15 Slide
This document was uploaded by user and they confirmed that they have the permission to share it. If you are author or own the copyright of this book, please report to us by using this DMCA report form. Report DMCA
Overview
Download & View 15 Slide as PDF for free.
More details
- Words: 3,478
- Pages: 57
TYPES OF CAPTIVES • Captive insurers represent a special case of risk retention, and, in some instances, risk transfer. •
A captive insurance company is an entity created and controlled by a parent, whose main purpose is to provide insurance to that parent.
•
Within the context of this definition, two types of organizations may be considered. 1.
Pure captives
2.
Association or group captives 15-1
Pure Captives • A pure captive is an insurance company established by a non-insurance organization solely for the purpose of underwriting risks of the parent and its affiliates. • "Captive" does not include insurance subsidiaries whose purpose is to write insurance for the general public (e.g., Sears Roebuck subsidiary Allstate, or J. C. Penney Insurance Company. 15-2
Association Captives • An association or group captive is an insurance company established by a group of companies to underwrite their own collective risks. •
These organizations are also sometimes referred to as "trade association insurance companies”(TAICs) and also as "risk retention groups."
• The term "risk retention group" was added to the terminology of captive field by the Risk Retention Acts of 1981 and 1986. 15-3
Pools • A risk sharing pool represents a mechanism that is closely related to and sometimes confused with the association or group captive, but which is actually a separate technique. • A group of entities may elect to pool their exposures, sharing the losses that occur, without creating a formal corporate insurance structure. •
In this case, a separate corporate insurer is not created, but the risks are nevertheless "insured" by the pooling mechanism. 15-4
Pools • Many authorities believe that pooling is appropriately classified as either transfer or retention, depending on the situation. •
In one sense, pooling is a form of transfer, in the sense that risks of the pooling members are transferred from the individuals to the group.
•
In another sense, it is a form of retention, in which the organization's risks are retained, along with those of the other pooling members. 15-5
Captive Domiciles • Captives have traditionally been classified as onshore or offshore. •
An onshore captive is incorporated domestically and conducts business in the United States.
•
An offshore captive is incorporated in a foreign jurisdiction and operates from that location, but it may still primarily insure U.S. risks.
•
Usually, foreign captives operate under the surplus line laws of the states. 15-6
Captive Domiciles The domiciles with the largest numbers of captives included Bermuda the Cayman Islands the Isle of Guernsey the State of Vermont Luxembourg
15-7
Domestic Captives • A domestic captive can be organized as an insurance company under the same state laws as other insurance companies. •
Under this approach, however, the captive is subject to the same capital and surplus requirements and other regulations as any other insurer.
15-8
Growth of Captives • The thirty-five year period from 1960 to 1995 witnessed a phenomenal growth in the number of captives worldwide. •
From a hundred or so in the late 1950s, the number of captives licensed worldwide at the end of 1995 was 3,199.
•
By 1995, it was estimated also that over half of the Fortune 500 companies have established captives. 15-9
A Brief History of Captives • The earliest captives were organized by the railroads in the 1800s. • The late 1800's saw a revolt of New England textile manufacturers against the rigid fire insurance rates of the time. • The Church Insurance Co., possibly the first group captive, was formed by the Episcopal Church in 1929.
15-10
A Brief History of Captives • During the 1950s, there was a modest increase in the number of captives, mainly by U.S. companies in the process of transformation to multinational corporations. • Another expansion in the number of captives occurred in the 1960s, this time motivated by a shortage of property insurance owing to the insurance cycle. • A major growth in captives occurred in the 1970s, as a result of restrictions in the market for medical malpractice insurance. 15-11
Reasons for Growth of Captives • The reasons for the phenomenal growth in captives during the past 30 years are complex. •
Basically, they include a failure of the established insurance market to adjust rapidly enough to increasingly sophisticated risk financing needs of insurance users.
