Captive Insurance 101 - ddwmwealth.com · A captive insurance company is a subsidiary of its Parent...

Captive Insurance 101Captive Insurance 101

Right for your practice? An overviewRight for your practice? An overview

DISCLOSUREDISCLOSURE

Securities offered through Triad Advisors LLC, Member FINRA/SIPC. Advisory Services offered through Triad Hybrid Solutions LLC, a Registered Investment Advisor.

Securities offered through Triad Advisors LLC, Member FINRA/SIPC. Advisory Services offered through Triad Hybrid Solutions LLC, a Registered Investment Advisor.

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Right for your practice? An overviewRight for your practice? An overview


� Panelists

� Adam Forstot, USA Risk Group

� Bill Buechler, CPA, Crowe Horwath LLP

� Rosemary Wickham FCAS, MAAA, Merlinos & Associates

� Moderator

� Ben Whitehouse, Associate Counsel, Tennessee DOI / Captive Section

� Coordinators

� Bill Dunham, Jonathan Hayes & Daniel Head Valley Vista Asset Management

� Panelists

� Adam Forstot, USA Risk Group

� Bill Buechler, CPA, Crowe Horwath LLP

� Rosemary Wickham FCAS, MAAA, Merlinos & Associates

� Moderator

� Ben Whitehouse, Associate Counsel, Tennessee DOI / Captive Section

� Coordinators

� Bill Dunham, Jonathan Hayes & Daniel Head Valley Vista Asset Management

4

AgendaAgenda

� Captive Overview

� Pre-Formation

� Feasibility

� Formation

� Post-licensure

� Captive Overview

� Pre-Formation

� Feasibility

� Formation

� Post-licensure

5

Captive OverviewCaptive Overview

� What is a captive insurance company?

� How many? (Domestically / globally)

� How prevalent?

� What types?

� What risks and coverages?

� What is a captive insurance company?

� How many? (Domestically / globally)

� How prevalent?

� What types?

� What risks and coverages?

6

How Captive Insurance Operates within

Traditional Insurance Marketplace



Se

ve

rity

Frequency

RISKHIGH

LOW HIGH 7





Se

ve

rity

Frequency

RISKHIGH

LOW HIGH

Self Insurance

8





Se

ve

rity

Frequency

RISKHIGH

LOW HIGH

Self InsuranceToaster

9





Se

ve

rity

Frequency

RISKHIGH

LOW HIGH


Traditional Insurance

10





Se

ve

rity

Frequency

RISKHIGH

LOW HIGH



11





Se

ve

rity

Frequency

RISKHIGH

LOW HIGH



Cyber

Hurricane

Liability Property

12





Se

ve

rity

Frequency

RISKHIGH

LOW HIGH



Cyber

Hurricane

Liability Property

Custom Insurance Market

13





Se

ve

rity

Frequency

RISKHIGH

LOW HIGH



Cyber

Hurricane

Liability Property


Betty Grable's Legs

Football Player

Concussions

14





Se

ve

rity

Frequency

RISKHIGH

LOW HIGH



Cyber

Hurricane

Liability Property


Betty Grable's Legs

Football Player

Concussions

NO COVERAGE

15





Se

ve

rity

Frequency

RISKHIGH

LOW HIGH



Cyber

Hurricane

Liability Property


Betty Grable's Legs

Football Player

Concussions

NO COVERAGE

TRIAFlood

16





Se

ve

rity

Frequency

RISKHIGH

LOW HIGH



Cyber

Hurricane

Liability Property


Betty Grable's Legs

Football Player

Concussions

NO COVERAGE

TRIAFlood

17





Se

ve

rity

Frequency

RISKHIGH

LOW HIGH



Cyber

Hurricane

Liability Property


Betty Grable's Legs

Football Player

Concussions

NO COVERAGE

TRIAFlood

Emp. FraudD & O

W/C, Healthcare

Deductible

Reimbursement

Captive Insurance

18

PRE-FORMATION – Purpose PRE-FORMATION – Purpose

� How can a captive benefit / enhance your client’s business? Your Business?

� Advantages

� Increased control over:

�Coverage features. Claims handling. Ultimate cost. Investment. Insurance program profit.

� Insulation / separation from commercial insurance market

� Access to reinsurance market

� Tax considerations

� How can a captive benefit / enhance your client’s business? Your Business?

� Advantages

� Increased control over:

�Coverage features. Claims handling. Ultimate cost. Investment. Insurance program profit.

� Insulation / separation from commercial insurance market

� Access to reinsurance market

� Tax considerations

19

PRE-FORMATION – Costs PRE-FORMATION – Costs

� Costs associated with starting a captive insurance company, including, but not limited to:

�Actuarial fees

�Captive management setup fees

�Attorney fees for organizational documents and advice

�Licensing and application fees to state of domicile

�Tax opinion (optional)

� Range depends upon service providers, domicile chosen, and size of the company.

