captive insurance companies: business, estate planning and...

Captive Insurance Companies: Business, Estate

Planning and Asset Protection Considerations Best Practices for Structure, Implementation and Choice of

Domicile Through Industry-Specific Case Studies

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TUESDAY, JULY 8, 2014

Presenting a 90-Minute Encore Presentation of the Teleconference with Live, Interactive Q&A

Kevin Allgood, Senior Vice President, Hub International, Westmont, Ill.

Michaeline Gordon, Principal, Dolgin Law Group, Chicago

Lou Schendl, Manager, Timberview Captive, Peoria, Ill.

Robert K. Wold, AFIS, CLCS, Vice President, Hub International, Westmont, Ill.

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Captive Insurance Companies Business, Estate Planning, and Asset Protection Considerations

Dolgin Law Group, LLC

Attorneys at Law

Disclosure

IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with Treasury

Department regulations, we inform you that any U.S. federal tax advice contained in

this communication (including any attachments) is not intended or written to be used,

and cannot be used for the purpose of (i) avoiding penalties that may be imposed or

recommending to another party any transaction or matter addressed herein.

The examples contained herein are hypothetical and do not reflect specific strategies

developed for actual clients. They are for illustrative purposes only.


Attorneys at Law 6

What is A Captive?

• A captive insurer (or “Captive”) is a special-purpose insurance company formed

primarily to underwrite the risks of its parents or affiliated groups.

• It is classified as an Alternative Risk Transfer (“ART”) entity versus a Traditional Risk

Transfer (“TRT”) entity.

• Performs the same functions as TRT. It Issues polices, collects premiums, and pays

claims.

• It is formed to finance-underwrite the risk of its owners or related entities, which gives

those owners maximum control of their at risk dollars.

• A Captive traditionally supplements pre-existing risk management and financing

procedures.

• Does not offer insurance to the public.

• Regulations governing Captives are typically less onerous than those regulations

governing traditional commercial carriers

7

The Basic Captive Structure

Parent Corp.

Risk Pool Captive

Premiums

Pays Claims Pays Claims

Premiums

8

History of a Captive

• The history of Captives can be traced back hundreds of years to ship owners where

they would share, exchange, and transfer risk.

• Up to the 1950’s 100 Captives had been formed.

• 1970’s and 1980’s saw significant growth in the captive industry due to captive laws

passed in Colorado, Tennessee, and Vermont, and federal legislation making it easier

to operate similar interest captives.

• Tax Reform Act of 1986 congress passed IRC 831 (b) election for captive insurance.

• By 1995 3,200 Captives had been formed.

• In 2008 there were close to 6,000 Captives in existence worldwide, and more than

40% of all major U.S. corporations operating at least one Captive.

9

The Captive Space

Ownership •Pure/Single Owner

•Small Captive

•Pure/Group Ownership

–Industry

–RRG

No Ownership •Sponsored

–Protected Cell

•Association

•Fronting with Re-Insurance

International Risk Management Institute www.irmi.com Captives and the Management of Risk by Kathryn A. Westover Captive Practices and Procedures by Kathryn Westover Taken Captive R. Wesley Sierk, III

10

http://www.irmi.com/

Current Captive Market

11

Profits and Trends

• Out of every $1 you pay as premium, roughly $0.60 goes to cover the expected losses, $0.40 for commissions & administrative expenses.

• The insurer holds that $1 and invests it, earning investment income.

• Insurers set up a reserve for future losses as a liability on their books, thereby deferring the recognition of income (and therefore income tax).

• With a captive, you can flip the situation so these advantages become yours.

How to Profit from and Insurance Company

Current Trends In the Insurance Industry • Carriers are tightening underwriting

standards.

• Increasing Premiums (hardening

market).

• New target combined loss ratio is 95%.

• 2013-2014 2%-3% Property & G/L

Increase.

• 2013-2014 5%-10% Worker’s

Compensation Increase.

12

What is Uninsurable Risk?

The fishermen know that the sea is dangerous and the storm terrible, but they have never found these dangers sufficient reasons for remaining ashore.