15-12
Reasons for Growth of Captives • The motivation for the expansion of captives during the period of the 1950s through the 1980s was a perceived failure of the traditional insurance market to meet consumers need for coverage. •
A secondary motivation was the belief that certain tax benefits were available through captives that could not be attained under a retention program. 15-13
Reasons for Growth of Captives • Tax considerations • Inability to obtained needed coverage • Desire to reduce insurance costs • Desire to improve cash flow • Desire to create a profit center • Need to move capital in international markets
15-14
Tax Considerations • Premiums paid to commercial insurers qualify as tax deductions because they represent ordinary and necessary business expenses. • The IRS has persistently refused to recognize contributions to a self-insurance reserve as a deductible expense. •
Some captives were formed in the belief that a tax deduction not available for self-insurance would be granted for payments to a captive. 15-15
Tax Considerations • Although the IRS has generally disallowed a deduction for premiums paid to a captive insurer by its parent, there are exceptions. •
Premiums paid to a captive may, under very specific and limited circumstances, be deductible by the parent corporation
15-16
Inability to Obtain Coverage 1. The most difficult lines of coverage have been product liability, professional medical liability, architects and engineers and accountants, pollution liability, and liability insurance for municipalities, petroleum operations, and certain hazardous contractor exposures. 2. Coverage is available, but at an enormous price. 3. There are some exposures for which the traditional market has never provided coverage at all, or any reasonable size market. 15-17
Lower Expense Ratio • The anticipated savings from the use of captives are the same as those expected from other forms of retention. • These include the elimination or reduction of the expense component in insurance premiums. • Premium taxes and acquisition cost savings can produce a direct saving or from about 5 percent to as much as 15 percent of premiums.
15-18
Desire to Improve Cash Flow • Insurance buyers have always recognized that insurers enjoyed a cash flow benefit arising from the timing of the payment of premiums it received and the time at which those premiums were paid out in losses. • Some captives have been formed to gain the advantage of the cash flow associated with the timing of premium payments and loss payments.
15-19
Cash Flow • Thirty years ago, the bulk of property and liability insurer reserves consisted of unearned premium reserves, the reserves representing the unexpired terms of the policies in force. • Over time, the composition of reserves has shifted. •
With the growth in litigation, loss reserves, especially on casualty lines such as liability and workers compensation came to dominate insurer’s balance sheets. 15-20
Cash Flow • Whereas the turnover in unearned premium reserves was fairly rapid and occurred on schedule, the reserves for unpaid losses compound, as each year’s unpaid losses are added to the unpaid losses of earlier years. •
The growth in loss reserves created cash flows of a new magnitude which, combined with record level interest rates created a package too appealing for some companies to resist. 15-21
A New Profit Center • Hundreds of captives have developed into insurance and reinsurance companies that write the exposures of parties other than their parent. • Such captives are generally referred to as profit center captives or as broad captives. • It is doubtful that this has been the prime motivator for the formation of any captives, but it is a benefit that supports other reasons for captive formation. 15-22
Move Capital in International Markets • Another benefit of a captive is the ability to move money in international markets. •
Exchange controls and restrictions on currency convertibility do sometimes occur and a captive insurer serves as a means through which these restrictions can be bypassed.
• A captive provides a means of moving money from one county to another by accepting payments from its parent in the foreign currency. 15-23
Taxation of Captives • The taxation of captive insurance companies has been a source of contention between captive owners and the IRS almost from the inception of the captive concept. • The disagreement has concerned both the taxation of the captive's income, and the deductibility of the premiums paid by the parent to the captive. 15-24
Taxation of Captives • Initially, offshore captives were a source of concern to the IRS, because of the foreign income aspect, which permitted a captive to retain untaxed income in a foreign jurisdiction. • In addition, the IRS objected to the deduction of what it considered to be essentially loss reserves in a retention (self-insured) program.
15-25
Deductibility of Premiums The IRS position since 1972 has been: • A captive is an insurance company in form only, not substance. • Since there is no shifting of risk and no loss of control of the premiums, the premiums paid to a captive are self-insurance reserves and not deductible. • The captive has been formed primarily for the purpose of tax avoidance and therefore premiums to it are not deductible. 15-26
Revenue Ruling 77-316. •
Revenue Ruling 77-316 was issued on August 29, 1977, and formalizes the position taken by the IRS in 1972.
•
It specifically disallows deductibility of insurance premiums paid by a domestic corporation to its insurance subsidiary.
15-27
Revenue Ruling 77-316. 1. The parent places insurance with the subsidiary, which retains 100% of the risk. None of the premium is deductible. 2. The parent places insurance with an unrelated domestic insurer, which passes 95% of the risk to the parent's subsidiary. Only the premium charged by the fronting company for retaining 5% of the risk is deductible. 3. The parent places insurance directly with the captive, which reinsures 90% of the risk with an unrelated insurer. The premium paid for the reinsurance is deductible. 15-28
Revenue Ruling 78-338, IRB 38,6 • Gives approval of so-called "association captives." The insurer in question was owned by 30 shareholders, none of which controlled the company or contributed more than 5% of its total premiums. •
A large number of insureds creates a true element of insurance through spreading of risk.
