Hot Topics Captive Insurance Federation of Regulatory Counsel Washington, D.C. November 20, 2015 Harry Baumgartner, Esq. Bressler, Amery & Ross, P.C. Florham Park, NJ 973-966-9675 hbaumgartner@bressler.com www.bressler.com
2 Hot Topics Developments in Captive Taxation What is Insurance? IRS Focus on Micro-Captive Shams Self-Procurement / Direct Procurement Tax Federal Home Loan Bank Membership Emerging Issues / Opportunities
3 Captive Insurance Companies What are They? A closely held insurance company owned and controlled by its insureds Licensed Insures / reinsures risks of owners or related parties Can insure third-party risk in many states and off-shore domiciles Regulated by special legislation governing captives Regulated differently than commercial insurers Onshore, offshore Generally licensed in only one domicile ~35 states have enacted captive legislation
4 Captive Insurance Companies Types Single-Parent Captive (66%) Wholly owned by one parent company Insures or reinsures risks of parent, affiliated entities, or chosen unrelated parties Group/Association (4%) Owned by multiple companies or an association, and insures / reinsures risks of the group Risk Retention Group (3%) Regulated under federal legislation, licensed in one state, able to operate in all states on registered basis Can only write liability lines of risk (not including workers comp) Protected Cell Captives or Cell Captives (4%) Insures / reinsures risks of unrelated parties (generally), where insureds are renting insurance capacity Special Purpose Vehicles (9%) Other (14%) e.g., Branch captive Formed in separate domicile as a branch or subsidiary of single-parent captive Allows off-shore captives access to TRIPRA, employee benefit coverages required to be U.S.-domiciled Allows domestic captives to meet certain regulatory requirements in other states
5 Captive Insurance Companies Reasons Increase control over: Ultimate cost Reduced cost, increased tax efficiency Breadth of coverage Insure uninsurable risk Company financials, structural considerations e.g., different deductible buy-down programs Claims handling Loss control Market conditions, commercial insurers Retain risk, increase negotiation leverage, access to reinsurers Operate as profit centers Retained premium Investment income Ceding commissions Certain tax benefits for qualified captives
6 Captive Insurance Companies Typical Uses Deductible buy-downs for all commercial insurance e.g., subsidiaries need lower retentions than parent assumes High casualty retentions and loss projections Uninsurable or costly insurance program e.g., medical malpractice Access to TRIPRA, employee benefits e.g., medical stop loss, LTD, group life Alternatives to regulatory requirements e.g., environmental remediation financial assurance Top-line growth from customer insurance programs e.g., product warranties Direct access to reinsurance markets
7 Federal Tax Issues Parent company is a tax-paying entity Premiums deductible as ordinary business expense No premiums in SIR model Accelerated deductions on reserves Not deductible in self-insured retention model SIR claims deductible when paid Qualifying as insurance company for federal tax purposes Key question from federal tax standpoint: Is the captive a bona-fide insurance company? Legitimate non-tax business purpose, genuine insurance risk, common indicia of insurance Business Purpose Doctrine Genuine transaction with economic substance compelled by business or regulatory realities imbued with tax-independent considerations. Definition of Insurance Risk Shifting Actual transfer of economic consequences to insurer Factors = adequate capitalization, parental guarantees, loan-backs, arm s length pricing, claims filed and paid, etc. Risk Distribution Brother-Sister Arrangements Third-Party Risk / Pooled Risk
8 Brother-Sister Risk Distribution Parent Company Seven subsidiaries inferred from Revenue Ruling 2002-90 Captive Cannot have substantial concentration of risk in single entity Premium Payments Not Tax-Deductible Tax-Deductible* *Note: IRS had held to position that subsidiaries must not be disregarded entities for tax purposes, although recent activity and Tax Court opinions suggest this restriction may be evolving. (See Rev. Ruling 2005-40, Rent-a-Center, Securitas cases)
9 Third-Party Risk Distribution 50% unrelated risk stated as a safe harbor from Revenue Ruling 2002-89, though Tax Court opinions tolerate less Parent Company Third Party / Pool Risk Captive Premium Payments
10 Recent Tax Court Opinions Rent-A-Center v. IRS (2014) Operated 2,623-3,081 rental stores, and had 14,300-19,740 employees and 7,143-8,027 vehicles 15 brother-sister entities, but 66% concentrated in one entity Had parental guaranty to meet certain solvency requirements IRS sought to reverse five years of deductions Split opinion (10-6) finds bona-fide insurance company created for legitimate nontax purposes sidiaries had sufficient number of statistically independent risks to meet risk-distribution test Parental guaranty was for a unique regulatory purpose and did not involve an undercapitalized captive Dissent: Guaranty eliminated risk-shifting and captive was undercapitalized IRS did not appeal
11 Recent Tax Court Opinions Securitas Holdings v. IRS (2014) Case involved parental guaranty and concentration of risk in one entity IRS seeks to disallow deductions Court finds that: The large number of employees, offices, vehicles, and services insured by captive met the risk-distribution test because captive was exposed to a large pool of statistically independent risks Existence of parental guaranty by itself is not enough to justify disregarding the captive insurance arrangement Rather, if guaranty did not shift ultimate risk of loss back to parent and case does not involve an undercapitalized captive, guaranty alone was not enough to negate compliance with the risk-shifting test
12 Recent Tax Court Opinions R.V.I. Guaranty Co. v. IRS (2015) Case involved dispute over insurance risk vs. investment risk Residual value insurance Insured parties were lessors of physical assets or provided financing for the assets Estimated value that assets should have on return from lessees Insured risk of loss between estimated and actual value upon return IRS says that s an investment risk, not insurance risk Assessed $55M tax deficiency Tax Court analysis concludes it met test for insurance risk Insured paying premium to transfer meaningful risk of loss Because risk of loss is low does not mean it s not insurable States delegated authority to regulate insurance, including what qualifies as insurance Similar coverage available in commercial market