-Vincent Van Gogh Insurable Risk

• Boat & Building-Property

• Slips and Falls-Third Party General Liability Claims

• Staff and Employee Issues-Workers Compensation

• Profits-Business Interruption

Uninsurable Risk

• Toxic Sea or Pollution

• Over fishing

• Regulatory Body or Administrative Actions

• Loss of a Key Client or Market

• Anything That Keeps The Fisherman Up at Night

13

Managing Risk

Risk Control

The goal of the risk control techniques is

to reduce the frequency and severity of

losses as much as possible with the

resources available.

• Exposure Avoidance

• Loss prevention

• Loss Reduction

• Segregation

Risk Financing

If losses cannot be avoided, they could

occur; and they must be paid for. Two

options exist.

• Risk Retention

• Risk Transfers

14

Holistic Risk Management

1990’s Holistic Risk Management Trend or Enterprise Risk Management (ERM)

By identifying and proactively addressing risks and opportunities, business enterprises

protect and create value for their stakeholders, including owners, employees, customers,

regulators, and society overall. (ERM)

• Hazard Risk

• Liability torts, Property damage, Natural catastrophe

• Financial Risk

• Pricing risk, Asset risk, Currency risk, Liquidity risk

• Operational Risk

• Customer satisfaction, Product failure, Integrity, Reputational risk

• Strategic Risk

• Competition, Social trend, Capital availability

15

Determining & Assessing Risk

• Establishing Context

• Identifying Risks

• Analyzing/Quantifying Risks

• Integrating Risks

• Assessing/Prioritizing Risks

• Treating/Exploiting Risks

• Monitoring and Reviewing

SEV

ERIT

Y

FREQUENCY

RETAIN

SHARE

TRANSFER

16

Why Form a Captive?

• Premium Stability

• Premium Deductibility

• Cost Savings

• Exert Control

• Cash Flow

• Profit Center

• Coverage Availability

• Improved Risk Management

• Works seamlessly with existing risk management team

• Simple and as hands off as you desire

• Access to Reinsurance

• Favorable Regulations & Tax Treatment

• Asset Protection

• Unique strategies for philanthropy goals

17

Selling a Captive-Defining the Team

Trusted Advisors

• CPA

• Attorney

Consultants

• Program Manager or Captive Manager

• Insurance or Risk Consultant

Takeaway

• Never pre-judge a Captive opportunity.

18

Industry Candidates

• Contractors

• Builders & Developers

• Car Dealerships

• Manufacturers

• Real Estate

• Retail

• Pharmaceuticals

• Agribusinesses

• Hotel Chains

• Service Providers

• Medical Profession

• Healthcare Facilities

• Professional Service Practices

• Franchisor

• Franchisees

• Restaurant

19

Captive Prospect Profile

Generally speaking if a company meets one or more of the following business criteria

they could be a candidate for a small captive insurance program:

• A closely-profitable business

• Pretax profits of at least $500,000

• Gross revenues equal to or greater than $5 million

• Stable cash flow

• Substantial self insured/ uninsured business risk

It is important to note field is very broad. There is not a one size fits all model every

Captive is unique in some way.

20

Captive and Estate Plan Strategy

• Estate and gift planning should be considered in tandem with a Captive Insurance

Company (“Captive”) strategy


Attorneys at Law 21

What is a Captive?

Must meet definition of “insurance” for tax purposes, (bona-fide risk management

purposes, reasonable premiums, and adequate capitalization)

Must be able to establish appropriate “risk shifting” and “risk distribution” (Helvering v.

LeGierse, 1941)


Attorneys at Law 22

What Is a Captive?

A Captive insurance company must be taxed as a “C” Corporation

Possible to create multiple classes of stock, vesting schedules, liquidation

preferences, etc.

Key employee incentives

Premiums paid are deductible as “ordinary and necessary” business expense under

IRC

162

Premiums will not be taxable income under 831(b)

Investment income will be taxed as ordinary income at corporate marginal rates


Attorneys at Law 23

What Is a Captive?

If the Captive is profitable, profits can be accumulated, distributed as dividends, or

paid out to shareholders upon liquidation


Attorneys at Law 24

Business Fit for a Captive

• Profitable ($500,000 or more in profits) businesses with uninsured risk

• Businesses where owner(s) are looking for asset protection, wealth accumulation

and/or wealth transfer


Attorneys at Law 25

Benefits of a Captive

Shareholders of Captives

As earnings accrue in the entity, the value of investment increases on a tax-

deferred basis

Distributions of dividends are currently taxed at favorable tax rates


Attorneys at Law 26

Shareholders of Captives

As earnings accrue in the entity, the value of investment increases on a tax-

deferred basis

Distributions of dividends are currently taxed at favorable tax rates of 15% to

20%.

