuming XXX/AXXX reinsurance Captives assuming variable annuity business Captives assuming long-term care insurance Adopted during 2015 NAIC Spring Meeting. 44

45 Creating a Captive Risk Management Program 45

46 Captive Design Life Cycle 46

47 The Facilitator: The Captive Manager Reinsurance Companies Investment Managers Auditors Domicile Banker Domicile Regulators CM General Registry Actuary US Legal Counsel Shareholder s & Directors Domicile Legal Counsel 47

48 The Facilitator: The Captive Manager Structure and design of solutions for potential clients. Captive feasibility studies and Company Formation Preparation of Business Plans and License Applications Regulatory Reporting & Local Compliance Oversight and management of regulatory and financial matters Operational control and management Monthly, quarterly and annual financial management Coordination of Corporate Meetings Registered Office and Company Secretarial Services Transitional management of existing captives 48

49 Captive Design Life Cycle Phase 1 Review Current Insurance Program Pre Feasibility Analysis Fronting/Reinsurance Availability Analysis 49

50 Captive Design Life Cycle Phase 1 Review Current Insurance Program Develop a due diligence questionnaire for completion by Business Owners Objective: Traditional Program, Financial Ability, Alternative Risk Analyze survey results to: Understand current terms of Owners Understand the desirable features Understand the current challenges Gather current Insurance Carriers Determine premium volume 50

51 Captive Design Life Cycle Phase 1 Pre Feasibility Analysis Identification of coverages desired, strength of current traditional program Business Owner to provide data Captive Manager will define the necessary underwriting data needed Actuarial Firm will define data necessary to complete study Captive Manager coordinates with Business Owner and external resources to obtain underwriting information Captive Manager pulls data together, organize it and provide to Users Captive Manager coordinates, participates and provides analytical to Actuaries Captive Manager evaluates fronting carriers to achieve program objectives Captive Manager and Business Owner develops Program for presentation. 51

52 Captive Design Life Cycle Phase 1 Fronting/Reinsurance Availability Analysis Captive Manager will present to our BPO Partners as well as others. Captive Manager will work with BPO Partner to obtain desired structure Captive Manager coordinates with fronting carrier to develop BPO captive structure BPO Partner approval to be obtained Provide information to Actuary to complete Captive Feasibility Study proforma financials 52

53 Captive Design Life Cycle Phase 2 Feasibility Study Domicile Analysis 53

54 Captive Design Life Cycle Phase 2 Feasibility Study The majority of On-Shore Domiciles require a Feasibility Study Pinnacle will be the actuarial firm preparing the Feasibility Study 54

55 Feasibility Study Will: Analyze principles of risk financing and captive options Provide risk retention analysis and evaluation of risk financing facilities Define the advantages and disadvantages of Captives Overview of proposed BPO insurance structures and identification of reinsurance covers suitable for a Captive Claims analysis of proposed lines of business Captive domicile review Capital/solvency requirements Five year business plan and financial projections for Captive Review underwriting guidelines Review operating matters Provide accounting and taxation considerations Review of implementation plan 55

56 Captive Design Life Cycle Phase 2 Domicile Analysis On-shore domiciles Capital requirements are larger than most off-shore domiciles. Risk based capital for solvency is being implemented with most on shore domiciles Program familiarity is limited and normally requires additional time to get Approved in Principle Off-shore domiciles Capital requirements are more reasonable Experience is greater and easier to get specialty programs Approved in Principle 56

57 Primary Areas of Domicile Analysis Regulation Domicile regulations should be acceptable to the parent company, insurers and reinsurers, as well as to the governing bodies of the parent companies. It may also be important to choose a domicile where the Regulator is accessible and prepared to work with you to achieve your objectives. Fiscal Framework When considering tax implications, you may need to consider: whether the domicile offers a tax system which enables you to align the captive with your wider group tax strategy; how the parent company s tax authorities will view the chosen domicile (for example are there any Controlled Foreign Company issues)? 57