� Costs associated with starting a captive insurance company, including, but not limited to:

�Actuarial fees

�Captive management setup fees

�Attorney fees for organizational documents and advice

�Licensing and application fees to state of domicile

�Tax opinion (optional)

� Range depends upon service providers, domicile chosen, and size of the company.

20

PRE-FORMATION – Procedures PRE-FORMATION – Procedures

� How do the financial statements of a captive insurance company impact the Parent company’s financial statements?

� A captive insurance company is a subsidiary of its Parent and will be consolidated into

the Parent’s financial statements

� Typically, captive financial statements are immaterial to the consolidated group

� Must I travel to the domicile state to meet with all of my service providers, or can this be done via conference calls?

� How do the financial statements of a captive insurance company impact the Parent company’s financial statements?

� A captive insurance company is a subsidiary of its Parent and will be consolidated into

the Parent’s financial statements

� Typically, captive financial statements are immaterial to the consolidated group

� Must I travel to the domicile state to meet with all of my service providers, or can this be done via conference calls?

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FEASIBILITY – PurposeFEASIBILITY – Purpose

� Why do you need a feasibility study?

� Who uses it? For what?

� To assist management in determining if a captive makes sense

� Required by regulators

� Which advisors are involved in the feasibility analysis?

� Actuary, captive manager, accountant, attorney, current insurance agent / broker

� Why do you need a feasibility study?

� Who uses it? For what?

� To assist management in determining if a captive makes sense

� Required by regulators

� Which advisors are involved in the feasibility analysis?

� Actuary, captive manager, accountant, attorney, current insurance agent / broker

22

FEASIBILITY – Process FEASIBILITY – Process

� How does the feasibility study relate to the business plan?

� Feasibility study has a financial focus

� Business plan also covers:

�Overview of business and insured(s)

�Risk assessment and insurance coverages

�Domicile

� IRS requirements (business purpose, risk distribution, risk transfer)

� How long does the study take? How much does it cost?

� Approximately 4 weeks after data is received

� How does the feasibility study relate to the business plan?

� Feasibility study has a financial focus

� Business plan also covers:

�Overview of business and insured(s)

�Risk assessment and insurance coverages

�Domicile

� IRS requirements (business purpose, risk distribution, risk transfer)

� How long does the study take? How much does it cost?

� Approximately 4 weeks after data is received

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FEASIBILITY – Product FEASIBILITY – Product

� What is covered by the feasibility study?

� Loss and loss adjustment expense forecast

� Premium / rate estimates

� Capital requirements

� Pro-forma financials

� What is covered by the feasibility study?

� Loss and loss adjustment expense forecast

� Premium / rate estimates

� Capital requirements


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FEASIBILITY – Product

Data needed for loss forecast

FEASIBILITY – Product

Data needed for loss forecast

Client experience and

industry data

Client experience and

industry data

� Client / Company Data

� Historical losses

� Exposures and premiums

� Retentions

� Reinsurance terms / quotes

� Client / Company Data

� Historical losses

� Exposures and premiums

� Retentions

� Reinsurance terms / quotes

Retention reinsurance structureRetention reinsurance structure

� Industry data (as needed)

� Loss costs (loss per exposure)

� Loss development patterns

� Loss and exposure trend

� Size of loss distributions

� Industry data (as needed)

� Loss costs (loss per exposure)

� Loss development patterns

� Loss and exposure trend

� Size of loss distributions

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Client ExperienceIndustry Data

Retention Reinsurance

StructureLoss Forecast

Premium EstimateCaptive Expenses

Profit ProvisionRisk Margin

Capital Requirement

Available Capital Risk Appetite

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� Projected captive results based on all of the aforementioned, and more….

� Typically uses five year projections: balance sheet – income statement – cash flow

� Base case and adverse case scenarios illustrated

� Projections may be used by regulators to evaluate actual performance v. projected during the early years of the captive

� May be compiled by the actuary or the captive manager


� Projected captive results based on all of the aforementioned, and more….

� Typically uses five year projections: balance sheet – income statement – cash flow

� Base case and adverse case scenarios illustrated

� Projections may be used by regulators to evaluate actual performance v. projected during the early years of the captive

� May be compiled by the actuary or the captive manager

27

FEASIBILITY – An owner’s perspectiveFEASIBILITY – An owner’s perspective

� Who and what determines the final decision to proceed?

� Directly address EACH internal stakeholder’s concerns

� Engage external partners during the process

� Drive the process, while concurrently being patient

� Understand all of the numbers

� What happens if a decision is reached NOT to proceed?

� Who and what determines the final decision to proceed?

� Directly address EACH internal stakeholder’s concerns

� Engage external partners during the process

� Drive the process, while concurrently being patient

� Understand all of the numbers

� What happens if a decision is reached NOT to proceed?

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FORMATION – The PlayersFORMATION – The Players

� Which service providers are most commonly?