15-29
Revenue Ruling 78-277, 1978 IRB 29,9 • In this ruling, the IRS indicated that a captive's assumption of outside risks is a factor in the tax-payer's favor, permitting deductibility of premiums paid by the parent company. •
The percentage of outside risks that must be assumed has not been prescribed by the IRS.
15-30
Opposition to IRS Position • In spite of the firm stance on the point by the IRS, many U.S. corporations feel that the IRS position is incorrect. • They argue that the IRS is wrong in failing to recognize an offshore captive as a separate legal entity and that a properly structured captive—i.e., distinct and separate from its parent and with sufficient assets and capitalization to carry on its business and meet its liabilities—will eventually rebut the IRS position. 15-31
Court Support for IRS Position The IRS position on deductibility of premiums to a single-parent captive has been upheld by the courts in Carnation Company v. Commissioner of IRS, and in Clougherty Packing Company versus Commissioner of IRS. 15-32
1991 Victory For Captives • In 1991, the U.S. Tax Court ruled in three separate but related cases that companies may deduct premiums paid to their captive subsidiaries. The three related cases were brought by • Harper Group, which owns Rampart Insurance Co., • Sears, Roebuck & Co., which owns Allstate Insurance Co., and • Amerco Co., which owns Republic Western Insurance Co. 15-33
1991 Victories for Captives • The companies argued that taking business deductions for premium payments to their captive subsidiaries was legitimate because the captive insurers were bonafide companies that did business with other unaffiliated companies. • The Internal Revenue Service argued that a corporate parent and its units constitute a single economic unit and there can be no shifting of risk. 15-34
1991 Victories for Captives The Tax court rejected the IRS's position • The effect of the court’s ruling is that captive owners may deduct premiums from their federal income taxes if the captives write relatively large amounts of business for unrelated or third part y business. • The captive must be a separate insurance company, regulated by insurance laws, and have sufficient premium income or retained earnings to pay losses. 15-35
Taxation of Captive Income - TRA-86 • Although premiums paid to single-parent captives are nondeductible, the exceptions permitted for group-owned captives created a tax loophole for off-shore association captives that was not addressed until the Tax Reform Act of 1986. • Prior to TRA-86, the income of an offshore captive derived from premiums on U.S. exposures was taxed under complicated rules applicable to a "controlled foreign corporations" (CFC). 15-36
Taxation of Captive Income - TRA-86 • Although the law defined a CFC as one in which 25% of the shareholders were U.S. residents, only shareholders owning 10% or more of the foreign corporation were counted in making the determination. • This meant that an offshore captive owned by 20 participants, each with 5% of the stock, was not classed as a CFC and escaped taxation of its income, even though the parent recognized a deduction for the premiums paid to the captive. 15-37
Taxation of Captive Income - TRA-86 • This means that under prior law, the owners of an off-shore captive could defer payment of taxes on the captive’s profits until actual receipt, if their ownership in the captive was less than 25 percent. • Under the new law, regardless of the percentage of ownership, the profits of the captive are imputed to the shareholders and are currently taxable, whether they are paid out or not.
15-38
State and Foreign Income Taxes. • A domestic corporation will be subject to any applicable state income taxes. • State income taxes normally do not apply to a foreign corporation.
15-39
State Premium Taxes • In general, premiums paid to off-shore, nonadmitted insurers are not subject to state premium taxes if all negotiations and activities associated with obtaining and signing the policy are conducted offshore. • Captives licensed to do business in a particular state are subject to the state’s premium tax. • When the captive is not subject to the premium tax because it is not licensed, an excess and surplus line premium tax may apply. 15-40
Federal Excise Tax • Section 4371 assesses a 4% tax on premiums (except life insurance) written directly to most foreign insurers. • There is also a 1% tax on premiums ceded (reinsured) with foreign carriers. • The excise tax is levied on the insured rather than the insurer, but it is in lieu of the U.S. income taxes the foreign carrier would incur if it operated a business in the U.S. 15-41
Structuring The Captive There are three choices concerning the corporate structure of a captive insurance company: stock, mutual reciprocal
15-42
Captive Management Companies • During the past 30 years, there has been a growing number of brokers and consultants who have established captive management firms. •
This relieves the parent of a captive of the need to assemble the technical competence required for the management of the captive.