If the shareholders of the Captive are family members of the owners of the

parent company-income insures to them

Benefits of a Captive


Attorneys at Law 27

Definition of Insurance

Risk Shifting

Risk Shifting is established in a Captive by the payment of the premium in

exchange for the assumption of liability to make payment if the risk matures


Attorneys at Law 28

Risk Distribution

Case law has defined this concept as follows:

Risk distribution occurs when particular risks are combined in a pool with

other, independently insured risks

By placing risks in a larger pool and increasing the total number of

independent, randomly occurring risks, the business benefits from the

mathematical concept of the law of large numbers in that the ratio of actual

to expected losses tends to approach one

Definition of Insurance


Attorneys at Law 29

Case Law History of Captives

In Humana v. Commissioner (881 F.2 247 (6th Cir. 1989)), the Captive won a victory

This case involved a parent with a group of operating subsidiaries paying premiums

to a Captive subsidiary

The Court of Appeals held that the payments made by the subsidiaries would be

deductible as insurance whereas the payments made by the parent would be

disallowed, under the rationale of the prior decisions (Carnation Co. v.

Commissioner and Clougherty Packing Co. v. Commissioner)

The case established that brother-sister entities related to the Captive could legally

pay insurance premiums to the Captive and derive valid tax deductions


Attorneys at Law 30

Legal History of Captives

After the Humana decision, the IRS set out safe-harbor rules

The IRS now challenges transactions they see as abusive on a “facts and

circumstances” case by case basis


Attorneys at Law 31

Revenue Ruling 2002-89

IRS safe-harbor if less than 50% of the risk insured by a single-parent Captive

(and the rest from unrelated parties)


Attorneys at Law 32


Single-parent Captive insuring 12 domestic subs of parent but no risk outside the

family

No one sub accounts for less than 5% nor more than 15% of the risk premium


Attorneys at Law 33


Held to be adequate risk distribution and the premiums deductible by the

paying entities

Although the IRS will not challenge situations where 12 subsidiaries are insured, it does NOT mean that you need 12 entities to have a valid captive insurance arrangement Dolgin Law Group, LLC

Attorneys at Law 34


The IRS continued to provide examples from which safe-harbor rules can be drawn

One example in the ruling shows that dealing with an unrelated insurance company that insures only the taxpayer cannot provide a deductible insurance expense because no risk distribution occurred

It also clarified that disregarded entities such as “single-member LLCs” would not be considered separate entities for risk distribution purposes


Attorneys at Law 35

Rev. Proc. 2002-75

The IRS said they will issue private letter rulings on whether there is adequate risk shifting and risk distribution to qualify the payor for an insurance deduction and to determine if the Captive is an insurance company for federal income tax purposes


Attorneys at Law 36

Rev. Proc. 2002-75

The IRS said they will issue private letter rulings on whether there is adequate risk shifting and risk distribution to qualify the payor for an insurance deduction and to determine if the Captive is an insurance company for federal income tax purposes


Attorneys at Law 37

Captive Formation

Who can own a Captive:

Children and Family

Trusts for the benefit of Owner’s Beneficiaries

Family Partnership/LLC

Key Employees


Attorneys at Law 38

Captive Formation

At the time of formation, common or preferred stock can be sold to:

The owners’ beneficiaries or trusts for their benefit

Key employees

Shareholders of the sponsoring entity

At retirement, death or disability, shares can be redeemed at capital gains rates


Attorneys at Law 39

A Captive can be formed inside a trust for children and grandchildren

The Captive can be gifted after formation

The captive can be sold later

To owners’ beneficiaries or trusts for their benefit

Key employees

Officers-shareholders of sponsoring entity

Captive Formation


Attorneys at Law 40

Captive Advantages

Federal gift and estate tax exemption for 2014: $5.34M per person ($10.68M per

married couple)