� Captive Manager

� Accounting / Tax Consultant

� Actuary

� Third Party Administrator

� Legal Counsel

� Additional consultants and service providers (bank, custodian, investment advisor, investment manager, underwriter, ERISA counsel, reinsurance intermediary / broker)

� Are there different or additional service providers to be engaged following formation?

� Which service providers are most commonly?

� Captive Manager

� Accounting / Tax Consultant

� Actuary

� Third Party Administrator

� Legal Counsel

� Additional consultants and service providers (bank, custodian, investment advisor, investment manager, underwriter, ERISA counsel, reinsurance intermediary / broker)

� Are there different or additional service providers to be engaged following formation?

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FORMATION – Process FORMATION – Process

� Application for admission – how long does the licensing process take?

� Domicile specific application forms filed with state regulatory body

� Most domiciles complete their review within 30-45 day time frame of submission

� Who is responsible for preparing the application?

� Captive owner / sponsor will work with captive manager and other consultants to:

�Prepare the plan of operation

�Complete the application

�Gather all required supplemental documents

� Application for admission – how long does the licensing process take?

� Domicile specific application forms filed with state regulatory body

� Most domiciles complete their review within 30-45 day time frame of submission

� Who is responsible for preparing the application?

� Captive owner / sponsor will work with captive manager and other consultants to:

�Prepare the plan of operation

�Complete the application

�Gather all required supplemental documents

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FORMATION – PlanningFORMATION – Planning

� Making the application process more efficient:

� Prepare a formation checklist

� Obtain buy-in

� Identify and obtain commitment of individuals who will serve as board members and officers of the captive company

� Start early

� Understand capabilities of service providers and regulators to insure that you meet your deadlines

� Understand the requirements of third parties

� Making the application process more efficient:

� Prepare a formation checklist

� Obtain buy-in

� Identify and obtain commitment of individuals who will serve as board members and officers of the captive company

� Start early

� Understand capabilities of service providers and regulators to insure that you meet your deadlines

� Understand the requirements of third parties

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FORMATION – PlanningFORMATION – Planning

� Governance matters that should be considered during formation

� Pure / Group / Sponsored Captive structures

� Board composition. Identification of directors and officers

� Communication of roles, obligations, and fiduciary responsibilities

� Need for committees (finance, risk management, etc.)

� Program eligibility – admission requirements – withdrawal / expulsion processes

� Governance standards for Risk Retention Groups

� What are the capital and surplus requirements for captive insurers?

� Minimum capital and surplus

� Additional surplus as required by domicile’s regulatory body

� Forms of surplus and their implications on financial statements

� Governance matters that should be considered during formation

� Pure / Group / Sponsored Captive structures

� Board composition. Identification of directors and officers

� Communication of roles, obligations, and fiduciary responsibilities

� Need for committees (finance, risk management, etc.)

� Program eligibility – admission requirements – withdrawal / expulsion processes

� Governance standards for Risk Retention Groups

� What are the capital and surplus requirements for captive insurers?

� Minimum capital and surplus

� Additional surplus as required by domicile’s regulatory body

� Forms of surplus and their implications on financial statements

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FORMATION – Getting the bird into the airFORMATION – Getting the bird into the air

� Actions needed to prepare your captive for doing business

� Complete corporate organization of the captive

� Appoint initial board and officers

� Board adopts organization resolutions

� Open bank and investment accounts

� Establish trust accounts or other security arrangements

� Execute contracts with service vendors

� Execute contracts with shareholders and / or members

� Collect capital and surplus contributions

� When can the captive begin operations?

� Actions needed to prepare your captive for doing business

� Complete corporate organization of the captive

� Appoint initial board and officers

� Board adopts organization resolutions

� Open bank and investment accounts

� Establish trust accounts or other security arrangements

� Execute contracts with service vendors

� Execute contracts with shareholders and / or members

� Collect capital and surplus contributions

� When can the captive begin operations?

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POST-LICENSURE – Purpose POST-LICENSURE – Purpose

� How do you evaluate if the captive should cover additional risks?

� Identify the need of uninsured risk in current business plan

� New or emerging coverages not originally anticipated

� Determine if your current captive can support additional coverage; begin with review of written premium to surplus

� What is required if you decide to change the business plan?

� Requires prior approval from the commissioner

� How can you take money out of the captive? When can you? What needs to be considered?

� Distributions of capital or surplus require prior approval of the commissioner.

� How do you evaluate if the captive should cover additional risks?

� Identify the need of uninsured risk in current business plan

� New or emerging coverages not originally anticipated

� Determine if your current captive can support additional coverage; begin with review of written premium to surplus

� What is required if you decide to change the business plan?

� Requires prior approval from the commissioner

� How can you take money out of the captive? When can you? What needs to be considered?

� Distributions of capital or surplus require prior approval of the commissioner.

