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Captive Insurance Risk Management Vehicles
Executive Summary
Agenda• What is a Captive?• Why Form a Captive?• Types of Captives• Traditional Captive Insurance Program• Micro-Captive• Discussion/Questions
What is a Captive?A captive is an insurance company that insures the risks of its owner, affiliates, or a group of companies. It issues policies, collects premiums, and pays claims.
Captive Industry Facts
• First captives formed in the 1920’s…or much earlier?
• Over 82% of Fortune 1000 companies own a captive insurance company
• Over 25,200 captives across the globe today and growing at a rate of 225+ per year
Captive Growth Continues
* Business Insurance 2015 Market Insights – Crain Communications
Domiciles Summary
Purposes of Forming a Captive:
Minimize Insurance Spend
Facilitate Cash Flow Improvement
Potential Wealth Accumulation
Improve Risk Management Focus
• Reduce Net Insurance Cost• Pricing Stability• Purchase Only What Needed
• Investment Income• Capture Underwriting
Profit
• Estate Planning• Asset Growth• Asset Protection
• Clarity in Claims Process• This is the Driver of
Other Areas
Types of Captives
• Group / Association Captives – owned & operated by a group of members; 100% of risk and assets pooled
• Sponsored or Rent-A-Cell Captives – owned & operated by a sponsoring entity; liabilities and assets legally segregated
• Single Parent Captives – insures the risk of the owner and it subsidiaries, traditionally used by large Fortune 2000 companies
• Micro-Captive – is a single parent captive that has special tax benefits, focused on small to mid-size businesses
What types of risk go into a captive?
Insured Risk ● Workers Comp ● Property ● Auto ● General & Professional Liability
Traditional Captive Coverage
Micro-Captive Coverage
“Un” or Underinsured Risk● Construction Defect ● Product Warranty● Wind/Property ● Reputation Damage
● Administrative Actions ● Loss of Key Employees
● Policy Exclusions/DIC ● Loss of Major Client● Credit Default Risk ● Punitive Damages ● Litigation Defense ● Cyber & Privacy Risk● Health Specific Stop Loss ● Med-Mal Deductible
Actuarial Considerations –Avoid “Underwriting by the blind”
• Regulators primary job is to ensure solvency of the captive and captive managers are competing for clients
• But risk charges must be market “appropriate and justifiable” to the IRS
• Actuarial basis is critical to sustained success of risk management and tax benefit balance
• Red Flag Example: EPLI Primary $3MM = $12,000EPLI 831(b) $3MM = $250,000Secondary layer = 269 x market
Who’s Involved in a Captive?
CAPTIVE
Domicile
Actuary
Audit & Tax
Banking
Loss Control
TPA
Fronting & Reins.
Captive Manager
Agent/Broker
Asset Mangmt
Traditional Captive
Why Form a Group Captive?• Control, control, control over:
– Ultimate cost• Reduce to the reinsurance portion of spend, plus claims
– Coverage breadth– Claims handling– Loss control– Embedded insurance company profit
Coverage To Consider• General Liability
• Products Liability
• Completed Operations
• Workers Compensation• Statutory Coverage
• Employers Liability
• Automobile Liability• Physical Damage
• Cargo
Group Captive Program
Profits
Captive Manager
Insured
Agent/Broker
Fronting Carrier
Captive Program Reinsurance Carrier
Claims TPALoss Control
Claimant
Captive Funding & Loss Example
Why a Group Captive?• Premiums based on your loss experience• Insulated from market conditions• Operating Costs are lower• Only the best risks of the group accepted• Focused loss prevention and claims management• Return of unused loss funds and investment
income
831(b) Micro-Captive
For Those New To The Topic…
• 831(b) is not a type of captive, but rather a tax election
• Available to all types of property & casualty insurers – IF considered and insurance company for tax purposes
IRS Code; Section 831(b)
• Under section 831(b)(2)(A)(i) of the IRC, captives that write $1.2 million or less per year only pay tax on investment income
• Underwriting profit accumulates tax deferred
• Premium must be actuarially supported
New Captive Formations• Small captives have been a driver of captive
growth over the past three years• Why the growth:
– Improving economic conditions leading to increased risk exposure to the bottom line and more capital
– Proliferation of enterprise risk management in mid-size organizations identifying unknown risk areas
– Mid-size organizations do not have the same ability to absorb large uninsured claims like their larger competitors/counterparts.
What types of risks go into a micro-captive?
• Not designed to replace commercially placed P&C coverage
• Not designed for high frequency risks such as work comp, property, auto or general liability.