15-43
Feasibility Studies • A detailed feasibility study is usually made before setting up any captive insurer. • Such studies may be made by internal staff, brokers with captive experience, captive management firms, or by independent consultants. • Most of the larger brokers and captive company management firms have expertise and knowledge regarding captives. 15-44
Fronting Company Arrangements • In some lines of insurance, especially workers compensation and often auto liability, coverage must be written by an insurer licensed in the state where the coverage is provided. • This means that an unlicensed captive can not write these lines directly. Owners of captives can, however, use the captive to reinsure a licensed company.
15-45
Fronting Company Arrangements • A fronting company is an insurance company that is unrelated to the captive and which takes all of the risk and reinsures it 100% (or substantially, say 90% or 95%) according to the requirements of the law in the country or state in which the risk is located. • Although the exposure is reinsured with the captive, the fronting company is contractually liable to the insureds, and if the captive cannot meet its obligations, the fronting company must nevertheless pay incurred losses. 15-46
Captives as Reinsurers • Captive insurers sometimes function as reinsurers, taking a part of the risk written by other insurance companies. • In some cases, the reinsurance arrangement involves the parent company's risk, which is written by a "fronting" company (discussed above) and then reinsured with the captive.
15-47
Rent-A-Captive • The other side of fronting involves the recipient of the program, the rent-a-captive operations, usually domiciled in an offshore location. • Sometimes, captive find that they are not operating on a cost-efficient basis, because they are not maximizing the use of surplus or spreading administrative costs over large premium base.
15-48
Rent-A-Captive • One solution, implemented by a number of captive owners has been to increase the volume of business written by their offshore captive by soliciting outside business.
• An easy way to do this was to offer the captive to other firms that either did not want to make the capital contribution required to form an offshore captive, or who found it difficult to justify creation of their own captive. 15-49
The Risk Retention Act of 1986 • The Risk Retention Act of 1986 amended the Product Liability Risk Retention Act of 1981. • The 1981 act was passed to provide relief for insurance buyers during the product liability crisis of the late 1970s, and was limited to products exposures. • The 1986 law expanded the provisions of the law to apply to most liability coverages. (Workers compensation, employers liability, and personal risks are excluded from the new law). 15-50
Risk Retention Act of 1986 Like its predecessor, the Risk Retention Act of 1986 authorized two mechanisms for group treatment of liability risks:
1. Risk retention groups for self-funding (pooling) and 2. Purchasing groups for joint purchase of insurance
15-51
Risk Retention Groups • A risk retention group is essentially a groupowned insurer whose primary activity consists of assuming and spreading the liability risks of its members. • They are insurance companies, regularly licensed in the state of domicile, and owned by their policyholders who, in effect, double as shareholders. 15-52
Risk Retention Groups • The members are required to have a community of interest (i.e., similar risks) and once organized, they can offer "memberships" to others with similar needs on a nationwide basis. • A risk retention group need be licensed in only one state, but may insure members of the group in any state. •
The jurisdiction in which it is chartered regulates the formation and operation of the group insurer. 15-53
Risk Retention Groups and Insolvency Funds • Risk retention groups are prohibited from joining the state insolvency guaranty fund. • In the event of insolvency of a risk retention group, there is no source of recovery other than the assets of the group. • Policies issued by risk retention groups are usually required to include a statement about the absence of protection under the state insolvency fund. 15-54
NOTICE This policy is issued by your risk retention group. Your risk retention group may not be subject to all of the insurance laws and regulations of your state. State insurance insolvency guaranty funds are not available for your risk retention group.
15-55
Requirement For Success • Elements in the successful operation of a risk retention group are basically the same as the requirements for the successful operation of any insurance mechanism. • In addition, there must be a willingness on the part of the participants to share risks with others in the pool. • This means, among other things, that the group must exercise selectivity in the choice of its members. 15-56
Purchasing Groups • A "purchasing group" is a legal entity which purchases insurance for its members. •
Like participants in risk retention groups, members of purchasing groups must be in similar or related businesses which exposure them to similar liability risks.
•
However, unlike a risk retention group, a purchasing group does not retain risk.
