POOLING ARRANGEMENTS FOR ENTERPRISE RISK CAPTIVES Spring Forum/Pooling... · POOLING ARRANGEMENTS FOR ENTERPRISE RISK CAPTIVES ... Enterprise Risk Pooling ... 35% of pooled risk BLUE

POOLING ARRANGEMENTS FOR ENTERPRISE RISK CAPTIVES

DCIA SPRING FORUMMay 12-13, 2015

Hotel DuPontWilmington, DE

Charles J. (“Chaz”) LavelleBingham Greenebaum Doll LLP3500 National City Tower101 S. Fifth StreetLouisville, KY 40202502/[email protected]

Jeffrey K. SimpsonGordon, Fournaris & Mammarella, P.A.1925 Lovering AvenueWilmington, DE 19806302/[email protected]

Enterprise Risk Pooling

Enterprise Risk =

– High Severity/Low Frequency

– First Party

Pooling =

– Third Party Risk

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WHY?

• Distribute Risk• Limit Impact of Large Loss• Shift Economic Impact To Others

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Today’s Discussion• Tax Aspects

• Risk Distribution Generally• Authority

• Structural Aspects• Key Features• Practical Considerations

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JUDGEMENT-FREE ZONE

• Everyone is Different• Many ways to do it

UNDERSTAND AND MANAGE RISKS

• Reading Tealeaves• Consider Pros & Cons

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Risk Distribution

Risk Distribution (from Rev. Rul. 2002-91)

• Risk distribution incorporates the statistical phenomenon known as the law of large numbers.

• Distributing risk allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as premiums

• By assuming numerous relatively small, independent risks that occur randomly over time, the insurer smooth's out losses to match more closely its receipt of premiums

• Risk distribution necessarily entails a pooling of premiums, so that the potential insured is not in significant part paying for its own risks

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Risk Distribution (cont’d)

• Risk Distribution thus has two elements:

– enough exposure units (allowing the law of averages [law of large numbers] to operate)

– pooling of premiums from which to pay losses (does it require multiple insureds to pay those premiums?)

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Theories for Success

There are two theories on which taxpayers with single owner captives have been successful in sharing risk

– “Brother-Sister” (Siblings)

– Sufficient “Third-Party,” “outside” or “unrelated” business (Strangers)

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“Brother-Sister” Insurance

• “Brother-Sister” Insurance

Parent

Insurance

SubsidiaryOper.

Sub

Oper.

Sub

Oper.

Sub

Oper.

Sub

Oper.

Sub

100%100%

Insurance

100% 100% 100% 100%

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“Brother-Sister” (cont'd)

• In Rev. Rul. 2001-31, the IRS essentially announced that it would abandon “economic family” and follow the Humana case in “plain vanilla” situations. It obsoleted Rev. Rul. 77-316

• In Rev. Rul. 2002-90, brother-sister insurance was found where there were 12 subsidiaries, each with between 5% and 15% of the risks, which risks were independent and homogeneous

• In Humana, Hospital Corporation of America and Kidde, the courts found that premiums paid by the parent are not insurance, even though they found there was brother-sister insurance, under the balance sheet test

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Third-Party, Unrelated or Outside Business

• Third-Party, Unrelated or Outside Insurance

Parent

Unrelated

Insureds

Insurance

Subsidiary

Operating

Subsidiaries

100%

100%

Insurance Insurance

Insurance

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Rev. Ruls. 88-72 and 89-61

• Sufficient “unrelated business” or outside business

– The IRS initially ruled that no related party premiums paid to a captive were deductible, even if they represented a very small percentage of the captive’s insurance portfolio. Rev. Rul. 88-72 and Rev. Rul. 89-61

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Sears case

• The IRS lost this case when it challenged the deductibility of premiums paid by Sears to its wholly owned insurance company, Allstate -- one of the largest insurance companies in the world. Sears’ premiums were less than 1% of Allstate’s premiums

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Sears case (cont'd)

• Third-Party or Outside Insurance

Sears

Unrelated

InsuredsAllstate

100%

ownership

99 ¾%

Insurance

¼%

Insurance

14

Harper Group case

• The Courts of Appeals have also ruled for the taxpayer in three other “outside” business cases: Amerco, Harper Group and Ocean Drilling

• The lowest amount of outside business in these cases was 29% for one of Harper Group’s years, where both the parent and subsidiaries are insureds

• Gulf found 2% outside business insufficient to support insurance

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Rev. Rul. 92-93 (employee benefits as third-party insurance)

• The IRS has ruled that life insurance on employees is unrelated business. Rev. Rul. 92-93. Several captives have obtained approval from the Department of Labor to provide insurance for employees of the captive’s affiliates.

