Captives and Risk Pooling
Captives and Risk Pooling
Speakers:
Lanette Frostestad
McKesson Corporation
Kieran O’Mahony
Aon Insurance Managers, (Cayman) Ltd.
Donna Weber
Marsh Management Services, Inc.
P. Bruce Wright
Dewey & LeBoeuf LLP
Moderator:
Roger Gillett
Benefits of pooling
•
Many captives strive to write unrelated (third party) business to spread
their risk, increase premium writings and conduct themselves as a “bona
fide” insurance company for tax purposes.
– Reduce cost of Captive program by accelerating deduction for losses
•
Most captives do not have the underwriting and claims management
expertise that would allow them to achieve this goal, on their own –
(without volatility!).
•
By becoming a member of a “pool of peers” whereby a captive
participates on a quota share reinsurance basis, a captive benefits from
accepting third party business that is:
– Pre-screened / Pre-underwritten
– Ceded on fair and equitable basis with no anti-selection
•
The “Portfolio Effect” - Reduction in variability of assumed Treaty losses
— Relative variability of Treaty lower than individual participant
Captive Taxation…
Insurance Company Treatment Through Reinsurance Pooling
• Insurance companies can deduct loss reserves - Corporations cannot
– Accelerated deduction on loss reserves reduces overall cost of
program by 5%-12% over self-insurance
• To achieve insurance company tax treatment a captive must fit the
Brother-Sister/Humana structure OR write 3rd party/unrelated
premium
– Unrelated premium min. between 30% to 51% of captive writings
– Humana structure – min. 12 subsidiaries, no one with more than
15% of risk…7 subsidiaries
• For companies which previously relied on the Humana fact pattern the addition of FIN48 raised the bar
– A definitive determination must be made that a tax position meets
a "more likely than not" threshold
• Captives that cannot meet the Humana test or have a border-line
position should consider writing unrelated premium
General Participation Requirements
•
•
•
•
•
A captive insurance company
Willing to take on risk and losses of others
Willing to devote the time necessary to manage the process
Accurate, consistent loss data
Expected, eligible losses of at least $2.5 million
– Workers’ Comp
– Auto Liability
– General Liability
• Willing to fund for losses prospectively
How does pooling work?
• Policyholders (via their captive) pay a premium that is based
on their anticipated loss pick, for a given layer
• Exchange a company’s individual risk for a (quota) share of a
portfolio (or “pool”) of similar risks
• Underwriting/pricing based upon a common approach to all
• No retrospective rating
• Premium is the basis of % participation in Treaty
• Captive assumes a share of the entire book of (pool’s) risk
• Treaty Reinsurers pay all insured losses
Nexus Re Program Structure
Mechanics Of Operation
Nexus Re – Brief Background
• Reinsurance company - wholly owned subsidiary of United
Insurance Company, A.M. Best rating of A- (“Excellent”).
Managed by Aon Insurance Managers (Cayman) Ltd.
• Nexus Re and its predecessors have provided risk pooling to
captives for over 30 years
– Nexus Re: 1999 onwards (1991, originally)
• Section 953(d) tax election taken
• Nexus Re enables “risk conversion” to take place:
– An exchange of an company’s individual risk for a (quota)
share of a portfolio (or “pool”) of similar risks
• Allows for the underwriting of third-party risks in a controlled
environment
Nexus Re Pool – contract flow (1st Party)
ABC
• Policyholder:
• purchases deductible reimbursement policy from captive
or a
• guaranteed cost policy from an admitted carrier
Corp
ABC
Captive
• Captive Insurance Company:
• issues deductible reimbursement policy to policyholder or
reinsures locally admitted carrier
• buys (facultative) reinsurance from Nexus Re
• Nexus Re:
• Underwrites and accepts facultative cession from captive
• Retrocedes (on a treaty basis) this and all other incoming
Nexus Re
facultative agreements (from the various captives)
Nexus Re Pool – retro to captives
(3rd Party)
Nexus Re
Quota Share
Retrocession
Treaty –
various %
Captive
n...