The federal gift tax rate is currently 40%

Gift and GST tax do not apply to assets that are subject to full and adequate

consideration (premiums) Treas. Reg. Sec. 25-2511-1 (g) (1)

A Captive can allow for transfer of the business to family members


Attorneys at Law 41

A State Income Tax Protection Trust

It may be desirable to form the Trust in a state that offers income tax advantages

Or, the use of an Incomplete Non-Grantor Trust

Allows income distributed from the Captive to be taxable in a no-tax state

Illinois or California versus Nevada or Delaware


Attorneys at Law 42

State Income Protection Trust

Revocable Trust

Incomplete Non-Grantor

Trust

Business Captive

Insurance Company

100%

Premiums

100%


Attorneys at Law 43

ASSET PROTECTION TRUST

As a C Corporation captive assets are protected from the owner’s creditors and the

creditor’s of the owner’s business

Using a foreign or domestic asset protection trust will allow for distributions to be

protected from creditors


Attorneys at Law 44

ASSET PROTECTION TRUST

Holding Company LLC

Asset Protection

Trust

Business

Captive Insurance Company

100%

Premiums

100%


Attorneys at Law

45

Dynasty Trust

Using a dynasty trust is appropriate if the captive owner desires to pass the captive

via a trust not owned by his or her estate

The owner of the Captive will receive the benefits of the captive insurance company’s

profits and distributions. The current estate tax rate is 40% for estate assets in

excess of the current exclusion. Assume you have a properly structured captive

insurance premiums of $1,200,000, the estate and gift tax savings could be $480,000

a year ($1,200,000 x 40%).


Attorneys at Law 46

Estate/Dynasty Trust

Revocable Trust

Dynasty Trust

Business Captive

Insurance Company

99

% V

oti

ng

Premiums


Attorneys at Law

47

Domicile

Captive is animal of state law; governed by state insurance department

Must go through process of evaluating states friendly to type of insurance Captive will

issue

Friendly states: Montana, Delaware, Vermont, District of Columbia, Utah, Wyoming,

Hawaii, Connecticut and New Jersey


Attorneys at Law 48

Off-Shore Captives

Off-shore Captives may offer more asset protection

Management fees

More IRS scrutiny of off-shore Captive

Election under

953(d) allows Captive to be taxed as on-shore Captive


Attorneys at Law

49

Timberview Captive

• The “Timberview” idea evolved from a thought that a Captive insurance company could be a solution to a particular farmer’s future estate tax liability.

• With the 7 farmers…it quickly evolved to be so much more!

• A company that makes possible for farmers to control RISK to build, protect and access wealth – and when the time is right, transfer it to the next generation.

• This is about BUILDING WEALTH…

• What are you doing with your $$$ today?

50

I don’t have to tell you about risks.

Farmers manage them every day!

• Weather

• Timing (planting, harvesting and applying)

• Farm Practices

• Land fertility

• Pest

• Seed varieties

• Market fluctuations

• Geo-Political

• Regulation

51

Major Issues Facing Farmers Today.

• Higher grain prices

• Higher input cost

• Higher land cost and values

• Increased risk to lawsuits, etc

• Higher tax rates

• Uncertainty in the future Farm bill and Federal Crop insurance

• Increasing healthcare cost

• Rapidly increasing Estates

• Increased PROFITS

52

Increasing Profits

According to Farmdocs.com average Illinois grain farms net incomes.

(http://www.farmdocdaily.illinois.edu/2011/05/profitability_and_farm_size_on.html)

1998-2002 $65 per acre

2001-2004 $95 per acre

2007-2009 $236 per acre

ILLINOIS Farm Land Prices on average $10,000/acre to $15,000/acre

53

http://www.farmdocdaily.illinois.edu/2011/05/profitability_and_farm_size_on.html

Strategies for increased profit…

• Taxed deferred Retirement accounts

• Equipment and Building purchases and improvements

• Pay taxes and invest (Market, Land etc)

• Timberview Captive?

Timberview Captive is a strategy that gives you increased control and access to your wealth.

54

Timberview Captive

•Protected Cell/Incorporated Cells/Series LLC

– Pure Captive within a Series LLC structure

• Optimal Combination of Retention and Risk Sharing.

• Think of Timberview as an apartment/condominium building. Timberview itself is the building, the SBUs are the apartments/condos.