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Revocation of Rev. Ruls. 88-72 and 89-61

• In Rev. Rul. 2001-31, the IRS essentially announced that it would abandon “economic family” and follow the Humana case in “plain vanilla” situations. It obsoleted Rev. Rul. 77-316 and the rulings (Rev. Ruls. 88-72 and 89-61) that insurance did not exist for related parties, no matter how much “third-party” business was present

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Rev. Rul. 2002-89

• Rev. Rul. 2002-89 ruled that there was no insurance of the parent where 90% of the captive’s premiums were from the parent, but there was parent insurance where less than 50% of the captive’s premiums were from the parent and the remainder were from unrelated parties

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Rev. Rul. 2002-89 (cont'd)

• Rev. Rul. 2002-89 (assume all other factors are “plain vanilla”)

Parent

Unrelated

InsuredsCaptive

100%

ownership

10% of the

Premiums

90% of the

Premiums

Unrelated

InsuredsCaptive

more than

50% of the

Premiums

less than

50% of the

Premiums

Parent

NOT INSURANCE INSURANCE

100%

ownership

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10% vs. 30% vs. 50% Outside Business

• Thus, the IRS official position is that 10% outside business is too little and 50% is sufficient. The IRS has not ruled on areas in between 10% and 50%, but it has been noted that 30% (Harper Group) is exactly half-way in between

• The Insurance Excise Tax Audit Guide (9/24/08) states that when all premiums are pooled (commingled funds), all premiums are likely to be considered insurance if outside third-party premium are greater than 30%. Chapter 6

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Homogeneity

• In IRS Notice 2005-49, the IRS asked for comments on the significance of “homogeneity”

• Insurance is homogenous if all the risks are in the same line of coverage

• The homogeneity issue is whether the IRS risk distribution tests (e.g., 50% unrelated business or 12 brother-sister corporations with 5-15% of the premiums) are computed on a line-by-line basis or on a company-wide basis

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Homogeneity (cont’d.)

• For example, is there insurance if the captive writes 49% of its business in a liability policy with the parent and 51% unrelated property damage? 51% employee health insurance?

• If there are twelve brother-sister corporations each paying $100,000 of premiums, do they all have to insure the same coverage line or can one insure property while the others insure workers’ compensation?

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Homogeneity (cont'd)

• Both the CICA and VCIA comments on homogeneity in response to IRS Notice 2005-49 state that homogeneity is not required in order to have insurance and that heterogeneous risks are sometimes preferred

• In CCA 200837041 – the Taxpayer’s section 501(c)(15) tax exempt status was revoked, in part, because it had twelve policies of ten different types for two insureds

23

Homogeneity (cont'd.)

• ILM 200849013 – Taken as a whole, the insurance program insured sufficient “brother-sisters,” after relaxing the 15% standard a little

• If insurance were tested on a line-by-line basis, at least some lines would not be insurance (e.g., one insured)

• The National Office refused to take a position on homogeneity

• It allowed the Examination Division to determine if homogeneity is relevant

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Counting the Percentage of Insurance

• How do you count the percentage insurance?

• Presumably the percentage net premium is the percentage of insurance (the Revenue Rulings assumed that the percentage of gross and net premiums was identical)

• If different coverage's are provided, is the percentage insurance directly proportional to net premiums?