•
Rather, it purchases group liability insurance from insurance companies for its members. 15-57
A captive insurance company is an entity created and controlled by a parent, whose main purpose is to provide insurance to that parent.
•
Within the context of this definition, two types of organizations may be considered. 1.
Pure captives
2.
Association or group captives 15-1
Pure Captives • A pure captive is an insurance company established by a non-insurance organization solely for the purpose of underwriting risks of the parent and its affiliates. • "Captive" does not include insurance subsidiaries whose purpose is to write insurance for the general public (e.g., Sears Roebuck subsidiary Allstate, or J. C. Penney Insurance Company. 15-2
Association Captives • An association or group captive is an insurance company established by a group of companies to underwrite their own collective risks. •
These organizations are also sometimes referred to as "trade association insurance companies”(TAICs) and also as "risk retention groups."
• The term "risk retention group" was added to the terminology of captive field by the Risk Retention Acts of 1981 and 1986. 15-3
Pools • A risk sharing pool represents a mechanism that is closely related to and sometimes confused with the association or group captive, but which is actually a separate technique. • A group of entities may elect to pool their exposures, sharing the losses that occur, without creating a formal corporate insurance structure. •
In this case, a separate corporate insurer is not created, but the risks are nevertheless "insured" by the pooling mechanism. 15-4
Pools • Many authorities believe that pooling is appropriately classified as either transfer or retention, depending on the situation. •
In one sense, pooling is a form of transfer, in the sense that risks of the pooling members are transferred from the individuals to the group.
•
In another sense, it is a form of retention, in which the organization's risks are retained, along with those of the other pooling members. 15-5
Captive Domiciles • Captives have traditionally been classified as onshore or offshore. •
An onshore captive is incorporated domestically and conducts business in the United States.
•
An offshore captive is incorporated in a foreign jurisdiction and operates from that location, but it may still primarily insure U.S. risks.
•
Usually, foreign captives operate under the surplus line laws of the states. 15-6
Captive Domiciles The domiciles with the largest numbers of captives included Bermuda the Cayman Islands the Isle of Guernsey the State of Vermont Luxembourg
15-7
Domestic Captives • A domestic captive can be organized as an insurance company under the same state laws as other insurance companies. •
Under this approach, however, the captive is subject to the same capital and surplus requirements and other regulations as any other insurer.
15-8
Growth of Captives • The thirty-five year period from 1960 to 1995 witnessed a phenomenal growth in the number of captives worldwide. •
From a hundred or so in the late 1950s, the number of captives licensed worldwide at the end of 1995 was 3,199.
•
By 1995, it was estimated also that over half of the Fortune 500 companies have established captives. 15-9
A Brief History of Captives • The earliest captives were organized by the railroads in the 1800s. • The late 1800's saw a revolt of New England textile manufacturers against the rigid fire insurance rates of the time. • The Church Insurance Co., possibly the first group captive, was formed by the Episcopal Church in 1929.
15-10
A Brief History of Captives • During the 1950s, there was a modest increase in the number of captives, mainly by U.S. companies in the process of transformation to multinational corporations. • Another expansion in the number of captives occurred in the 1960s, this time motivated by a shortage of property insurance owing to the insurance cycle. • A major growth in captives occurred in the 1970s, as a result of restrictions in the market for medical malpractice insurance. 15-11
Reasons for Growth of Captives • The reasons for the phenomenal growth in captives during the past 30 years are complex. •
Basically, they include a failure of the established insurance market to adjust rapidly enough to increasingly sophisticated risk financing needs of insurance users.