55

What risks are insured…

• Administrative Actions – Covers cost resulting from EPA and other regulators.

• Pollution Liability – traditional farm and ranch policies cap coverage at $100,000

• Product and Liability Recall – Will provide more extensive coverage for things like aflatoxin etc.

• Agribusiness Continuity – Provides cash flow to the farm operation in the event of an unforeseen circumstance involving machinery, key employees etc.

• Crop Supplement 71% - 90% - Policy follows form of the Fed Crop policy. Same schedule of insurance, acreage report and production reports.

56

Timberview – Actuarial Support

• Program Design

• Rating Models

• Annual Reserve Valuation

• Regulatory Compliance

57

Timberview – Risk Mitigation Strategy

• Spread of Risk

• Pool Excess Exposure

• Coverages, Policy Limits Selected

• Ratemaking Risk Margin

• P&C Basket Aggregate Retention

58

Timberview – Excess Risk Pool

Est. Annual Estimated SBU

Avg # Acres Revenue Size Class Premium Risk

2,000 1,800,000 Small 250,000 160,000

3,750 3,375,000 Medium 500,000 300,000

7,500 6,750,000 Large 750,000 600,000

SBU

SHARED RISK POOL

SBU SBU SBU

59

Timberview – Excess Risk Pool

Example #1 Example #2

Premium:

Direct 436,529 436,529

Ceded to Pool (196,438) (196,438)

Assumed from Pool 196,438 196,438

Net SBU Premium 436,529 436,529

Losses:

Direct 0 500,000

Ceded to Pool 0 (200,000)

Assumed from Pool 92,055 92,055

Net SBU Losses 92,055 392,055

Net UW Gain/Loss 344,474 44,474

60

Financial Matters: Accounting, Audit, and

Tax

• Provide assurance over financial statements

• Auditor - Independent, are not involved in “books and records”

Required annually under insurance regulations

• Complexities of insurance accounting

Domicile Reporting

Actuarial Reporting

• Prepare and file annual tax returns

Domicile

IRS

61

Financial Matters: Flows of Cash

• Cash into SBU

Initial capital

Premium

Investment income and capital gains

• Cash out of SBU

Claims

Dividends/capital gains

Expenses (including income taxes)

Investment activities

62

Timberview Captive Structure: Series

Business Unit (SBU)

• With this design, the owner can start shifting potential profit to the next generation while keeping full control over the business.

• Moreover, the owner does not yet have to address the ownership of the operating business itself.

John

Doe

Doe

Farm Operations,

Inc.

Doe

Dynasty

Trust

Timberview

Series 001

d/b/a - Doe

Insurance Co.

$250K gift

Premiums

Policies

1 voting

share

99 non-voting

shares

100%

ownership

$250K capital

contribution

63

Timberview Captive Structure: Steps

Step 1:

• Form and fund a new irrevocable trust

or utilize an existing trust

• Trust should be a dynasty trust.

• Trust will generally be a “grantor trust”.

John

Doe

Doe

Farm Operations,

Inc.

Doe

Dynasty

Trust

Timberview

Series 001

d/b/a - Doe

Insurance Co.

$250K gift

Premiums

Policies

1 voting

share

99 non-voting

shares

100%

ownership

$250K capital

contribution

64


Step 2:

• Form the captive insurance company

through Timberview by applying for a

Series License.

• The captive application must be

reviewed carefully to ensure that this

arrangement is properly described.

John

Doe

Doe

Farm Operations,

Inc.

Doe

Dynasty

Trust

Timberview

Series 001

d/b/a - Doe

Insurance Co.

$250K gift

Premiums

Policies

1 voting

share

99 non-voting

shares

100%

ownership

$250K capital

contribution

65


Step 3:

• Once the captive is established and

the policies are in place, then the fun

starts.

• Every time a premium payment is

made, it is a wealth transfer with no

transfer tax issues.

John

Doe

Doe

Farm Operations,

Inc.

Doe

Dynasty

Trust

Timberview

Series 001

d/b/a - Doe

Insurance Co.

$250K gift

Premiums

Policies

99 non-voting

shares

100%

ownership

$250K capital

contribution

66

Timberview Captive Structure: Accessing

Funds

John

Doe

Doe

Farm Operations,

Inc.