58 Primary Areas of Domicile Analysis Investment, Capital and Profits Which domiciles have policies on capital requirements, fund transfers and investments that best complement your overall strategy? Services and Costs Is an appropriate infrastructure of professional service providers in place to properly support your captive? Will you be able to appoint board members of sufficient caliber and suitable experience; and how do set-up and running costs compare? 58

59 Primary Areas of Domicile Analysis Environment For the long term viability of the captive, the domicile needs to be politically and economically stable, with good communications infrastructure. Access and logistics are also important. 59

60 Captive Design Life Cycle Phase 3 Go / No Go Decision 60

61 Captive Design Life Cycle Phase 4 Corporate Risk Management Restructuring Captive License Application and Formation 61

62 Licensing Process Develop Business Plan Meet with regulatory representative Appoint officers and directors Reserve name of captive Select service providers, e.g. legal, actuarial, auditor (CPA), bank, claims, risk management Draft organizational documents, e.g. articles of incorporation and bylaws Hold organizational meeting Finalize and submit Captive Application to selected domicile 62

63 Captive Design Life Cycle Phase 5 Begin Insurance Operation 63

64 Approval Certificate of Authority issued Establish bank account and capitalize captive Commence writing business Will need Business Owner s assistance in implementing: Company meetings Internet meeting to all operating divisions Company function attendance Fronting Carrier underwriting support 64

65 Advantages of Captive Ownership Access to reinsurance markets previously unavailable. Preservation and protection of Assets. Access to underwriting profits of the Fronting Carrier. Efficient use of cash flow for risk financing. Customized coverages to address business needs. Creation of a new profit center within your Organization. 65

66 Advantages of Captive Ownership Investment income on premiums and loss reserves. Reduction of overall premium expense and smoothing cash flow outflows. Stabilization of insurance rates and coverages. Overall tax reduction to your Organization. 66

67 Why should a Fronting Carrier use Captive? To maximize utilization of surplus. Ceding premium to a Captive allows larger programs to be written without committing significant amounts of surplus. Minimize loss exposure. To maximize return on committed surplus Binding of programs that normally the Company would avoid. 67

68 What are the Keys to Success? Good risk management and control of losses Sufficient financial stability of the Client Initial collateral required Potential for later collateral calls based upon claim experience and overall payrolls Full support from the Participants Understanding of the functionality and making sure the client fully understands the commitment and the operation of the SPC structure 68

69 What are the Keys to Success? Fronting and reinsurance support Strong service providers Good communication Long term commitment It typically takes 18 to 24 months before a GAAP profit is realized. 69

70 Essential Terms of a Captive Program 1. First year annual premium 2. Deductible (if any) All deductibles are outside of the segregated cell. Deductibles are computed in the claims ceding and billed directly to the Client on an incurred basis. 3. Program Expense Computed on ceded premiums only. Components of Program Expense is illustrated later. 70

71 Essential Terms of a Captive Program 4. Quota Share Agreement Percentage of premiums and losses ceded to the segregated cell. Typical quota share is 90.0 % SPC and 10.0 % GIC. 5. Collateral Requirement 6. Aggregate Stop Loss % This is the maximum claim liability that the Client is liable for. 71

72 Legal Agreements for a Captive 72

73 Due Diligence Documents Both on-shore and off-shore domiciles require that the Captive owner(s) complete the due diligence documents. The documents are the substance and deciding factor for the approval of a newly formed Captive. In addition to the due diligence documents, a Captive Feasibility Study, Business. Plan Narrative and Financial Projection model are submitted for consideration by the selected domicile. A listing of the required documents and forms for completion will be provided can be provided at the point of engagement. 73

74 Questions? Brian Kilbane, Senior Manager Dixon Hughes Goodman LLP DHG Insurance 225 Peachtree Street NE, Suite 600 Atlanta, GA Doug Stein, Partner Strategic Law, LLC 5909 Peachtree-Dunwoody Road NE Suite 800 Atlanta, GA Eric Halter, President Patriot Captive Management, Inc. 27 Hospital Road PO Box Grand Cayman, KY

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