34

POST-LICENSURE – Purpose POST-LICENSURE – Purpose

� Key regulatory deadlines that need to be met to stay in compliance

� File annual statement with regulatory body*

� File NAIC statements (for RRGs and SPFIs)*

� File audited financial statements*

� File Certification of Adequacy of Loss Reserves by an independent actuary*

�* deadlines vary based on type of captive and / or calendar year vs. fiscal year

� Pay applicable license renewal fee to regulatory body, depending upon domicile

� Prepare and file all necessary federal and state tax returns and pay any taxes

� Key regulatory deadlines that need to be met to stay in compliance

� File annual statement with regulatory body*

� File NAIC statements (for RRGs and SPFIs)*

� File audited financial statements*

� File Certification of Adequacy of Loss Reserves by an independent actuary*

�* deadlines vary based on type of captive and / or calendar year vs. fiscal year

� Pay applicable license renewal fee to regulatory body, depending upon domicile

� Prepare and file all necessary federal and state tax returns and pay any taxes

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POST-LICENSURE – Annual itemsPOST-LICENSURE – Annual items

� What are the annual costs?

� Captive management fee

� Actuarial fee

� Audit and tax fee

� Legal fees

� Licensing fees

� Taxes

� Other 3rd party administrative fees

� What are the annual costs?

� Captive management fee

� Actuarial fee

� Audit and tax fee

� Legal fees

� Licensing fees

� Taxes

� Other 3rd party administrative fees

� What are the annual filing requirements?

� Audited financial statement

� Annual statement

� What are the annual filing requirements?

� Audited financial statement

� Annual statement

36

POST-LICENSURE –

Examinations and Governance

POST-LICENSURE –

Examinations and Governance

� By statute, captives must go through a regulatory examination at least every 5 years.

� Cost of exam varies by type.

� Pure captives typically have lower cost than risk retention groups or protected

cell captives

� Most domiciles target exams to be complete in 180 days

� Other post-licensure items to be considered

� Annual meeting within the domicile

� Director and officer elections

� Director and officer appointments / changes subject to regulatory approval

� Officers, directors, and key employees must file annual conflict of interest

disclosures with Board

� By statute, captives must go through a regulatory examination at least every 5 years.

� Cost of exam varies by type.

� Pure captives typically have lower cost than risk retention groups or protected

cell captives

� Most domiciles target exams to be complete in 180 days

� Other post-licensure items to be considered

� Annual meeting within the domicile

� Director and officer elections

� Director and officer appointments / changes subject to regulatory approval

� Officers, directors, and key employees must file annual conflict of interest

disclosures with Board 37

Questions?Questions?

BreakBreak

Daniel Head – Valley Vista Asset Management and Head Investment Partners, KnoxvilleDaniel Head – Valley Vista Asset Management and Head Investment Partners, Knoxville

39

Captive Insurance Tax UpdateCaptive Insurance Tax Update

Ben Whitehouse, Tennessee Department of Commerce & Insurance / Captive SectionBen Whitehouse, Tennessee Department of Commerce & Insurance / Captive Section

40

Its Good to be an Insurance CompanyIts Good to be an Insurance Company

� Tax treatment of an insurance company

� Insurance company can establish reserves

� Insurance premium may be deductible as a business expense

� For small companies, IRC § 831(b) election.

BUT . . . Must qualify as insurance company for

federal tax purposes

� Tax treatment of an insurance company

� Insurance company can establish reserves

� Insurance premium may be deductible as a business expense

� For small companies, IRC § 831(b) election.

BUT . . . Must qualify as insurance company for

federal tax purposes

41

Taxation of Insurance CompaniesTaxation of Insurance Companies

� Insurance companies are taxed as C corporations. See I.R.C. § 1361(b)(2)(B); 26 C.F.R. § 301.7701-2(b)(4).

� Dividends may be qualified dividends and taxed to shareholder at preferred rate.

� Corporation claims premium paid to insurance company as deductible I.R.C. §162(a) ordinary and necessary business expense. (i.e. – insured corporation doesn’t pay 21% tax on cost of premium).

� Insurance companies are taxed as C corporations. See I.R.C. § 1361(b)(2)(B); 26 C.F.R. § 301.7701-2(b)(4).

� Dividends may be qualified dividends and taxed to shareholder at preferred rate.

� Corporation claims premium paid to insurance company as deductible I.R.C. §162(a) ordinary and necessary business expense. (i.e. – insured corporation doesn’t pay 21% tax on cost of premium).

42

Taxation of Insurance CompaniesTaxation of Insurance Companies

� Insurance company only recognizes underwriting profit. I.R.C §832(b) (i.e. – no tax paid on reserves). No deduction for claims paid.

� Small insurance companies with less than $1.2 million ($2.2 million in 2017 indexed for inflation) in annual premium can elect I.R.C §831(b) status, and pay no tax on underwriting profit and are taxed only on investment income

� Insurance company only recognizes underwriting profit. I.R.C §832(b) (i.e. – no tax paid on reserves). No deduction for claims paid.

