Title Slide

JUN 8 – 10, 2015

www.bermudacaptive.bm

Intercompany Loans: Intercompany Loans: Why or Why Not?Why or Why Not?

Intercompany Loans: Why or Why Not?

Speakers:

• Dawne Davenport, Actuarial Consultant & Vice President, Marsh Captive Solutions

• Richard Irvine, Partner - Tax, PwC

• Donald Thorpe, Senior Director, Fitch Ratings

Moderator:

• Ryan Sulley, Assistant Vice President, Marsh Captive Solutions

Captive Investment Portfolios

Source: Marsh Captive Solutions 2014 Benchmarking Survey

Many Perspectives

Corporate Governance Perspective

• Board approval of loans – Standing credit agreement– Approve each loan

• What is the value of an intercompany loan to the parent company?

• Loans versus dividends

Regulatory Perspective

• Are such transactions a form of self-dealing?

• Most captive regulators are comfortable with intercompany loans

Bottom line: Regulators want assurance that sufficient cash is available to pay claims when they come due

Bermuda Specific:

- Is an Admitted Asset, but not a Relevant Asset

- Relevant Asset approval (Regulation 11)

Accounting Perspective

- Credit worthiness of the affiliate company (i.e. is the loan collectable?)

- Effective interest rates

Investment Perspective

US Treasury Yield 30 Years

Source: Yahoo Finance

Consider whether:

•The loan represents bona fide indebtedness

•The loan is permitted by domicile statutes/regulators

•Timely repayment permits the captive to meet its anticipated liquidity needs

•It is commercially reasonable to expect the loan to be paid back in accordance with its terms

CICA Perspective

• Fitch links the captive’s rating to the sponsoring parent’s rating

• Liquidity to pay claims

• Analytical considerations:– Type of risk– Loan terms– Other sources of liquidity

A Credit Analyst’s Perspective

• Captive’s rating ≤ parent’s rating (single parent captives)

• Need a credit opinion of the parent– Captive has one owner– Captive has one (or few) insured(s)– Intercompany loans may be a material asset

• By their nature, captive insurers have concentrated risk– Intercompany loans tend to intensify this risk

Captive’s Rating Linked to Parent’s

• Key Question: How will the captive pay its claims?– Normal claim levels– Unexpectedly high claim levels

• Are there scenarios where the captive fails to pay claims even though the sponsor has not defaulted on the loan?– If so, then the intercompany note could cause the captive’s

rating to be lower

Impaired Liquidity is the Core Risk

• Fronting arrangements

• Nature of the claim– Property

• Paid to captive sponsor• Can be subject to large, unexpected losses (i.e., cats)

– Liability• Paid to third parties• Often longer-tailed and more predictable

• Sponsor’s liquidity

Other Considerations

• Note terms are critical– Demand notes– Ranking– Ability to net payments

• Other potential sources of liquidity– Reinsurers– Letters of credit

Other Considerations (continued)

• There is no US tax law guidance which specifically prohibits an “affiliated asset” between a captive insurance company and affiliated party (a.k.a., loanback)

• The Internal Revenue Service in “unofficial statements” have indicated they believe a loanback could negate a captive insurance transaction because– a loanback negates “risk shifting”– a loanback results in a “circular flow of cash”, – a loanback fails “common notions of insurance”, or– a loanback is part of a “sham” transaction

• The IRS in a number of public revenue rulings have concluded favorably on a captive insurance transaction where the specific facts in the rulings indicated “no loanbacks”.– Revenue Rulings 2002-89, 2002-90, 2002-91 and 2005-40

Intercompany Loans – US Tax Landscape

• The IRS sought comments on loanbacks in Notice 2005-49 where the CICA/VCIA commented that an otherwise valid insurance arrangement which otherwise satisfied the requisite criteria for deductibility should not be negated due to a loanback and the Service should consider all facts and circumstances, including:– Whether the loans represent bona fide indebtedness, which is

enforceable by their terms and which contains commercially reasonable terms;

– Whether the loans are permitted by the statutes or regulatory authorities of the insurance company’s domicile;

– Whether the timely repayment of the indebtedness, together in the insurance company’s other resources, permits the insurance company to meet its anticipated liquidity needs; and

– Whether, taking into account the solvency of, and security (if any) provided by, the debtor, it is commercially reasonable to expect the loans to be repaid in accordance with their terms.

Intercompany Loans – US Tax Landscape

• Rent-a-Center, Inc. and Affiliated Subsidiaries v. Commissioner (01/14/2014)– First tax case to address the implications of a related party asset– Captive invested in Treasury Shares of the Parent Company

• Treasury Shares were approved by the Bermuda Monetary Authority as a Relevant Asset

– IRS asserted a “circlular flow of cash but court found no evidence was present

– IRS asserted a sham transaction (in general) and the Court did not agree

– Court found no reason why the Treasury Shares should not be considered a “good” asset

• Dissenting opinion concluded the captive was undercapitalized if you disregarded the Treasury Shares

– Treasury Shares were valued at $108m

Intercompany Loans – US Tax Landscape

• “Lipstick on a pig, its still a pig but looks better”– All loanbacks should be evidenced by common commercial

documentation– All loanbacks should be entered into at “arms length”– All loanbacks should be respected, e.g., stated terms and conditions

met– Borrower’s ability to pay– Try to avoid significant loanbacks to insureds– Board of Directors of the Captive should apply appropriate “due

dilligence” in evaluating the loanback– Asset/liability matching should be documented– Cash flow needs of the captive should be documented– Explicit regulatory approval is a “plus”

Intercompany Loans – US Tax Landscape