An Introduction to Captive Insurance F. Hale Stewart, JD, LLM, CTEP, CWM, CAM Author of the book U.S. Captive Insurance Law Captiveinsuranceinfo.com

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

What Companies Are More Likely to Benefit From a Captive Doctors and other professionals Manufacturers Commercial real estate Construction companies Transportation companies Shipping Companies

What Are the Benefits of Forming A Captive?  Custom Insurance Policies  The Beech Case  Using Individual loss experience in determining insurance rates  Broader Insurance Coverage  Third party insurer insures standard risk  The captive underwrites specialty risk  Asset protection  Estate Planning  Tax arbitrage

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.

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.

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.

Running the Captive  Domicile manager  Legal counsel  Audit  Actuarial Services  Investment manager

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.

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

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?

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. Or, a captive must have at least 12 subsidiaries in order to have sufficient risk distribution.

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