• Think of risks that are typically not insurable or coverage is hard to find:
What types of risk go into a captive?
Insured Risk ● Workers Comp ● Property ● Auto ● General & Professional Liability
Traditional Captive Coverage
Micro-Captive Coverage
“Un” or Underinsured Risk● Construction Defect ● Product Warranty● Mold and Pollution ● Reputation Damage
● Administrative Actions ● Loss of Key Employees
● Policy Exclusions/DIC ● Loss of Major Client● Credit Default Risk ● Punitive Damages ● Litigation Defense ● Cyber & Privacy Risk● Health Specific Stop Loss ● Med-Mal Deductible
Actuarial Example
Realizing Underwriting Income
• Captive underwriting income taxed as qualified dividends OR capital gains.
• Estate planning recommended• Encourage to discuss with CPA, tax attorney,
legal counsel and CFO.
Qualify for Insurance Accounting Tax Treatment?
• To be deemed an insurance company and make the 831(b) election both of the following two tests must be met:1. Risk Shifting – premium must be priced fairly
(actuarially supported risk)2. Risk Distribution/Sharing – law of large numbers
Risk Distribution: Option 1
• Revenue Ruling 2002-90• Referred to as Brother-Sister Test• Must have 12 subsidiaries (i.e. Brother-Sister
companies) to meet safe harbor• Each sub should have between 5-15% of the total
captive risk (no one company can have 51%)• Case law lowers the number of Brother-Sister
companies needed to 6
Risk Distribution: Option 2
• Revenue Ruling 2002-89• Ruling requires more than 50% of the risk derived
from unrelated third parties to meet safe harbor• Case law requires only 30% third party risk• Most captives making 831(b) election use this option to
meet risk distribution• This is where POOLING FACILITIES come in to play
Micro-Captive Marketplace Overview
• Increased regulatory activity over the past year– Domicile positioning– IRS “Dirty Dozen”– Senate finance committee bill– IRS audit activity– Tax shelter promoter investigation (captive
managers)– Various publications running stories on topic
IRS Dirty Dozen• Each year the IRS publishes its “Dirty Dozen”, which
warn taxpayers against twelve concerns, including phishing, identity theft, EITC scams, tax shelters, etc.
• In IR 2015-19, the IRS, for the first time, linked captives electing section 831(b) with “tax shelters”
• The IR states that a captive electing section 831(b) is a “legitimate structure”
IRS Dirty Dozen, Cont.• However, it warned that abusive situations could
include: – Unscrupulous promoters who receive hefty fees and
sometimes purport to insure “esoteric, implausible risks, for exorbitant premiums.”
– Premiums that cover the amount needed to reduce income or $1.2 million
– Underwriting and actuarial substantiation for the premiums is missing or insufficient
– The promoters dupe those unsophisticated in insurance to continue the charade.
• In the the last five years, the explosive growth in 831(b) election captives has led to increased IRS scrutiny of aggressive captive structures that do not have a non-tax business purpose.
• Audits are accelerating• Just because someone is being audited, doesn’t mean they have done
anything wrong.• There have been no results announced from investigators
• Protecting America from Tax Hikes of 2015 (HR 2029) which passed December 18, 2015 included changes to section 831(b):
• The maximum premium allowable for an insurance company electing section 831(b) is increased to $2,200,000, which will be indexed for inflation.
• The changes apply to taxable years beginning after December 31, 2016
What is Changing
To be eligible to make a section 831(b) election, an insurance company must meet either of the two following diversification tests:
• Test 1: No more than 20% from any one policy holder• Premiums are the greater of net written or direct premiums • Related
insureds are treated as one policy holder
• Test 2: The same person owns the operating company and the insurance company
• The details are more complex than the preceding sentence • There is a 2% de minimus tolerance for different ownership
What is Changing…continued
• Information from the inception of the captive, even if it preceded the years under audit
• All emails, marketing materials, etc.
• Comprehensive questions on how one got involved in the captive and was consulted
• What commercial insurance was in place, what are the gaps and exclusions, how the captive program fit
• What is the operating company’s risk management program o How were the premiums priced
• For the ten years prior to its inception, were there any losses that would have been covered by the captive program had it been in place
• What is the loss experience of the related party and pool insurance
• What are the investments
The Audit – Information Requested
The Bottom Line…
Discussion/Questions
Brandon M. White, CIC, CRMPresident/Founder
Sophia NajjarVice President/Healthcare Specialist
Important Notice
The information in this presentation is for information purposes only and is not designed or intended to provide legal, tax, or other professional advice since such advice always requires consideration of individual circumstances.