15-12
Reasons for Growth of Captives • The motivation for the expansion of captives during the period of the 1950s through the 1980s was a perceived failure of the traditional insurance market to meet consumers need for coverage. •
A secondary motivation was the belief that certain tax benefits were available through captives that could not be attained under a retention program. 15-13
Reasons for Growth of Captives • Tax considerations • Inability to obtained needed coverage • Desire to reduce insurance costs • Desire to improve cash flow • Desire to create a profit center • Need to move capital in international markets
15-14
Tax Considerations • Premiums paid to commercial insurers qualify as tax deductions because they represent ordinary and necessary business expenses. • The IRS has persistently refused to recognize contributions to a self-insurance reserve as a deductible expense. •
Some captives were formed in the belief that a tax deduction not available for self-insurance would be granted for payments to a captive. 15-15
Tax Considerations • Although the IRS has generally disallowed a deduction for premiums paid to a captive insurer by its parent, there are exceptions. •
Premiums paid to a captive may, under very specific and limited circumstances, be deductible by the parent corporation
15-16
Inability to Obtain Coverage 1. The most difficult lines of coverage have been product liability, professional medical liability, architects and engineers and accountants, pollution liability, and liability insurance for municipalities, petroleum operations, and certain hazardous contractor exposures. 2. Coverage is available, but at an enormous price. 3. There are some exposures for which the traditional market has never provided coverage at all, or any reasonable size market. 15-17
Lower Expense Ratio • The anticipated savings from the use of captives are the same as those expected from other forms of retention. • These include the elimination or reduction of the expense component in insurance premiums. • Premium taxes and acquisition cost savings can produce a direct saving or from about 5 percent to as much as 15 percent of premiums.
15-18
Desire to Improve Cash Flow • Insurance buyers have always recognized that insurers enjoyed a cash flow benefit arising from the timing of the payment of premiums it received and the time at which those premiums were paid out in losses. • Some captives have been formed to gain the advantage of the cash flow associated with the timing of premium payments and loss payments.
15-19
Cash Flow • Thirty years ago, the bulk of property and liability insurer reserves consisted of unearned premium reserves, the reserves representing the unexpired terms of the policies in force. • Over time, the composition of reserves has shifted. •
With the growth in litigation, loss reserves, especially on casualty lines such as liability and workers compensation came to dominate insurer’s balance sheets. 15-20
Cash Flow • Whereas the turnover in unearned premium reserves was fairly rapid and occurred on schedule, the reserves for unpaid losses compound, as each year’s unpaid losses are added to the unpaid losses of earlier years. •
The growth in loss reserves created cash flows of a new magnitude which, combined with record level interest rates created a package too appealing for some companies to resist. 15-21
A New Profit Center • Hundreds of captives have developed into insurance and reinsurance companies that write the exposures of parties other than their parent. • Such captives are generally referred to as profit center captives or as broad captives. • It is doubtful that this has been the prime motivator for the formation of any captives, but it is a benefit that supports other reasons for captive formation. 15-22
Move Capital in International Markets • Another benefit of a captive is the ability to move money in international markets. •
Exchange controls and restrictions on currency convertibility do sometimes occur and a captive insurer serves as a means through which these restrictions can be bypassed.
• A captive provides a means of moving money from one county to another by accepting payments from its parent in the foreign currency. 15-23
Taxation of Captives • The taxation of captive insurance companies has been a source of contention between captive owners and the IRS almost from the inception of the captive concept. • The disagreement has concerned both the taxation of the captive's income, and the deductibility of the premiums paid by the parent to the captive. 15-24
Taxation of Captives • Initially, offshore captives were a source of concern to the IRS, because of the foreign income aspect, which permitted a captive to retain untaxed income in a foreign jurisdiction. • In addition, the IRS objected to the deduction of what it considered to be essentially loss reserves in a retention (self-insured) program.
15-25
Deductibility of Premiums The IRS position since 1972 has been: • A captive is an insurance company in form only, not substance. • Since there is no shifting of risk and no loss of control of the premiums, the premiums paid to a captive are self-insurance reserves and not deductible. • The captive has been formed primarily for the purpose of tax avoidance and therefore premiums to it are not deductible. 15-26
Revenue Ruling 77-316. •
Revenue Ruling 77-316 was issued on August 29, 1977, and formalizes the position taken by the IRS in 1972.
•
It specifically disallows deductibility of insurance premiums paid by a domestic corporation to its insurance subsidiary.
15-27
Revenue Ruling 77-316. 1. The parent places insurance with the subsidiary, which retains 100% of the risk. None of the premium is deductible. 2. The parent places insurance with an unrelated domestic insurer, which passes 95% of the risk to the parent's subsidiary. Only the premium charged by the fronting company for retaining 5% of the risk is deductible. 3. The parent places insurance directly with the captive, which reinsures 90% of the risk with an unrelated insurer. The premium paid for the reinsurance is deductible. 15-28
Revenue Ruling 78-338, IRB 38,6 • Gives approval of so-called "association captives." The insurer in question was owned by 30 shareholders, none of which controlled the company or contributed more than 5% of its total premiums. •
A large number of insureds creates a true element of insurance through spreading of risk.