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Pooling

• One way to insure third-party risks is to participate in “pools”

• While pools represent an established mechanism to insure unrelated risks, there was not much authority addressing their tax treatment until the last few years

• None of the authority is precedential, except for Rev. Rul. 2009-26

26

PLRs 201219009-201219011

• PLRs 201219009 through 201219011:– Three different rulings concerning unrelated

taxpayers that participated in the same insurance program

– Each insured (and affiliates) purchased insurance from its related captive

– 14 other captives did the same– The 15 captives reinsured x% (51%?) of their risks to

a pool, which pool retroceded a pro rata share back to the 15 captives

– Held – this is insurance– See also PLR 201224018 and 200844011

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PLRs 201219009-201219011 (cont’d)

• “Further, no opinion is expressed as to the federal income tax consequences of the transaction described above if Company makes any loans to its affiliated insureds or parties related thereto”

• “Further, no opinion has been requested and none has been expressed as to whether the reinsurance pool is an entity for federal income tax purposes”

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PLRs 201219009-201219011 (modified)

Contractual

Pool;

no

captive

exceeded

15%

P’ship A & Corp AOperating Entities

Corporation BOperating Entity

Partnership COperating Entity

This slide illustrates pooling, but does not address the number of insureds or show the number of insurers (15) resulting in risk distribution.

CAPTIVEA*

CAPTIVEB*

CAPTIVEC*

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PLR 201030014

• PLR 201030014 involved a sole proprietor that insured with a captive owned by a trust for the proprietor and his spouse

• The captive reinsured its risks with a Pooling Company, which pooled numerous risks and reinsured a proportionate part of several pools (a pool for each coverage)

• No captive insured more than 15% of the pools

• The next slide illustrates the concepts, but not the facts, of PLR 201030014

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Pooling

Ins. Co.45X Red Co Risks

+ 35X Yellow Risks

+ 20X Blue Co Risks

RED INSURANCE LTD.

45% of pooled risk

YELLOW INSURANCE LTD.

35% of pooled risk

BLUE INSURANCE LTD.

20% of pooled risk

BEFORE AFTER

Each coverage line has a separate pool.

This slide illustrates pooling, but does not address the number of insureds or insurers

needed for sufficient risk distribution.

RED INSURANCE LTD.

$45x of risk from Red Co.


$35x of risk from Yellow Co.

BLUE INSURANCE LTD.

$20x of risk from Blue Co.

Mr. Red

Yellow Co.

Group

Blue Co.

Group

PLR 201030014 (modified)

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PLR 200907006• PLR 200907006 involves a 100% pool, similar to PLR

201030014

• A group of related insureds insured with a captive

• That captive and 5 other unrelated captives reinsured 100% of their risks with “Lead Insurance Company,” which in turn retroceded (re-reinsured) a proportionate part of the risks to each captive

• Each captive insured a part of the risks of at least 12 insureds, none of which was more than 15% of the insured risks

• The IRS found insurance and cited the group captive ruling, although it seems the “unrelated business” ruling applied

• The next slide illustrates the concepts, but not the facts, of the PLR

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PLR 200907006 (modified)

Lead

Ins. Co.45X Red Co Risks

+ 35X Yellow Risks

+ 20X Blue Co Risks

RED INSURANCE LTD.

45% of pooled risk


35% of pooled risk

BLUE INSURANCE LTD.

20% of pooled risk

BEFORE AFTER



RED INSURANCE LTD.




BLUE INSURANCE LTD.


Red Co.

Group

Yellow Co.

Group

Blue Co.

Group

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PLRs 200950016 and 200950017

• Unrelated groups of insureds in the same industry insured three layers of coverage's with a fronting company

• The fronting company retained the upper layer and reinsured the lower and middle layer to Reinsurer A

• Reinsurer A retained the lower layer and reinsured the middle layer to Reinsurer B

• Reinsurer B reinsured a pro-rata portion of the middle layer to captive insurance companies owned by owners of the respective insured groups

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PLRs 200950016 and 200950017 (modified)

Reinsurer B45X Red Co Layer 2

+ 35X Yellow Layer 2

+ 20X Blue Co Layer 2

RED INSURANCE LTD.

45% of Layer 2 pooled risk



BLUE INSURANCE LTD.




RED CO.


YELLOW CO.


BLUE CO.


Front retains

Layer 3

Reinsurer A

retains Layer 1

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Are Brother–Sister Risks Third-Party Risks?

• “Brother-Sister” Insurance

Parent

Insurance

SubsidiaryOper.

Sub

Oper.

Sub

Oper.

Sub

Oper.

Sub

Oper.