� Small insurance companies with less than $1.2 million ($2.2 million in 2017 indexed for inflation) in annual premium can elect I.R.C §831(b) status, and pay no tax on underwriting profit and are taxed only on investment income

43

Insurance Company StatusInsurance Company Status

�Risk Shifting: The insurer must take on the risk of a loss from the insured.

� There has to be a loss event (not just a variation in timing of payments)

� The insurer has to be able to lose money on the policy.

� The insurer has to be financially available to cover the loss

� Parental guarantees may defeat risk shifting.

�Risk Shifting: The insurer must take on the risk of a loss from the insured.

� There has to be a loss event (not just a variation in timing of payments)

� The insurer has to be able to lose money on the policy.

� The insurer has to be financially available to cover the loss

� Parental guarantees may defeat risk shifting.

44

Insurance Company StatusInsurance Company Status

�Risk Distribution: The risk must be spread across multiple insureds

� If the captive only insures its parent with one line of coverage, there is no risk distribution.

� A traditional insurer that insures many hundreds of insures with multiple lines of coverage has achieved risk distribution.

� IRS Guidance: 50% unrelated non-parent premiums, or 12 sister companies (none with more than 15% premium, or 31 unrelated group captive insureds (none with more than 15% of premium.

�Risk Distribution: The risk must be spread across multiple insureds

� If the captive only insures its parent with one line of coverage, there is no risk distribution.

� A traditional insurer that insures many hundreds of insures with multiple lines of coverage has achieved risk distribution.

� IRS Guidance: 50% unrelated non-parent premiums, or 12 sister companies (none with more than 15% premium, or 31 unrelated group captive insureds (none with more than 15% of premium.

45

Insurance RiskInsurance Risk

� A “true hazard.”

� A pure risk that can only result in either a loss or a neutral outcome.

� Not an investment risk which can generate either a gain, a loss, or a neutral outcome. Rev. Rul. 89-96.

� Not a “business risk.”

� Must contain some fortuity (some likelihood, but not a certainty, that a loss will occur)

� A “true hazard.”

� A pure risk that can only result in either a loss or a neutral outcome.

� Not an investment risk which can generate either a gain, a loss, or a neutral outcome. Rev. Rul. 89-96.

� Not a “business risk.”

� Must contain some fortuity (some likelihood, but not a certainty, that a loss will occur)

46

Captive Must Act like a Real Insurance

Company

Captive Must Act like a Real Insurance

Company

� Reasonable capitalization without parental guarantee.

� Reasonable premiums and reserves

� Standard investments

� Real risks

� No comingling of assets.

� Maintaining corporate formalities

� Independent operation

� Non-tax business purpose

� Reasonable capitalization without parental guarantee.

� Reasonable premiums and reserves

� Standard investments

� Real risks

� No comingling of assets.

� Maintaining corporate formalities

� Independent operation

� Non-tax business purpose

47

Tax Litigation and Rulings History of

Captives


Captives

� Helvering v. LeGierse, 312 U.S. 531 (1941) – risk shifting and risk distribution required for contract to be treated as insurance.

� Rev. Rul. 77-316, “economic family doctrine”

� Humana v. Commissioner, 881 F.2d 247 (6th Cir. 1989). Insurance contracts between “brother-sister” companies is risk shifting, but no risk shifting in contracts between “parent-child” companies.

� Helvering v. LeGierse, 312 U.S. 531 (1941) – risk shifting and risk distribution required for contract to be treated as insurance.

� Rev. Rul. 77-316, “economic family doctrine”

� Humana v. Commissioner, 881 F.2d 247 (6th Cir. 1989). Insurance contracts between “brother-sister” companies is risk shifting, but no risk shifting in contracts between “parent-child” companies.

48


Captives


Captives

� Harper Group v. Commissioner, 979 F.2d 1341 (9th Cir. 1992) Holds that captive insuring 30% “unrelated risk” sufficient to achieve risk shifting risk distribution.

� Rev. Rul. 2001-31, IRS abandons economic family doctrine, but reserves right to challenge captive transactions based on facts and circumstances.

� Harper Group v. Commissioner, 979 F.2d 1341 (9th Cir. 1992) Holds that captive insuring 30% “unrelated risk” sufficient to achieve risk shifting risk distribution.

� Rev. Rul. 2001-31, IRS abandons economic family doctrine, but reserves right to challenge captive transactions based on facts and circumstances.

49


Captives


Captives

� UPS v. Commissioner, 254 F.3d 1014 (11th Cir. 2001). Excess declared value charges on shipments ultimately sent to Bermuda-based captive. Court held that utilization of a captive did not run afoul of economic-substance doctrine and was not a sham transaction.

