Bermuda Captive Seminar RIMS New York Chapter September 16, 2010

Bermuda Captive Seminar

RIMS New York Chapter

September 16, 2010

PanelBeverley Todd, Executive Vice President, JLT Insurance Management (Bermuda) Ltd.

Carol Feathers, Managing DirectorAppleby Management (Bermuda) Ltd.

Neil Horner, Head of Corporate, Attride-Stirling & Woloniecki

Richard Irvine, Tax Partner, PricewaterhouseCoopers Bermuda

Shelby Weldon, Director, Insurance Licensing & AuthorisationsBermuda Monetary Authority

Agenda

1. Why Bermuda?

2. Why companies form captives and latest captive uses

3. How to form a Captive

4. Captive Tax Update

5. Bermuda’s Captive Regulation

Why Bermuda?

Beverley Todd, Executive Vice PresidentJLT Insurance Management (Bermuda) Ltd.

Why Bermuda

• Largest captive domicile• Blue chip offshore financial centre• 3rd largest insurance centre worldwide• One stop shop – access to insurance and reinsurance markets• Robust yet flexible regulatory environment• Professional infrastructure• Quality of workplace• Key geographical location• Competitive prices• Segregated Accounts & SPI Legislation• No Income or Capital taxes

Why Bermuda – Largest Captive Domicile

Why Bermuda – Captive FormationsSource: Bermuda Monetary Authority, Report of New Incorporations Dec 2009* Includes Class 3A; 3B & Composites

Class of Insurer 2009 2008

Class 1 9 5

Class 2 6 4

Class 3 19* 24*

Class 4 1 2

Long- Term 4 5

SPI 3

42 40

Why Companies Form Captives

• Insurance subsidiary of a commercial/financial company, or a consortium or an association of individuals

• Formed to primarily insure or reinsure the risks of its parent, or of a number of parties with risks in common or unrelated risks

• Usually formed in a specialized environment or “domicile” – “onshore” or “offshore”.

What is a Captive?

• Single Owner

• Multi-owner or Association

• Rent-a-Captive – multiple non-owner

• Protected or Segregated Cell Captive (PCC, SPC SAC) – any of the above

Types of Captive

Why Form a Captive?

• Reduce the Total Cost of Risk

• Risk Management Reward & Focus

• Direct Reinsurance Market Access

• Additional Capacity

• Flexibility in Program Design

• “Uninsurable” Risk

• Profit Centre

• Information and Control

Traditional Uses of Captives

• Traditional risks:

o Workers Compensation

o Auto Liability

o General Liability

• Expected Losses over $1 million

• Long tail covers seeking tax advantage


Workers Comp./ Employers Liability 35.9% gggggggggggggggggggggggggggggggggggggggggggg

General Liability 33.4% ggggggggggggggggggggggggggggggggggggggggg

Auto Liability 10.3% gggggggggggg

Professional Liability (other) 6.8% gggggggg

Medical Malpractice 3.6% gggg

Marine Liability 2.3% gg

Aviation Liability 1.8% gg

Umbrella 1.6% g

Products Liability 1.5% g

A&H (General) 0.9% g

Offshore Energy Liability 0.7% g

Life (General) 0.6% g

Personal Accident/ Travel 0.5% g

Casualty Lines of Business (Total Casualty = 100%) | 2009Source: Bermuda Annual Market Survey on Captives


Prop. Damage and Business Interruption 52.1% gggggggggggggggggggggggggggggggggggggggggggg

Product Warranty 12.1% gggggggggg

Marine Hull and Cargo 8.9% ggggggg

Agriculture 8.5% ggggggg

Offshore Energy Physical Damage 4.3% ggg

All Risk to Equipment 3.8% ggg

Aviation Hull and Cargo 2.9% gg

Auto P D 2.9% gg

Credit Risk 2.5% gg

All Risk to Builders and Contractors 0.8% g

Environmental Risk 0.7% g

All Other Property Lines 0.6% g

Property Lines of Business (Total Property = 100%) | 2009Source: Bermuda Annual Market Survey on Captives

• Capital commitment - the captive’s capital is not available for use in the parent’s business

• Adverse results - the captive’s capital can be eroded by adverse results under the insurance program

• Operating costs - a captive does incur operating costs and demands a time commitment from senior management

What are the disadvantages?