15-29
Revenue Ruling 78-277, 1978 IRB 29,9 • In this ruling, the IRS indicated that a captive's assumption of outside risks is a factor in the tax-payer's favor, permitting deductibility of premiums paid by the parent company. •
The percentage of outside risks that must be assumed has not been prescribed by the IRS.
15-30
Opposition to IRS Position • In spite of the firm stance on the point by the IRS, many U.S. corporations feel that the IRS position is incorrect. • They argue that the IRS is wrong in failing to recognize an offshore captive as a separate legal entity and that a properly structured captive—i.e., distinct and separate from its parent and with sufficient assets and capitalization to carry on its business and meet its liabilities—will eventually rebut the IRS position. 15-31
Court Support for IRS Position The IRS position on deductibility of premiums to a single-parent captive has been upheld by the courts in Carnation Company v. Commissioner of IRS, and in Clougherty Packing Company versus Commissioner of IRS. 15-32
1991 Victory For Captives • In 1991, the U.S. Tax Court ruled in three separate but related cases that companies may deduct premiums paid to their captive subsidiaries. The three related cases were brought by • Harper Group, which owns Rampart Insurance Co., • Sears, Roebuck & Co., which owns Allstate Insurance Co., and • Amerco Co., which owns Republic Western Insurance Co. 15-33
1991 Victories for Captives • The companies argued that taking business deductions for premium payments to their captive subsidiaries was legitimate because the captive insurers were bonafide companies that did business with other unaffiliated companies. • The Internal Revenue Service argued that a corporate parent and its units constitute a single economic unit and there can be no shifting of risk. 15-34
1991 Victories for Captives The Tax court rejected the IRS's position • The effect of the court’s ruling is that captive owners may deduct premiums from their federal income taxes if the captives write relatively large amounts of business for unrelated or third part y business. • The captive must be a separate insurance company, regulated by insurance laws, and have sufficient premium income or retained earnings to pay losses. 15-35
Taxation of Captive Income - TRA-86 • Although premiums paid to single-parent captives are nondeductible, the exceptions permitted for group-owned captives created a tax loophole for off-shore association captives that was not addressed until the Tax Reform Act of 1986. • Prior to TRA-86, the income of an offshore captive derived from premiums on U.S. exposures was taxed under complicated rules applicable to a "controlled foreign corporations" (CFC). 15-36
Taxation of Captive Income - TRA-86 • Although the law defined a CFC as one in which 25% of the shareholders were U.S. residents, only shareholders owning 10% or more of the foreign corporation were counted in making the determination. • This meant that an offshore captive owned by 20 participants, each with 5% of the stock, was not classed as a CFC and escaped taxation of its income, even though the parent recognized a deduction for the premiums paid to the captive. 15-37
Taxation of Captive Income - TRA-86 • This means that under prior law, the owners of an off-shore captive could defer payment of taxes on the captive’s profits until actual receipt, if their ownership in the captive was less than 25 percent. • Under the new law, regardless of the percentage of ownership, the profits of the captive are imputed to the shareholders and are currently taxable, whether they are paid out or not.
15-38
State and Foreign Income Taxes. • A domestic corporation will be subject to any applicable state income taxes. • State income taxes normally do not apply to a foreign corporation.
15-39
State Premium Taxes • In general, premiums paid to off-shore, nonadmitted insurers are not subject to state premium taxes if all negotiations and activities associated with obtaining and signing the policy are conducted offshore. • Captives licensed to do business in a particular state are subject to the state’s premium tax. • When the captive is not subject to the premium tax because it is not licensed, an excess and surplus line premium tax may apply. 15-40
Federal Excise Tax • Section 4371 assesses a 4% tax on premiums (except life insurance) written directly to most foreign insurers. • There is also a 1% tax on premiums ceded (reinsured) with foreign carriers. • The excise tax is levied on the insured rather than the insurer, but it is in lieu of the U.S. income taxes the foreign carrier would incur if it operated a business in the U.S. 15-41
Structuring The Captive There are three choices concerning the corporate structure of a captive insurance company: stock, mutual reciprocal
15-42
Captive Management Companies • During the past 30 years, there has been a growing number of brokers and consultants who have established captive management firms. •
This relieves the parent of a captive of the need to assemble the technical competence required for the management of the captive.