� UPS v. Commissioner, 254 F.3d 1014 (11th Cir. 2001). Excess declared value charges on shipments ultimately sent to Bermuda-based captive. Court held that utilization of a captive did not run afoul of economic-substance doctrine and was not a sham transaction.

50


Captives


Captives

� Rev. Rul. 2002-89

� If 90% of risks in captive come from parent, no risk shifting or distribution.

� Iess than 50% of risks in captive come from parent, risk shifting or distribution present.

� Rev. Rul. 2002-90

� Risk distribution present if there were 12 subsidiaries, each with no less than 5% and no more than 15% of the captive’s risks.

� Rev. Rul. 2002-89

� If 90% of risks in captive come from parent, no risk shifting or distribution.

� Iess than 50% of risks in captive come from parent, risk shifting or distribution present.

� Rev. Rul. 2002-90

� Risk distribution present if there were 12 subsidiaries, each with no less than 5% and no more than 15% of the captive’s risks.

51


Captives


Captives

� Rent-A-Center v. Commissioner, 142 T.C. 1 (2014); Securitas v. Commissioner, T.C. Memo 2014-225 (2014). May open the door for parent-child insurance contracts and some parental guarantees

� Rent-A-Center v. Commissioner, 142 T.C. 1 (2014); Securitas v. Commissioner, T.C. Memo 2014-225 (2014). May open the door for parent-child insurance contracts and some parental guarantees

52


Captives


Captives

� Avrahami v. Commissioner, 149 TC No. 7 (Aug. 21, 2017).

�Jewelry store owners based in Phoenix set up Nevis captive and purchased TRIA coverage.

�Court ultimately denied deductibility of premiums and 953(d) status of offshore entity.

� Inaccurate pricing of risks

�Cost of TRIA coverage procured through captive dwarfed traditional insurance buy.

�Policy exclusions were broad: “[Taxpayer’s actuary] testified that he did not know of any event in history that would have met these requirements.”

� Avrahami v. Commissioner, 149 TC No. 7 (Aug. 21, 2017).

�Jewelry store owners based in Phoenix set up Nevis captive and purchased TRIA coverage.

�Court ultimately denied deductibility of premiums and 953(d) status of offshore entity.

� Inaccurate pricing of risks

�Cost of TRIA coverage procured through captive dwarfed traditional insurance buy.

�Policy exclusions were broad: “[Taxpayer’s actuary] testified that he did not know of any event in history that would have met these requirements.”

53

The Service Is WatchingThe Service Is Watching

IR-2015-19, Feb. 3, 2015

WASHINGTON — The Internal Revenue Service today said using abusive tax shelters and structures to avoid paying taxes continues to be a problem and remains on its annual list of tax scams known as the “Dirty Dozen” for the 2015 filing season. "The IRS is committed to stopping complex tax avoidance schemes and the people who create and sell them," said IRS Commissioner John Koskinen. "The vast majority of taxpayers pay their fair share, and we are warning everyone to watch out for people peddling tax shelters that sound too good to be true.” Compiled annually, the “Dirty Dozen” lists a variety of common scams that taxpayers may encounter anytime but many of these schemes peak during filing season as people prepare their returns or hire people to help with their taxes. Illegal scams can lead to significant penalties and interest and possible criminal prosecution. IRS Criminal Investigation works closely with the Department of Justice (DOJ) to shutdown scams and prosecute the criminals behind them. . . .

Captive Insurance

Another abuse involving a legitimate tax structure involves certain small or “micro” captive insurance companies. Tax law allows businesses to create “captive” insurance companies to enable those businesses to protect against certain risks. The insured claims deductions under the tax code for premiums paid for the insurance policies while the premiums end up with the captive insurance company owned by same owners of the insured or family members.

The captive insurance company, in turn, can elect under a separate section of the tax code to be taxed only on the investment income from the pool of premiums, excluding taxable income of up to $1.2 million per year in net written premiums.

In the abusive structure, unscrupulous promoters persuade closely held entities to participate in this scheme by assisting entities to create captive insurance companies onshore or offshore, drafting organizational documents and preparing initial filings to state insurance authorities and the IRS. The 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.

Total amounts of 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 $1.2 million annually to take full advantage of the Code provision. Underwriting and actuarial substantiation for the insurance premiums paid are either missing or insufficient. The promoters manage the entities’ captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance to continue the charade.

IR-2015-19, Feb. 3, 2015

WASHINGTON — The Internal Revenue Service today said using abusive tax shelters and structures to avoid paying taxes continues to be a problem and remains on its annual list of tax scams known as the “Dirty Dozen” for the 2015 filing season. "The IRS is committed to stopping complex tax avoidance schemes and the people who create and sell them," said IRS Commissioner John Koskinen. "The vast majority of taxpayers pay their fair share, and we are warning everyone to watch out for people peddling tax shelters that sound too good to be true.” Compiled annually, the “Dirty Dozen” lists a variety of common scams that taxpayers may encounter anytime but many of these schemes peak during filing season as people prepare their returns or hire people to help with their taxes. Illegal scams can lead to significant penalties and interest and possible criminal prosecution. IRS Criminal Investigation works closely with the Department of Justice (DOJ) to shutdown scams and prosecute the criminals behind them. . . .