How a Typical Captive Operates

• Control of the captive will be by an appointed board of directors, usually a mix of local professionals and parent company workers

• The board then appoints local companies for services like banking, auditing etc

• Management company carries out all operational functions on behalf of the captive and provides insurance and other expertise that is required by the captive

Parent Corporation Or Association

Captive Board

Management Company

Auditors

Investment Managers

BankersRegulators

Lawyers

Captive Service Providers

Latest ideas on Captive use

Carol Feathers, Managing DirectorAppleby Management (Bermuda) Ltd.

• Continued soft market

• Interest rates low

• Below average return on investment

• Inflation on the rise

• Cash/liquidity still an issue

• Restricted credit, squeeze on collateral

Current Environment

• Incorporations continue

• Changing regulatory environment

• Economic environment driving strategic review and uses

• Owners are:o identifying untapped potential cost-saving mechanismso increasing retentionso accessing excess capitalo considering new lines of coverage

Current Captive Market

Liabilities and Capital

ExpensesIncome

Assets

The Parent Company

Where is the business coming from?

• Benefitso Retiree’s Medicalo Health Insurance

• Group Life – Company owned life insurance

• Pension

• Long Term Disability

• Short Term Disability

Expenses

• Product Contamination / Product Recall

• Owner Operator – Occupational Accident

• Extended Warranties

Income

• Cyber Risk

• Reputational Risk

• Residual Value

• Trade Credit

• Wealth Transfer

Assets

• Bailee Coverage / Storage Facilities

• Products Liability / Efficacy Combined

• Professional Indemnity

• Medical Malpractice

• Legacy Liabilities

Liabilities

• Segregated Cell Conversion

• License Class Changes

• Risk Management Funding

• Challenging Program Design

• Collateral Considerations

Other Interesting Developments

• Indications that P&C market will stay soft

• Organizations continue to assess the value of every $ spent

• Focus on optimizing risk

• Evaluate placing less coverage in the commercial insurance market and increasing retentions

• Combat high cost and availability of collateral

• Increase in global regulation

Outlook

Captives as a strategic risk financing tool are continuing to evolve and deliver benefits to the parent company in many areas, not just insurance and tax.

Conclusion

How to Form a Captive

Neil Horner, Head of CorporateAttride-Stirling & Woloniecki

Professional Services Team

The Incorporation Process

Steps to Licensing

1. Select Service Providers

2. Application to Incorporate and License

3. Incorporation, Organization and Capitalization

4. Register as an Insurer

Captive Insurance Company


• Insurance Manager / Principal Representative

• Auditors

• Actuary (if required)

• Legal / Corporate Secretarial

Step 1: Choosing Service Providers


Incorporation Submission• Registrar of Companies; and• Bermuda Monetary Authority:

o Authorisation and Compliance Division

Insurance Submission• Bermuda Monetary Authority:

o Insurance Divisiono Assessment & Licensing Committee (ALC)o Technical Advisory Group (TAG)

Step 2: Application to Incorporate and License


• Description of Shareholder

• Description of Insurance Businesso Lines of business to be writteno Layers to be writteno Fronting arrangementso Retention levels

• Reinsurance Program

• Investment Strategy

• Directors

• Service Providers

• 5 year financial projections

Step 2 Continued


• Incorporationo Receipt and filing of consent

• Organizationo Directors and Shareholders Meetings to:

• Issue shares• Approve bye-laws• Appoint auditors• Appoint insurance managers• Other formalities

• Capitalization

Step 3: Incorporation, Organisation & Capitilisation


• File formal application with the Bermuda Monetary Authority • The formal application should be the same as, or substantially similar to, the pre-incorporation application

Your Bermuda team of Professional ServiceProviders will lead you through steps 1 through 4

Step 4: Registration as an Insurer

Captive Tax Update

Richard Irvine, Tax PartnerPricewaterhouseCoopers Bermuda

Benefits of a properly structured captive

• In general reserves accrued for retained risks are not deductible for U.S. Federal income tax purposes (cash basis).

• Insurance premiums paid to a properly structured captive insurance company to fund retained risk should be currently deductible if coverage period of 12 months or less.

• A captive insurance company can set up deductible insurance reserves.

• Insurance premiums can generally be paid across borders to fund risk exposures and create local deductions.o Withholding tax versus Insurance Premiums Tax (IPT)

• Properly structured captive insurance arrangement generally accepted as a method of risk management.

• “Insurance” is neither defined in the statute nor the Treasury regulations.