Sub

100%100%

Insurance

100% 100% 100% 100%

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Are Brother–Sister Risks Third-Party Risks? (cont’d)

• From the perspective of a subsidiary, each of the other subsidiaries’ risk are “third party” in the sense that no subsidiary owns any stock in the other subsidiaries

• In light of Rev. Rul. 2001-31 and the abandonment of the “economic family” doctrine, the question arises whether the IRS will agree that parent premiums are insurance if the brother sister premiums are found to be insurance

• Harper Group also raised this issue, but did not have to answer it

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Key FeaturesLayer vs. First Dollar

Layer:• Protects Against Abusive & Nuisance Claims• Participants Feel Less Vulnerable• Very Few Shared Claims

First Dollar:• Every Claim is Shared• Increases Loss Frequency• Easier to Defend?

Struggle for Balance

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Key Features

Front or ReinsurancePool as Direct Writer:

• Facilitates High Volume Programs• Easier to Standardize and Issue Policies

• Beware of Multi-State Issues

Pool as Reinsurer• Easier for Pool (Simple Reinsurance)• May Add a Transaction (Reinsurance and Retrocession)

39

Key Features

Entity or Contract

Entity:• Direct regulation and frictional costs• May give participants more comfort• May be necessary if pool intends to retain risk

Contract:• Ease of entry and documentation• Can reduce administrative expenses• Who holds the money?• How do you pay claims?

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Key FeaturesTerm – Retrospective or Prospective

Several Pool Philosophies:• Fixed start date for current year• Rolling admission• Fixed future start date

Retrospective:• Mid or late year entry can force retrospective policy issuance• Might not be insurance

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Key Features

Premium Allocation

Consider how much premium is being pooled (typically in %)• Safe Harbor• Greater than 50%• But what if your quota share of pool includes your own

risk?

Consider how the % is determined• Often arbitrary or little actuarial support for

reasonableness• Easier to get comfortable in first dollar?• More difficult in layered or hybrid designs

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Key FeaturesMaximum Exposure (Stop Loss)

Always get asked• Some pools have stop loss provisions• Some pools buy stop loss coverage• Some pools ignore or don’t think they need stop loss

May be more important in open pools or pools with high limit exposures

Carefully circumscribed pools may not need it

Participant program or policy aggregates can operate as a virtual stop loss provision

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Key FeaturesCollateral

Natural Tension:• Captive owner wants his money in the captive• Pool needs to know the funds are available to pay claims

Common Methods:• Funds withheld• Pledged account• Controlled operating account or other set aside

Can be very messy if pool must collect from each participant to pay claims

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Practical Considerations

Open:• Can increase participants quickly• Broad diversity (risk, industry, geography)• Helpful in extraordinary situations

Closed:• More certainty regarding risks and vetting of participants• Enough participants?• Easier in and out

Open or Closed

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Practical ConsiderationsClaims

Magnitude and Frequency:• Pool’s history?• “Never had a claim!”• How much is enough?

Management:• Who adjusts claims and how?• What if there is a committee of participants?• Written record important

46

Practical Considerations

Transparency

How much do you need or want:• All participants known to one another?• All claims and claimants identified?

Should it work like a member-owned group?

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Practical ConsiderationsStandardization - Underwriting/Rating

Several different pool underwriting approaches:• All participants must be underwritten through pool’s

program• Pool must review and approve underwriting• Pool doesn’t consider underwriting

Does it matter for participant:• Subjectivity in rates• Not reviewing at all could be too laissez-faire• Otherwise, maybe more about confidence of the pool

provider

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Practical ConsiderationsStandardization - Coverages

Coverage selections may be more important than rating method because:

• Affect frequency and severity• Different appetites for different exposures• First party vs third party control

Homogeneity:• What does it mean?• Is it required?

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Practical ConsiderationsReaction to Experience

The most important factor of all?

How do you act like an insurance company?• What happens at renewal time?• Is there annual re-rating of underlying coverage?• Is there annual re-consideration of reasonableness of

premium allocation

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Documents

POOLING ARRANGEMENTS FOR ENTERPRISE RISK CAPTIVES Spring Forum/Pooling... · POOLING ARRANGEMENTS FOR ENTERPRISE RISK CAPTIVES ... Enterprise Risk Pooling ... 35% of pooled risk BLUE