Possibilities and Pittfalls 831 (b)s Possibilities and Pittfalls

Discussion Items Micro Captive Basics Does your captive “quack”? Story of PGIC Story of 3MP Quack?

Honigman Miller Schwartz and Cohn LLP Michael Domanski Honigman Miller Schwartz and Cohn LLP Partner

What is a captive? A captive is a licensed insurance company that commonly has a limited purpose to provide coverage to related / unrelated insureds that have relationships with the owners and / or “sponsor” of the captive Captives are evident across industries and have been used for over 30 years by healthcare providers to fund medical malpractice risk and other risks

SPCs / Cells / Series LLCs Domestic Cells / Series LLCs Each cell within a cell company is treated as a separate corporation for tax purposes Each series within a series LLC is classified as a separate partnership (if two or more members in the series), a disregarded entity (if only one member) or a corporation (if it so elects) Foreign Cells Each cell within the cell company conducting sufficient insurance business is treated as a separate corporation and therefore, eligible to make certain elections (e.g., a “domestication” election); otherwise, “non-insurance cells” are classified as an unincorporated division of the overall captive “Grandfather Rules” Some “insurance” cell captives established before 2010 can qualify as one consolidated corporation (contrary to the current rules)

Federal Tax Criteria for a Captive / Four Elements of Insurance Arrangement can qualify as insurance if the following elements are satisfied: Existence of an insurance risk (sufficient fortuity, more than an investment risk) Insurance in the commonly accepted sense (arm’s-length / commercial-like transactions) Risk shifting (lack of parental guarantees, adequate capitalization) Risk distribution (many insured parties)

What is an 831 (b) or “micro“ captive? 831(b) refers to the section of the Internal Revenue Code related to insurance companies Premiums cannot exceed $1.2 million If it applies, federal income taxes are imposed on the captive’s investment income only The premiums of other captives with similar ownership can be aggregated for purposes of the premium limitations A complicated series of “attribution” rules can apply for purposes of the ownership tests

What is the recent buzz about these entities? IRS was recently successful in obtaining the support of an Illinois U.S. District Court in enforcing summonses issued to Artex Risk Solutions, a multi-domicile captive manager, in connection with an audit of a large group of micro captives Increased IRS audit activity reflects the IRS’ close monitoring of the proliferation of micro captives that are involved in third party “pooling” structures and supports its public comments that it is concerned that such arrangements may not possess the necessary attributes of insurance or valid business fundamentals

What is the recent buzz about these entities? IRS rejected late last year several private letter ruling requests from taxpayers participating in captive pooling arrangements The IRS indicated in its rejections that it was revisiting whether non-traditional coverages could constitute insurance for tax purposes and was unwilling to validate transactions when more specifics were required to assess whether risk transfer/risk shifting had been achieved Such an approach was a drastic departure from the successful rulings that had been previously issued by the IRS in the context of substantially similar structures

Alliant Insurance Services, Inc. Lorraine N. Lewis Alliant Insurance Services, Inc. Executive Vice President

Does Your Captive Quack? Consulting team selection Domiciles Product selection Participation in risk pools Documentation Capitalization Distributions / loan backs

Best Practices – Evaluating a Start Up Feasibility study Legal review Tax and accounting review Actuarial review Insurance market review Selection of professional consulting team Selection of appropriate domicile Decision to incorporate

Malcolm T. Donnell PGIC, LLC. Shareholder

Physicians Guaranty Insurance Company Writes policies to insureds involved in the provision of healthcare services Captive was created to cover medical professional liability and other risks At one point retained and funded up to a $5M SIR Conducted LPT and medical professional liabilities out of the captive due to changes in market Management conducted diligence to determine if the captive remained a viable option

Physicians Guaranty Insurance Company Management decided to maintain captive: To continue to cover risks other than medical professional liability To cover medical professional liability when market conditions changed Movement of medical professional liability risk from captive into commercial market reduced captive premium Resulting premium less than $1.2M Captive meets definition of Section 831 (b) due to premium size

Bubba Beyer 3MP, LLC. Shareholder

3MP, LLC Insureds of the captive provide road paving and engineering services to home builders and developers High growth company with positive loss performance Owners wanted to explore alternative risk financing and insurance strategies Use of commercial insurers often results in the “trading of dollars”

3MP, LLC Diligence and feasibility included: Interview and selection of professional providers (actuarial, captive managers, legal and regulatory counsel, audit and tax counsel) Intentional selection of mature domicile Development of business plan, product selection and actuarial study Program refined based upon commercial market conditions and implemented accordingly