• Judicial precedent provides the following framework for evaluating whether a scenario is an insurance arrangement (LeGierse):o Presence of insurance risko Risk shiftingo Risk distributiono Commonly accepted notions of insurance

• Common Structureso Parent/Subsidiary (Carnation, Clougherty Packing)o Brother/Sister (Humana, Kidde, Malone)o Third-party risk (AMERCO, Harper, Sears)

Definition of Insurance for U.S. Federal Income Tax Purposes


Parent/Subsidiary

Premiums

• Parent has not shifted its risk to Captive.o Balance sheet approacho Revenue Ruling 2002-89

• Premiums paid from Parent to Captive are not deductible.

• Captive is not considered an insurance company.

Parent

Captive


Brother/Sister

Parent

• Parent has not shifted its risk to Captive.o Balance Sheet approach

• Premiums paid from Parent to Captive are not deductible.

Subs

• Subs generally shift risk to captive.• Premiums paid from Subs to Captive are generally deductible provided certain bona fides are satisfied: premiums are arm’s length, the Captive is adequately capitalized, and the Captive is not propped up.

Captive

• Generally treated as an insurance company.

Parent

Subs CaptiveSubs

Premiums

Premiums


Third-Party Risk

Parent

• Parent generally shifts its risk to Captive, provided sufficient third-party risk is present.o Third-party risk benchmark > 30% of total premium

• Premiums paid from Parent to Captive are generally deductible, provided bona fides are satisfied.

Subs

• Subs generally shift risk to Captive.

• Premiums paid from Subs to Captive generally deductible, provided bona fides are satisfied.

Captive

• Generally treated as an insurance company.

Parent

Subs CaptiveSubs

Third-party Risk Premiums

Premiums

Premiums

ExamplesForeign Parent

Subs CaptiveNon US DomicileU.S. Subs

* Premiums

* Note: U.S. federal excise tax likely to apply.

Summary

• Scenario should qualify as a brother/sister insurance arrangement provided the bona fides are present.

• Premiums paid from U.S. Subs to Captive should be deductible.

• Captive should be treated as an insurance company for U.S. federal tax purposes.

Primary Benefits

• Capital is minimized by pooling risks.

• Management of risk is centralized.

• U.S. federal and state tax deductions should be accelerated creating increased cash flow.

• Investment earnings not subject to U.S. federal or state taxation.

• Funds are moved from the U.S. to a tax efficient jurisdiction of the Foreign Parent.

Tax Update

RECENT

CHANGES

• The IRS announced on January 26, 2010 a proposal that would require certain businesses to provide information about their uncertain tax positions identified in their accounting statements; e.g. FIN 48 (primarily codified in ASC 740-10).

• The Service intends the new schedule to be filed by a business taxpayer with total assets in excess of $10 million if the taxpayer has one or more uncertain tax positions.

• Schedule will be filed with Form 1120, U.S. Corporation Income Tax Return, or other business tax returns.

Uncertain Tax Position Disclosure

• The Schedule will require o A concise description of each uncertain tax position for

which the taxpayer or a related entity has recorded a reserve

o The maximum amount of potential federal tax liability attributable to each position (determined without regard to the taxpayer’s risk analysis of its likelihood of prevailing on the merits).

• “Concise” and “Maximum tax liability” are further embellished.

• Significant commentary was provided to the Service



• Announcement 2010-30o IRS unveils draft Schedule UTP, Uncertain Tax Position

Statement, and instructionso For each identified uncertainty, calculation of the MTA

(Maximum Tax Adjustment) will be required on an annual basis:

• The draft instructions provide a detailed description of how to calculate the MTA

• For transfer pricing and valuation positions, can use a “ranking” approach

• A response on the question of penalties is outstanding, however one option is to seek legislation from Congress to impose new penalties for failure to file the form or to make adequate disclosures.

United States v. Textron Inc.

• First case to test the new aggressive position the IRS is taking regarding the request for tax accrual workpapers.

• The First Circuit vacated the district court’s determination that a public corporation’s tax accrual workpapers were protected from IRS summons by the work-product doctrine.

• The First Circuit held that the work-product privilege was not implicated with regards to the taxpayer’s tax accrual workpapers, because it found that the work papers were not prepared “for” litigation and were thus required to be produced pursuant to an IRS administrative summons.

• Next Step: Currently before Supreme Court on a petition for certiorari

Codification of Economic Substance

• On March 18, 2010, The “economic substance” doctrine (IRC §7701(o)) became law as part of the Hiring Incentives to Restore Employment (“HIRE”) Act.