Captive Insurance

Another abuse involving a legitimate tax structure involves certain small or “micro” captive insurance companies. Tax law allows businesses to create “captive” insurance companies to enable those businesses to protect against certain risks. The insured claims deductions under the tax code for premiums paid for the insurance policies while the premiums end up with the captive insurance company owned by same owners of the insured or family members.

The captive insurance company, in turn, can elect under a separate section of the tax code to be taxed only on the investment income from the pool of premiums, excluding taxable income of up to $1.2 million per year in net written premiums.

In the abusive structure, unscrupulous promoters persuade closely held entities to participate in this scheme by assisting entities to create captive insurance companies onshore or offshore, drafting organizational documents and preparing initial filings to state insurance authorities and the IRS. The 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.

Total amounts of 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 $1.2 million annually to take full advantage of the Code provision. Underwriting and actuarial substantiation for the insurance premiums paid are either missing or insufficient. The promoters manage the entities’ captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance to continue the charade.

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IRC § 831(b) Revisions IRC § 831(b) Revisions

� 2015 PATH Act (tax extenders bill)

� First substantive revisions to IRC § 831(b) since 1986

� Raised premium limits from $1.2M to $2.2M (indexed for inflation) beginning January 1, 2017.

� Captive must meet primary or alternate test to qualify for IRC §831(b) status:

� 2015 PATH Act (tax extenders bill)

� First substantive revisions to IRC § 831(b) since 1986

� Raised premium limits from $1.2M to $2.2M (indexed for inflation) beginning January 1, 2017.

� Captive must meet primary or alternate test to qualify for IRC §831(b) status:

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IRC § 831(b) Revisions IRC § 831(b) Revisions

� Primary Test (Risk Diversification test): The first requirement states that no one policy holder can represent greater than 20% of the overall risk/premium. Additionally when Congress defined “policy holder” they applied the control group test to the definition. In other words, even if the Captive Owner had 5 separate operating entities each taking 20% of the risk and therefore meeting the risk part of the test, the entities would most likely fail the control group test because they are all under common control. The separate entities would be deemed 1 policyholder (not 5) therefore failing the test.

� Alternate Test (Relatedness test): If the Captive Owner cannot pass the first test, the second says that no one who is a spouse or lineal decent of a business owner can hold more than a de minimis percent (2%)of the captive over what percentage they own of the operating companies. For discussion purposes: If Father owned 70% of the Business and Son owned 30% of the Business then the Captive could only be owned 70% Father and 30% Son (or technically 68% Father and 32% Son because of the de minimis rule).

� Primary Test (Risk Diversification test): The first requirement states that no one policy holder can represent greater than 20% of the overall risk/premium. Additionally when Congress defined “policy holder” they applied the control group test to the definition. In other words, even if the Captive Owner had 5 separate operating entities each taking 20% of the risk and therefore meeting the risk part of the test, the entities would most likely fail the control group test because they are all under common control. The separate entities would be deemed 1 policyholder (not 5) therefore failing the test.

� Alternate Test (Relatedness test): If the Captive Owner cannot pass the first test, the second says that no one who is a spouse or lineal decent of a business owner can hold more than a de minimis percent (2%)of the captive over what percentage they own of the operating companies. For discussion purposes: If Father owned 70% of the Business and Son owned 30% of the Business then the Captive could only be owned 70% Father and 30% Son (or technically 68% Father and 32% Son because of the de minimis rule).

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State/Domicile TaxationState/Domicile Taxation

� Tennessee: T.C.A. § 56-13-114

� Tax of 0.4% for all premiums collected by the captive on first $20 million of premium, 0.3% on all premiums in excess of $20 million.

� Tax on all assumed reinsurance premium of 0.225% on first $20 million of reinsurance premium, 0.15% on $20-$40 million of reinsurance premium, 0.05% on $40-$60 million of reinsurance premium, 0.025% on >$60 million of reinsurance premium.

� No cascade. Reinsurance tax not applicable if premium was previously taxed on direct basis.

� Tennessee: T.C.A. § 56-13-114

� Tax of 0.4% for all premiums collected by the captive on first $20 million of premium, 0.3% on all premiums in excess of $20 million.

� Tax on all assumed reinsurance premium of 0.225% on first $20 million of reinsurance premium, 0.15% on $20-$40 million of reinsurance premium, 0.05% on $40-$60 million of reinsurance premium, 0.025% on >$60 million of reinsurance premium.

� No cascade. Reinsurance tax not applicable if premium was previously taxed on direct basis.