Captive
Captive
Captive
Captive
“ABC”
2
3
4
Treaty Retrocession Agreement
Risks retroceded from Nexus Re to various Captives
•
•
•
•
Renewal date 1 January
Retrocession Treaty on risks-attaching basis
Reinsurance Agreements have limits on incoming business
Each captive accepts share of pool losses and premiums,
based on its premium as a share of the pool
– Provisional share at 1 January;
– adjusted during year;
– final adjustment when all programs underwritten
Green Island Reinsurance Treaty
Program Structure
Mechanics Of Operation
Green Island Reinsurance Pool Structure
• Reinsurance treaty arrangement in existence since 1997
– Contractual arrangement among participating captive insurers
– NOT a Legal Entity, Association or Partnership
• In 2011, 15 participating captives with over $410 million of Treaty
premium
• Exchange individual risk for a quota share of similar pooled risk
• Green Island reinsures:
– Primary $150,000/occurrence of:
• Workers Compensation or FELA (mandatory)
• General Liability and Auto Liability (optional)
• Does not interfere or replace underlying insurance arrangement
– Client still needs a licensed carrier or to be a qualified self-insurer
How Green Island Works
• Reinsurance policy period – January 1 to December 31
• Certain limits and exclusions apply to risk ceded to Treaty
• One independent actuarial firm rates all Participants annually based
on their individual historical loss experience
• Participant loss rate x estimated exposure base determines premium
– Provisional premium/share on January 1, adjusted for exposure
base audit after policy period ends
EXAMPLE:
• Participant Expected Losses = Participant Premium: $8,000,000
• Total Treaty Expected Losses = Total Treaty Premium: $400,000,000
• Participation percentage = 2%
Green Island - Premium Flow
1st
Parent
Party Risk
Total Premium
$16 million
Captive
Premium Ceded
$8 million
(expected losses)
Related Risk
100%
Premium Assumed
$8 million
(2% Quota share)
Green Island
Total Premium $400,000,000
Unrelated Risk
98%
Green Island – Loss Payment Flow
TPA of Parent
Loss Data sent from
TPA to Green Island
Parent
Captive
Green Island reimburses
Captive for 100% of
parent’s losses* within
reimbursed layer
Captive pays 2% of
Total Treaty Losses
Green Island
* subject to reinsurance policy limits
and policy exclusions
Advantages of Risk Pooling
•
•
•
•
•
•
•
The Portfolio Effect - Relative variability of pooled losses lower than
individual participant losses
Designed to provide recurring form of risk diversification and third-party
premium to captives to support insurance company tax treatment
– May provide ability to leverage premium to write other long-tail lines
Predictability in pay out pattern – pools that have large homogenous
book of business such as Workers’ Compensation make for smoother
payout curve
– Stabilize captive cash flow by reducing claims variability
Tailored Premiums – Rates are established based on individual
participant’s unique risk profile and loss experience; not on market
pricing.
– Rating is based on 100% of predicted ultimate losses
Structured to limit participants’ assumed risk while still meeting risk
transfer requirements
No additional capital or surplus required (if captive is already writing
pooled lines)
Structured to minimize counterparty credit risk concerns
Pooling Structures
• TAX ISSUES
• GENERAL
• DEDUCTIBILITY OF PREMIUM PAID TO
CAPTIVE REQUIRES, IN GENERAL,
• RISK TRANSFER
• RISK DISTRIBUTION
• UNRELATED BUSINESS
• AFFILIATES
• CONCENTRATION OF RISK
• HOMOGENEITY
Pooling Structures
• TAX ISSUES
• GENERAL
• FEDERAL EXCISE TAX
• IMPOSED INITIALLY ON PAYMENT OF PREMIUM
FROM A U.S. PERSON TO A FOREIGN PERSON (NOT
ETB) WITH RESPECT TO U.S. RISK, IRC §§ 4371 et
seq.
