Presenting a live 90-minute webinar with interactive Q&A Captive Insurance Companies: Risk Management Entity for Businesses Evaluating Business Uses and Legal Risks, Addressing Tax Implications, and Avoiding Regulatory Pitfalls WEDNESDAY, JULY 18, 2012 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific Today’s faculty features: F . Hale Stewart, Owner, The Law Office of Hale Stewart , Houston Jay D. Adkisson, Partner, Riser Adkisson , Newport Beach, Calif. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10 .
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A Primer on Captive Insurance And How to Structure Captive Insurance Transactions F. Hale Stewart, JD, LLM, CTEP, CWM, CAM Author of the book U.S. Captive Insurance Law Captiveinsuranceinfo.com 832-330-4101 5
Who Should Form A Captive? A company that has an above-average risk profile. A company or individual with the financial resources to contribute to the captive. Finally, a company should have a good combination of income and risk ◦ Ideally, a company should have $3 million in gross revenue ◦ But a company that has $1-$3 million may have enough risk to warrant looking at a captive. ◦ Please call if you have questions 6
What Companies Are More Likely to Benefit From a Captive Doctors and other professionals Manufacturers Exporters and Importers Dry Cleaning Construction Related Professions ◦ Contractors ◦ HVAC ◦ Plumbing Oil and Gas Hotels, Motels, Restaurants and Inns Transportation Companies 7
What Are the Benefits of Forming A Captive? • Custom Insurance Policies – The Beech Case – Using Individual loss experience in determining insurance rates • Gives the insured negotiating leverage with third party insurers – Third party insurer insures standard risk – The captive underwrites specialty risk • Captives can be used as wealth transfer vehicles • Small Insurance Companies are Taxed Advantaged – 831(b) 8
What Are the Benefits to Forming a Captive, con’t ? • Underneath the insurance and risk management purposes of a captive insurance company is a great tax arbitrage opportunity. – In the current year, the insured lowers his taxable income through the payment of insurance premiums. In forming the captive, the insured is most likely insuring a large amount of risk which was previously “self - insured,” meaning the insured paid for losses out of current earnings and savings. – The premiums are placed into a tax-advantaged vehicle – remember that small insurance companies are taxed on their current portfolio income rather than their current earnings. – When the insured sells his captive shares, the transaction is taxed as a capital gains transaction rather than as an ordinary income transaction. 9
What Are the Steps to Forming a Captive? • After a company decides to form a captive, the next step is to perform a feasibility study, which has three objectives. – It provides a blueprint for the entire captive program. – Second, it aids in compliance. – Third, the study can aid in selling important decision-makers within the organization on the plan. 10
What Are the Steps to Forming a Captive? The jurisdiction where the captive is being formed must determine if forming the captive is in the jurisdiction’s best interest. To do that, they will consider ◦ (i) The character, reputation, financial standing and purposes of the incorporators; ◦ (ii) The character, reputation, financial responsibility, insurance experience and business qualifications of the officers and directors; and ◦ (iii) Such other aspects as the commissioner shall deem advisable. 11
What Are the Steps in Forming a Captive, con’t • Next, the applicant must make a formal application to open an insurance company. The application must typically contain the following information – (A) The amount and description of its assets relative to the risks to be assumed; – (B) The adequacy of the expertise, experience, and character of the person or persons who will manage it; – (C) The overall soundness of its plan of operation; – (D) The adequacy of the loss-prevention programs of its parent, member organizations, or industrial insureds, as applicable; and – (E) Other factors considered relevant by the commissioner in ascertaining whether the proposed captive insurance company will be able to meet its policy obligations • Finally, there is the issue of original capital and surplus. 12
Running the Captive • Domicile manager • Legal counsel • Accounting/Audit • Actuarial Services • Investment manager 13
Shutting Down the Captive In most states, one of the following seven reasons will allow a state regulator to shut down a captive: ◦ 1. Insolvency or impairment of capital and surplus. ◦ 2. Refusal or failure to submit an annual report … or any other report or statement required by law or by lawful order of the director. ◦ 3. Failure to comply with the provisions of its own articles of incorporation, bylaws or other organizational document. ◦ 4. Failure to submit to an examination or any legal obligation related to the examination. ◦ 5. Refusal or failure to pay the cost of an examination. ◦ 6. Use of methods that, although not otherwise specifically prohibited by law, render its operation hazardous or its condition unsound with respect to the public or to its policyholders. ◦ 7. Failure otherwise to comply with the captive statute. 14
The IRS Fought Captive Insurance For Nearly 30 Years • They used three arguments – The Economic Family – Nexus of Contracts – Assignment of Income • No Court Accepted Any of the IRS’ arguments 15
Safe Harbor Guidance, Part I • Under Harper, a captive must comply with a three prong test: – (1) whether the arrangement involves the existence of “insurance risk”; – (2) whether there was both risk shifting and risk distribution; and – (3) whether the arrangement was for “insurance” in its commonly accepted sense. • The duck test – does the company “walk and talk” like an insurance company? 16
Safe Harbor Guidance, Part II The IRS has issued several Revenue Rulings that provide further safe harbor guidance A captive must derive at least 50% of its insurance revenue from a non-parent. ◦ Harper lowers this amount to 30% ◦ This is accomplished through reinsurance Or, a captive must have at least 12 subsidiaries in order to have sufficient risk distribution. 17
Private Letter Rulings, or, the Ultimate Safe Harbor • A Private Letter Ruling (or PLR) is "issued for a fee upon a taxpayer's request and describes how the IRS will treat a proposed transaction for tax purposes." • Private Letter Rulings create certainty – we know how the IRS will view a specific transaction 18
Staying Within the Law; Captive Insurance and Anti-Avoidance Law 19
What is Anti-Avoidance Law? • Generally, anti-avoidance law is a series of common law doctrines that prevent a taxpayer from manipulating the tax code and/or transactions in such a way as to bastardize congressional intent. • For example, a corporate reorganization is a tax-free event. Therefore, taxpayers will try to make a transaction look like a reorganization when in fact it is not. 20
For Example • A corporate reorganization must meet the following requirements: – There must be a plan of reorganization – The plan must meet the continuity of interest and business enterprise tests. – There must be a sound business purpose (the business purpose test). • If a “reorganization” does not meet these requirements, a court can strip the taxpayers of their tax-free treatment. 21
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