13 Recent Tax Court Opinions Validus Reinsurance v. U.S (2015) U.S. federal excise tax does not apply to retrocession contracts between two foreign reinsurers So-called cascading federal excise tax U.S. had argued tax should apply not only when foreign insurer reinsurers U.S.-based risk but also to subsequent retrocession contracts between foreign reinsurers Court rules that excise tax statute is ambiguous regarding application to wholly foreign reinsurers Ambiguity is resolved upon applying presumption against extraterritoriality
14 Mini-Captives, Micro-Captives, ERM Captives Section 831(b) of Internal Revenue Code Election to be treated small insurance company Election cannot be reversed without Treasury approval <$1.2M in annual premiums Legislation pending to raise maximum to $2.2M, with inflation adjustment Deduction by parent, reducing taxable income Only investment income taxed at federal level Captive premiums taxed at state premium tax rate Distributions from captive taxed at dividend rate Risk Management vs. Wealth Management Must be true insurance
15 831(b) Captives Owner(s) Premium Claim Payments Dividends 831(b) Small Captive Insurance Company Premium Claim Payments Dividends Insured(s) Reinsurance (Optional) Legend Possibly Definitely If captive qualifies as insurance company for federal tax purposes: Premium(s) deductible Premium income accumulates tax free in captive Investment income in captive taxed as ordinary income Dividends from captive taxed at dividend rate Claim payments are tax neutral
16 IRS on the Prowl 831(b) captives added to 2015 IRS Dirty Dozen list of abusive practices In this abusive structure, unscrupulous promoters assist with creating and selling poorly drafted insurance binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant premiums. Annual premiums often equal the amount of deductions business entities need to reduce income for the year; or, for a wealthy entity, total premiums amount to $1.2M annually. Underwriting and actuarial substantiation for the insurance premiums paid are either missing or insufficient. IRS conducting promoter audits of captive sponsors Criminal prosecutions of quasi-captive deals Congressional legislation pending Baby-and-bath-water issue Legitimate insurance vs. overt tax avoidance
17 IRS on the Prowl Audits Trust / ownership structure Business purpose doctrine Business plan Risk management, real insurance, real risk Marketing material e.g., Wealth Transfer, Estate-Planning Tool Feasibility study Formation documents Adequacy and nature of capitalization Type of coverages Risk pools (legitimate or improbable risk) Policy forms Arm s-length pricing Legitimate actuarial analysis Appropriate reserves Governance Claims, losses Loss prevention Cases to watch: Avrahami v. Commissioner, No. 17594-13; Feedback Ins. Co. v. Commissioner, No. 18274-13 (consolidated)
18 Dodd-Frank / NRRA Self-Procurement / Direct Procurement Tax Procurement of insurance from non-admitted insurer Crazy quilt scheme of taxation and enforcement ~ 40 states have self-procurement provisions 2% - 6% tax on gross written premium Tax applies to percentage of risk located in individual states Gross premium * % of particular risk in state * applicable state tax rate = tax assessment Self-reported tax Unlike surplus lines, collection /remittance not imposed on broker Some insureds pay in all states, some only pay in home state, some do not pay at all Constitutional and other arguments regarding nonapplicability to certain insureds e.g., Todd Shipyards
19 Dodd-Frank / NRRA Implications of Dodd-Frank Act of 2010 Nonadmitted Reinsurance and Reform Act Effective July 2011 Uniform system for surplus lines / self-procurement tax regulation Goal: Eliminate inefficiencies of multi-state system Only home state of parent corporation may tax nonadmitted insurance Interstate compact to collect, distribute taxes where risks located States need not join Can keep all assessments if they do not join No compact agreed Ongoing debate: Does it apply to captives? Captive = non-admitted insurer, as defined in act States with large captive populations say no Many other states say and aggressively enforce yes Captive Clarification Act pending in Congress Potential to reimpose tax on captives domiciled in home state of parent corporation
20 FHLB Membership Federal Home Loan Bank system provides reliable source of short- and long-term funds for lenders to finance housing Provides advances to members at favorable rates, which members use for mortgage origination and other needs Insurance companies can be members of the FHLB system REITs and other financial entities can gain membership, provided they own a qualified captive ~ 45 captive insurers members of FHLB FHFA proposed rule in September 2014 that would eliminate captive insurance company membership in FHLB system Rule: Primary business of insurer must be unaffiliated risk More then 1,300 comments received, the overwhelming majority of which were against the rule Bill introduced in Congress to prevent Federal Housing Finance Agency from excluding captive company membership Final rule may (or may not) be issued by year-end
21 Emerging Issues / Opportunities Opportunities presented by ACA Hospital, physician captives Some mandated provisions of ACA pre-empted by self-funded plans Increased interest in group captive alternatives Medical stop-loss coverage Employee benefits 77 U.S. captives now insure benefits, up from 9 in 2004 Increase in multi-national pooling by global corporations Combines group plans in different countries / companies under single arrangement Increased use of protected cells, pools Cyber-risk Hard market provides opportunity for legitimate risk pools
22 Emerging Issues / Opportunities Captives deploying cat risk into public market via insurance-linked securities Increased regulatory interest and oversight National Association of Insurance Commissioners, Federal Insurance Office, International Association of Insurance Supervisors NAIC: XXX / AXXX reinsurance captives Relationship to principle-based reserving Pending rule regarding fronting carriers ability to claim credit for reinsurance with certain captives Continued growth in non-traditional jurisdictions New Jersey, Texas, Florida, Connecticut, Ohio, Tennessee, etc. Competency issues / race to bottom vs. increased competition and opportunity