Captives and Risk Pooling

Captives and Risk Pooling

Speakers:

Lanette FrostestadMcKesson Corporation

Kieran O’Mahony Aon Insurance Managers, (Cayman) Ltd.

Donna WeberMarsh Management Services, Inc.

P. Bruce WrightDewey & 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)

Nexus Re Pool – retro to captives (3rd Party)

Captive

“ABC”

Captive

2

Captive

3

Captive n...

Quota Share Retrocession

Treaty – various %

Nexus Re

Captive

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

Total Premium $400,000,000

Related Risk100%

Unrelated Risk98%

Captive

Green Island

Premium Ceded$8 million

(expected losses)

Premium Assumed$8 million

(2% Quota share)

Parent 1st Party Risk

Total Premium $16 million

Green Island – Loss Payment Flow

Captive

Green Island

Parent

Captive pays 2% of Total Treaty Losses

Green Island reimburses Captive for 100% of

parent’s losses* within reimbursed layer

* subject to reinsurance policy limits and policy exclusions

TPA of Parent Loss Data sent from TPA to Green Island

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

04/20/23 21

• 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

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

REINSURANCEAGREEMENT

MANAGEDBY

FOREIGNMANAGER

A

B

C

D

DOMESTIC

DOMESTIC

953(d)

953(d)

A

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 Structures

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