15-43
Feasibility Studies • A detailed feasibility study is usually made before setting up any captive insurer. • Such studies may be made by internal staff, brokers with captive experience, captive management firms, or by independent consultants. • Most of the larger brokers and captive company management firms have expertise and knowledge regarding captives. 15-44
Fronting Company Arrangements • In some lines of insurance, especially workers compensation and often auto liability, coverage must be written by an insurer licensed in the state where the coverage is provided. • This means that an unlicensed captive can not write these lines directly. Owners of captives can, however, use the captive to reinsure a licensed company.
15-45
Fronting Company Arrangements • A fronting company is an insurance company that is unrelated to the captive and which takes all of the risk and reinsures it 100% (or substantially, say 90% or 95%) according to the requirements of the law in the country or state in which the risk is located. • Although the exposure is reinsured with the captive, the fronting company is contractually liable to the insureds, and if the captive cannot meet its obligations, the fronting company must nevertheless pay incurred losses. 15-46
Captives as Reinsurers • Captive insurers sometimes function as reinsurers, taking a part of the risk written by other insurance companies. • In some cases, the reinsurance arrangement involves the parent company's risk, which is written by a "fronting" company (discussed above) and then reinsured with the captive.
15-47
Rent-A-Captive • The other side of fronting involves the recipient of the program, the rent-a-captive operations, usually domiciled in an offshore location. • Sometimes, captive find that they are not operating on a cost-efficient basis, because they are not maximizing the use of surplus or spreading administrative costs over large premium base.
15-48
Rent-A-Captive • One solution, implemented by a number of captive owners has been to increase the volume of business written by their offshore captive by soliciting outside business.
• An easy way to do this was to offer the captive to other firms that either did not want to make the capital contribution required to form an offshore captive, or who found it difficult to justify creation of their own captive. 15-49
The Risk Retention Act of 1986 • The Risk Retention Act of 1986 amended the Product Liability Risk Retention Act of 1981. • The 1981 act was passed to provide relief for insurance buyers during the product liability crisis of the late 1970s, and was limited to products exposures. • The 1986 law expanded the provisions of the law to apply to most liability coverages. (Workers compensation, employers liability, and personal risks are excluded from the new law). 15-50
Risk Retention Act of 1986 Like its predecessor, the Risk Retention Act of 1986 authorized two mechanisms for group treatment of liability risks:
1. Risk retention groups for self-funding (pooling) and 2. Purchasing groups for joint purchase of insurance
15-51
Risk Retention Groups • A risk retention group is essentially a groupowned insurer whose primary activity consists of assuming and spreading the liability risks of its members. • They are insurance companies, regularly licensed in the state of domicile, and owned by their policyholders who, in effect, double as shareholders. 15-52
Risk Retention Groups • The members are required to have a community of interest (i.e., similar risks) and once organized, they can offer "memberships" to others with similar needs on a nationwide basis. • A risk retention group need be licensed in only one state, but may insure members of the group in any state. •
The jurisdiction in which it is chartered regulates the formation and operation of the group insurer. 15-53
Risk Retention Groups and Insolvency Funds • Risk retention groups are prohibited from joining the state insolvency guaranty fund. • In the event of insolvency of a risk retention group, there is no source of recovery other than the assets of the group. • Policies issued by risk retention groups are usually required to include a statement about the absence of protection under the state insolvency fund. 15-54
NOTICE This policy is issued by your risk retention group. Your risk retention group may not be subject to all of the insurance laws and regulations of your state. State insurance insolvency guaranty funds are not available for your risk retention group.
15-55
Requirement For Success • Elements in the successful operation of a risk retention group are basically the same as the requirements for the successful operation of any insurance mechanism. • In addition, there must be a willingness on the part of the participants to share risks with others in the pool. • This means, among other things, that the group must exercise selectivity in the choice of its members. 15-56
Purchasing Groups • A "purchasing group" is a legal entity which purchases insurance for its members. •
Like participants in risk retention groups, members of purchasing groups must be in similar or related businesses which exposure them to similar liability risks.
•
However, unlike a risk retention group, a purchasing group does not retain risk.
•
Rather, it purchases group liability insurance from insurance companies for its members. 15-57
Related Documents
15 Slide
May 2020 6
15 Slide
June 2020 17
Doni-slide 15&16 Fix.docx
November 2019 5
Slide
December 2019 39
Slide
May 2020 34