• CASCADING TAX, REV. RUL 2008-15
• POOL MEMBERS
• FORMED IN A U.S. DOMICILE
• IRC § 953(d) ELECTION
• NON-U.S. DOMICILED, NON-ELECTING
Pooling Structures
• TAX ISSUES
• CONSEQUENCES OF POOLING
• REV. RUL. 2002-91, 2002-2 C.B. 991
• GROUP CAPTIVE
• NO MEMBER HAS >15% OF VOTE OR HAS RISK
INSURED >15% OF TOTAL RISK INSURED
• NO OBLIGATION TO PAY ADDITIONAL PREMIUM
• ALL FUNDS AVAILABLE TO PAY ALL CLAIMS
• TRUE INSURANCE HAZARDS
• CAPTIVE FORMED TO FACILITATE SECURING
AFFORDABLE COVERAGE
Pooling Structures
• TAX ISSUES
• CONSEQUENCES OF POOLING
• TECHNICAL ADVICE MEMORANDUM (TAM)
1998-2010
•
"IN THE PRESENT SITUATION, UNDER COINSURANCE
AGREEMENT A COMPANY CONTRIBUTES ALL OF ITS DIRECT
CONSIDERATION AND ASSOCIATED RISKS TO BE POOL AND,
UNDER COINSURANCE AGREEMENT B, COMPANY RECEIVES
A QUOTA SHARE OF THE CONSIDERATION AND ASSOCIATED
RISK FROM THE POOL EQUAL IN DOLLAR TERMS TO NUMBER
f% OF THE AMOUNT COMPANY CEDED TO THE POOL ON
EACH LINE OF COVERAGE. THE RESULT IS THAT THERE ARE
A SUFFICIENT NUMBER OF UNRELATED COVERED ENTITIES
SUCH THAT NONE IS PAYING FOR A SIGNIFICANT PORTION
4/13/2015
21
Pooling Structures
• TAX ISSUES
• CONSEQUENCES OF POOLING
• TECHNICAL ADVICE MEMORANDUM (TAM)
1998-2010 (CONTINUED)
•
OF ITS OWN RISKS. ACCORDINGLY, GIVEN THAT
INSURANCE RISKS ARE COVERED, THE ARRANGEMENT
ACHIEVES ADEQUATE RISK SHIFTING AND RISK
DISTRIBUTION SUCH THAT THE CONTRACTS ISSUED BY
COMPANY CONSTITUTE INSURANCE FOR FEDERAL INCOME
TAX PURPOSES. FOR THE YEAR FOR WHICH THE PREDICATE
FACTS WERE REPRESENTED, THIS APPEARS TO BE MORE
THAN HALF OF COMPANY'S BUSINESS."
Pooling Structures
• TAX ISSUES
• FEDERAL EXCISE TAX
• CCA 200844011
A
B
C
D
A
DOMESTIC
DOMESTIC
953(d)
953(d)
REINSURANCE
AGREEMENT
MANAGED
BY
FOREIGN
MANAGER
B
C
D
Pooling Structures
• TAX ISSUES
• FEDERAL EXCISE TAX
• CCA 200844011
• CHARACTERIZES REINSURANCE AGREEMENT AS A
PARTNERSHIP
• CONCLUDES PARTNERSHIP IS FOREIGN AS IT IS
NOT DOMESTIC AND MANAGED IN FOREIGN
COUNTRY
• CONCLUDES PARTNERSHIP SHOULD BE TREATED
AS AN ASSOCIATION TAXABLE AS A CORPORATION
• CONCLUDES PAYMENTS FROM A, B, C AND D
SUBJECT TO FEDERAL EXCISE TAX IMPOSED
UNDER IRC §§ 4371 et seq.
Pooling Structures
• TAX ISSUES
• FEDERAL EXCISE TAX
• CCA 200844011
• POSITION QUESTIONED AS POOL REQUIRES
• JURIDICAL ENTITY
• RECEIPT OF PREMIUM
• MAINTENANCE OF CAPITAL/RESERVES/BANK
ACCOUNTS/INVESTMENT PORTFOLIO
• ISSUANCE OF POLICIES
• PAYMENT OF CLAIMS
• IRS SUBSEQUENT POSITION
Pooling from a Participant’s Perspective
• Provides additional options / flexibility in corporate risk financing
decision-making
– Can lower the cost of risk financing
– Provides formalized structure
• Stabilizes significant portion of captive cash flows and risk profile
• Third-party premium example:
– $8M pooled casualty premium
• Provides $7.68M (98% unrelated premium assuming
$400M total Treaty)
– Enables company to cede additional $7.68M -$17.32M of
related party premium to captive on tax advantaged basis
• Long-tail lines most beneficial from financial perspective
– Product / General Liability, Workers’ Comp., Product Recall,
Environmental Liability, Professional Liability
Considerations from a Participant’s Perspective
What to look for in pooling facility…
• Proven track record
• Facility large enough to provide sufficient level of risk
diversification and unrelated premium
• Structure that supports stable loss results
• Transparency in pooling structure and transactions
• Common actuarial “underwriting” approach
• Participant- based decision making
– Clear road-map for decisions
• Structure that mitigates credit risk