Doe

Dynasty

Trust

$1mm

1 voting

share

99 non-voting

shares

Timberview

Series 001

d/b/a Doe

Insurance Co.

Deed to Farmland

Farmland

$1mm FMV

John

Doe

Doe

Farm Operations,

Inc.

Doe

Dynasty

Trust

Timberview

Series 001

d/b/a Doe

Insurance Co.

Farmland

100%

ownership

Resulting Ownership:

$1mm Loan (limit set by Delaware DoI)

or

Dividend (approval by Delaware DoI)

Up to Certain Limits: (negotiated with

Delaware DoI)

– Acquire non-marketable securities

– Acquire real estate

– Acquire marketable securities

- Acquire Farm Equipment

1 voting

share

99 non-voting

shares

100%

ownership

100%

ownership

67

Year 1 Year 2 Year 3 Year 4 Year 5 Year 20

Upfront Deposit (25,000) - - - - -

Capital & Surplus Contribution 200,000 - - - - -

Deductible Premium 800,000 800,000 800,000 800,000 800,000 800,000

Participation Fees */1 (75,000) (75,000) (75,000) (75,000) (75,000) (75,000)

Investment Income */3 46,250 98,113 138,316 180,138 223,646 1,130,747

Fed Inc Tax (8,556) (18,151) (25,588) (33,326) (41,374) (209,188)

State Inc Tax Rate 5.00% 5.00% 5.00% 5.00% 5.00% 5.00%

State Inc Tax Amount (428) (908) (1,279) (1,666) (2,069) (10,459)

Annual Net Available for Claims 762,266 804,055 836,448 870,147 905,203 1,636,099

Cumulative Net Available for Investment 962,266 1,766,321 2,602,769 3,472,916 4,378,118 23,251,038

Year 1 Year 2 Year 3 Year 4 Year 5 Year 20

Gross Income 825,000 800,000 800,000 800,000 800,000 800,000

Participation Fees - - - - - -

Investment Income 41,250 64,802 89,726 115,529 142,241 676,830

Fed Inc Tax (on earnings) */4 (358,050) (347,200) (347,200) (347,200) (347,200) (347,200)

Fed Inc Tax (on investments) */2 (10,106) (15,876) (21,983) (28,305) (34,849) (165,823)

State Inc Tax Rate 5.00% 5.00% 5.00% 5.00% 5.00% 5.00%

State Inc Tax Amount (2,063) (3,240) (4,486) (5,776) (7,112) (33,841)

Annual Amount Available for Investment 496,031 498,485 516,057 534,248 553,080 929,965

Cumulative Available for Investment 496,031 994,516 1,510,573 2,044,821 2,597,901 13,666,555

No Captive Captive No Captive Captive

Income Taxes

Gross Income Available 4,025,000 4,000,000 16,025,000 16,000,000

Investment Income 453,547 686,464 6,519,722 10,612,519

Expenses - (375,000) - (1,500,000)

Total Income 4,478,547 4,311,464 22,544,722 25,112,519

Income Tax (1,857,969) (126,996) (8,552,182) (1,963,315)

Capital in Insurance Company 200,000 200,000

Post Tax 2,620,578 4,384,468 13,992,540 23,349,204

Potential Income Tax Savings 1,763,890 9,356,664

Withdrawing Money from Captive

LTCG Taxes - (836,894) - (4,629,841)

Available 2,620,578 3,547,574 13,992,540 18,719,363

Estate Taxes

Potential Estate Taxes (1,179,260) - (6,296,643) -

To Heirs 1,441,318 3,547,574 7,695,897 18,719,363

Additional Benefit to Heirs 2,106,257 11,023,466

TAX ESTIMATE

20 Year Analysis

FINANCIAL SNAPSHOT - SCENARIO WITH CAPTIVE

FINANCIAL SNAPSHOT - SCENARIO WITHOUT CAPTIVE

5 Year Analysis

68

Thank You Kevin Allgood

Hub International [email protected]

Michaeline Gordon Dolgin Law Group

[email protected]

Lou Schendl Timberview Captive

[email protected]

Robert K. Wold Hub International

[email protected]


Attorneys at Law 69

mailto:[email protected]




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