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State/Domicile TaxationState/Domicile Taxation

� Minimum premium tax of $5,000.

� Maximum premium tax of $100,000.

� Protected cell captives with more than 10 cells have minimum premium tax of $10,000 and maximum premium tax of up to $200,000.

� Insurance companies pay no Tennessee franchise and excise tax on their assets. T.C.A. § 67-4-2008(a)(14).

� Minimum premium tax of $5,000.

� Maximum premium tax of $100,000.

� Protected cell captives with more than 10 cells have minimum premium tax of $10,000 and maximum premium tax of up to $200,000.

� Insurance companies pay no Tennessee franchise and excise tax on their assets. T.C.A. § 67-4-2008(a)(14).

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Premium Tax HolidayPremium Tax Holiday

� Premium tax holiday applicable to ALIEN captives only.

� Tax intended to defray costs of redomestication from overseas.

� To be eligible, company must use Tenn. Code Ann. § 56-13-123 redomesticationprocedure.

� Eligible company files premium tax return as standard, but may elect to defer payment of premium tax in either first or second year in Tennessee.

� Companies that elect to defer must stay in business and not redomesticate for 5 years, or will owe foregone premium tax plus 10% interest.

� Premium tax holiday applicable to ALIEN captives only.

� Tax intended to defray costs of redomestication from overseas.

� To be eligible, company must use Tenn. Code Ann. § 56-13-123 redomesticationprocedure.

� Eligible company files premium tax return as standard, but may elect to defer payment of premium tax in either first or second year in Tennessee.

� Companies that elect to defer must stay in business and not redomesticate for 5 years, or will owe foregone premium tax plus 10% interest.

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Tennessee Self Procurement TaxTennessee Self Procurement Tax

� Tenn. Code Ann. § 56-2-411 revised in 2015 to apply to “citizens of this state procuring and holding insurance contracts or policies on the types of coverage listed in § 56-2-201 upon property situated or located in this state in companies not authorized to transact business in this state.”

� Taxed at surplus lines rate (5%).

� Tenn. Code Ann. § 56-2-411 revised in 2015 to apply to “citizens of this state procuring and holding insurance contracts or policies on the types of coverage listed in § 56-2-201 upon property situated or located in this state in companies not authorized to transact business in this state.”

� Taxed at surplus lines rate (5%).

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TN Self Procurement Tax ForgivenessTN Self Procurement Tax Forgiveness

� Tenn. Code Ann. § 56-13-114(i). Tax forgiveness for all past unreported § 56-2-411 self-procurement taxes on policies procured from a foreign or alien captive if that captive redomesticates to Tennessee by Dec. 31, 2018.

� Narrow exception for a partial redomestication

� Lines in new TN captive must be similar to lines placed in foreign/alien captive

� TN captive must maintain $15M in capital and $30M of annual premium.

� Exception covers large multinational companies with significant operations in Tennessee.

� Tenn. Code Ann. § 56-13-114(i). Tax forgiveness for all past unreported § 56-2-411 self-procurement taxes on policies procured from a foreign or alien captive if that captive redomesticates to Tennessee by Dec. 31, 2018.

� Narrow exception for a partial redomestication

� Lines in new TN captive must be similar to lines placed in foreign/alien captive

� TN captive must maintain $15M in capital and $30M of annual premium.

� Exception covers large multinational companies with significant operations in Tennessee.

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Questions?Questions?

QUESTIONS

Contacts and Resources

QUESTIONS

Contacts and Resources

� Adam Forstot, USA Risk Group [email protected] 800-872-7475

� Bill Buechler, CPA, Crowe Horwath LLP [email protected] 615-630-5530

� Rosemary Wickham FCAS, MAAA, Merlinos & Associates [email protected] 678-684-

4844

� Alex Renfro, Anjo LLC & 3 Star Insurance LLC [email protected] 214-734-3330

� Ben Whitehouse, Asst. General Counsel, Tennessee DOI / Captive Section

[email protected] 615-741-2616

� PDFs of today’s presentations will be posted at www.ddwmwealth.com and www.hip3.net . Links to those files will be sent to the email addresses of all attendees.

� Adam Forstot, USA Risk Group [email protected] 800-872-7475

� Bill Buechler, CPA, Crowe Horwath LLP [email protected] 615-630-5530

� Rosemary Wickham FCAS, MAAA, Merlinos & Associates [email protected] 678-684-

4844

� Alex Renfro, Anjo LLC & 3 Star Insurance LLC [email protected] 214-734-3330

� Ben Whitehouse, Asst. General Counsel, Tennessee DOI / Captive Section

[email protected] 615-741-2616

� PDFs of today’s presentations will be posted at www.ddwmwealth.com and www.hip3.net . Links to those files will be sent to the email addresses of all attendees.

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Captive Insurance 101 - ddwmwealth.com · A captive insurance company is a subsidiary of its Parent...

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