• States that “in the case of any transaction to which the economic substance is relevant, such transaction shall be treated as having economic substance only if:o (a) the transaction changes in a meaningful way (apart

from Federal income tax effects) the taxpayer’s economic position, and

o (b) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.”

Revenue Ruling 2009-26

• Revenue Ruling 2009-26: Illustrates applying insurance principles to reinsurance arrangements

• 2 situations:o (a) Company A reinsures multiple policies with Company

B (Company B writes no other business)o (b) Company A reinsures 1 policy with Company B

(Company B writes additional policies with other companies)

• Conclusion: Company B qualified as an insurance company per IRC Section 831 and both situations are considered to be insurance arrangements in the conventional sense as there was appropriate risk shifting and risk distribution.

Excise Tax – Cascading Theory

• Section 4371 of the Code imposes an excise tax on each policy of insurance, indemnity bond, annuity contract, or policy of reinsurance issued by any foreign insurer or reinsurer

• Revenue Ruling 2008-15 describes the insurance excise tax consequences of insurance premiums paid by one foreign (re)insurer to another

• Service position is the FET applies to every transaction of reinsurance with a foreign reinsurer (if US risks are reinsured) – Cascading Theory

• Significant IRS exam activity involving the FET

• Reinsurance of captives with foreign reinsurers

Notice 2008-19 – Stand Alone Treatment of Cells

• In conjunction with Revenue Ruling 2008-8, the IRS issued the Notice to propose further guidance regarding the status of such a cell as an insurance company within the meaning of §§ 816(a) and 831(c), and some of the consequences of a cell’s status as an insurance company.

• The Notice puts forth proposed guidance that would address (a) when a cell of a Protected Cell Company is treated as an insurance company for federal income tax purposes, and (b) some of the consequences of the treatment of a cell as an insurance company.

• Guidance was expected this summer; however, no guidance to date

Notice 2008-19 – Stand Alone Treatment of Cells

IRS Notice 2008-19

• Effect of insurance company treatment at the cell level under the proposed rule:

o Any tax elections that are available by reason of a cell’s status as an insurance company would be made by the cell;

o The cell would be required to receive an employer identification number (EIN) if it is subject to U.S. tax jurisdiction;

o The activities of the cell would be disregarded for purposes of determining the status of the Protected Cell Company as an insurance company for federal income tax purposes;

o The cell would be required to file all applicable federal income tax returns and pay all required taxes with respect to its income; and

o A Protected Cell Company would not take into account any items of income, deduction, reserve or credit with respect to any cell that is treated as an insurance company under the proposed rule making

IRC Section 162(m)

• The Patient Protection and Affordable Care Act adds a new provision to the Internal Revenue Code under Section 162(m). o rules on the deductibility of compensation made to

certain highly-paid individuals at publicly-traded companies.

• Adds a special provision applicable to health insurance providers (under a broad definition). Specifically, section 162(m)(6) will do the following:o Limits deductions at $500,000 for all remuneration paid

to all officers, employees, directors and independent contractors performing services for or on behalf of health insurance providers

IRC Section 162(m)

• To who does this provision apply - what are "health insurance providers?"o For taxable years beginning after December 31, 2009 and before

January 1, 2013, any employer which is health insurance issuer (under the Code) and which receives premiums for providing health insurance coverage (also defined under the Code)

o For taxable years beginning after December 31, 2012, any employer which is a health insurance issuer and with respect to which not less than 25% of the gross premiums received from providing health insurance coverage is from "minimum essential coverage" (as defined under the Act).

o All entities that are treated as members of the same controlled group under the qualified plan rules (Code Section 414) will be treated as one employer for the purpose of defining "health insurance provider.“

• Does your captive insure “health risks”?

IRS Exam Issues

• IRS continues to challenge captive insurance companies

• Variety of issues raisedo Risk concentration (e.g., risk distribution) where >50% of

the risk is concentrated in a single insuredo Existence of significant loanbackso Structural form followedo Timing of deduction of loss portfolio transfers

• Two Risk Distribution cases are docketed for Tax Court

Bermuda’s Captive Regulation

Shelby WeldonDirector, Licensing & Authorisations

Bermuda Monetary Authority


Outline

• Legislation

• Other Guidance

• Class Structure

• Ratios & Margins

• Statutory Financial Return

• Supervisory Model & Risk-Based Framework

• Regulatory Approach

• International Initiatives

• Insurance Act 1978

• Insurance Accounts Regulations 1980

• Insurance Returns & Solvency Regulations 1980

• Non-Resident Insurance Undertaking Act 1967

• Segregated Accounts Companies Act 2000


Legislation

Guidance Notes

20 separate Guidance Notes issued to date:

• Role of service providers

• Market Conduct

• Corporate Governance

• Risk Management and Internal Controls

• Investment Activity

• Investments in Affiliates

• Enhanced Capital

• Special Purpose Insurers


Code of Conduct

• Establishes duties, requirements and standards to be complied with by insurers including the procedures and sound principles to be observed;

• Application will take into account the insurer’s nature, scale and complexity

• Captive insurers should be mindful of the proportionality principle in establishing a sound corporate governance, risk management and internal controls framework.


Classes of General Insurance

• Class 1 - Pure Captives

• Class 2 - Group / Association Captives- Captives writing up to 20% unrelated business

• Class 3 - Captives writing > 20% but < 50% unrelated business

• Class 3A - Small Commercial Insurers

• Class 3B - Large Commercial Insurers

• Class 4 - Property Catastrophe / Excess Liability


Other Classes of Insurance

• Long-Term Insurers - Insurer writing long-term business (annuity or life, some accident and health business)

• Special Purposes Insurers - Insurer that carries on “special purpose business” where the Insurer fully funds its liabilities to the persons insured through the proceeds of a debit issuance or some other approved financing mechanism; cash; and time deposits.



Minimum Solvency Margin RequirementsClass of Insurer

Greater of

1100%

Related

2Under 20% Unrelated

320% to 50%

Unrelated

a) Minimum Statutory Capital & Surplus

$120,000 $250,000 $1 million

b) Premium Test: First $6 million of Net Premium Written

20% 20% 10%

Net Premium Written in excess of $6 million

10% 10% 15%

c) Loss Reserve Test: Loss and Loss Expense Reserve

10% 10% 15%

Minimum Liquidity Ratio: “Relevant Assets” shall not be less than 75% of RelevantLiabilities.

Statutory Financial Return

• Cover Sheet

• Declaration of Statutory Ratios

• Solvency Certificate

• Auditors Report

• Loss Reserve Specialist Opinion

Class 1 Only required if discounting reserves to meet solvency margin or more than 30% of the business written is professional liability

Class 2 Triennially (unless discounting reserves to meet solvency margin, or more than 30% of the business written is professional liability)

Class 3 Annually


• Captive vs. Commercial

• Risk-Based Approach

• Role of Principal Representative and Insurance Manager

• Captive Manager On-sites

• Segregated Accounts Companies (Rent-a-Captives).


Supervisory Model & Risk-Based Framework

Pragmatic Approach to Regulation

• “The World’s Risk Capital”

• Creativity and Innovation

• Section 56 Directions

• Modifying accounting regulationso Approving “relevant assets”o Admitting assetso Modifying filing requirements

• Regulations consistent with International Standards but applied appropriately for Bermuda Market.


International Initiatives• Monitoring and Actively Contributing to International Regulatory

Developments

• International Association of Insurance Supervisors (“IAIS”)o Member of IAIS Executive Committeeo Chair the Reinsurance Transparency Groupo Authority staff are on a total of 13 IAIS Committees

• Solvency IIo Capital Adequacy, Group Supervision, Disclosure &

Transparencyo Bermuda seeking Solvency II equivalence

• We believe our captive regime is already in accordance with international standards, however, we continue to monitor any global developments relevant to captives and we will adjust our regime accordingly.


Why Bermuda?

Bermuda Market Events

Event Date

Sedgwick’s Eighth Annual Hot Topics Seminar

October 6, 2010

Reinsurance Contract Wordings and Disputes

October 6 – 7, 2010

ALARYS 2010: Latin American Risk Management Conference

October 10 – 13, 2010

Goldman Sachs Asset Management 7th Annual Conference

November 16, 2010

Bermuda Captive Conference June 5 – 8, 2011

Bermuda Links

Organisation Link

Bermuda Monetary Authority www.bma.bm

Bermuda Market Solutions www.bermuda-insurance.org

Bermuda Captives www.bermudacaptive.bm

Bermuda Captive Owners Association

www.bcoa.bm

http://www.bma.bm/

http://www.bermuda-insurance.org/

http://www.bermudacaptive.bm/

http://www.bcoa.bm/

Documents

Bermuda Captive Seminar RIMS New York Chapter September 16, 2010