views February 2016 Navigating the Complexities of Captive Insurance Companies: How to Navigate Through the Truths and Myths of Captive Insurance Brian Kilbane, Senior Manager | Assurance Determining whether to establish a captive insurance company can be quite confusing, especially for individuals who have no previous insurance industry experience. Furthermore, a captive insurance company may not be the right insurance risk management solution for all companies. The following are critical factors that companies should consider when determining if such a program is right for them. Captives Can Provide Numerous Benefits A major reason why captive insurance companies are so popular is that there may be a variety of benefits in placing risk with a captive insurance company. As long as the company properly follows the rules and regulations and performs robust due diligence to determine if a captive is feasible for them, there can be much to gain from owning a captive insurance company. There are four main potential benefits from a captive insurance program as described in the table below: Minimize Insurance Costs Control Risk Improve Cash Flow Accumulate Wealth Potential reduction in premium costs Helps control claim costs Accelerated deductibility of certain tax deductions Certain captive structures allow premiums to be earned tax exempt • Premiums are priced based on your actual loss history. Retain underwriting profit • Profit is not going to a third party insurance company. • Since you own an insurance company, you are incentivized to control claim costs. Access to reinsurance market • Generally cheaper catastrophe coverage than tail coverage. • Tax deduction when reserves are established versus when claims are paid. Premium dollars are retained • Premium is not going to a third party outside the organization. • IRC§831(b) captives do not tax underwriting income on premium volume up to $2.2 million*. Distributions may be taxed at a preferential dividend rate vs.

the estate, corporate or personal tax rate. * Existing law exempts underwriting income on up to $1.2 million of premium volume through December 31, 2016 - the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”) increases this level to $2.2 million beginning on January 1, 2017, subject to certain eligibility requirements. Assurance | Tax | Advisory | dhgllp.com . views Buyer Beware – Mitigating the Risks of Owning a Captive • Insurable risk – The risks insured in the insurance contract must be a valid insurable risk of the company. There may be an incentive to “create” risks in order to maximize the use of the §831(b) $2.2 million premium tax amount – this circumstance should be avoided. Questions to ask - Is it appropriate for a farming company in Iowa to have terrorism risk coverage? Is it appropriate for a professional services company to have environmental risk liability? If the proposed risks do not seem to make sense, there is a chance that they would not hold up under IRS scrutiny. The benefits described above can only be achieved if it is feasible for your company to invest in a captive insurance company and the captive and related contracts are established in accordance with U.S. GAAP accounting guidance, applicable tax law including Internal Revenue Service (IRS) tax rulings, and regulations of the domiciliary jurisdiction. The section below highlights some of the risks and issues that you need to be mindful of as you work through the decision making process of whether a captive insurance program is right for you. • Premiums must reflect the risk of loss – Another way to maximize the use of the §831(b) $2.2 million premium volume threshold is to increase the premium dollars in an insurance contract to make them as high as possible. Premiums need to reflect the true cost (in a third party sense) of the risk of loss insured under the insurance contract, and should not be much higher than if the company would have purchased the same contract in the open market. If your consultant is not using actuarial studies or market based research techniques to develop the premiums in an insurance contract, then there is a risk that the premiums being charged may not be supportable under IRS scrutiny. Risks and Issues to Consider Feasibility Study Even if a captive insurance company is set up and complies with all applicable rules and regulations, you still may not achieve the benefits of the captive based on your facts and circumstances. Therefore, it is imperative that a robust feasibility study be performed.

This study performs the necessary due diligence procedures to determine if your current ownership structure, insurance programs and other factors create a profile that can lead to a successful captive arrangement. Be mindful of a pre-packaged captive solution. A captive is not a one-size-fits-all solution.

Without performing this feasibility study, you run the risk of not getting the maximum benefit from the captive, or unknowingly violating rules and regulations. • Risk Shifting/Distribution – Under judicial and administrative guidance, including IRS rulings, there must be sufficient risk shifting and risk distribution for an arrangement to pass muster as insurance for federal income tax purposes. While there are no specific bright line tests (or an actual definition for that matter) that are dispositive, the IRS has published several rulings that provide “safe harbor” rules for what constitutes insurance for federal income tax purposes. For example, in a parent-subsidiary relationship, at least 50 percent of the premiums in the captive should be unrelated, third party risk.

If the captive is insuring brother-sister companies, the IRS has ruled that 12 subsidiaries, where no subsidiary accounts for more than 15 percent of the total insured risk, is indicative of sufficient risk shifting/distribution. Finally, the IRS has ruled that disregarded entities, like LLC’s, will not be respected in determining the number of subsidiaries for purposes of risk distribution. Must have a valid insurance contract To achieve the benefits of insurance tax accounting, the contract between the insured and the captive insurance company must be a valid insurance contract, just as if the company were dealing with a third party insurance company. To be a valid insurance contract, the contract must possess the following characteristics: • Risk of loss – There needs to be a possibility that the captive insurance company can suffer a net economic loss if a large loss event were to occur. For example, in an auto insurance contract with an annual premium of $1,000, and a vehicle worth $15,000, there is a chance that the insurance company may suffer a net loss (loss in excess of $1,000) if the automobile was a total loss.

Contract provisions that provide for premium reimbursements; claim deposit accounts; or other provisions that mitigate the risk of loss to the captive may invalidate a contract as an insurance contract. Assurance | Tax | Advisory | dhgllp.com Complex new diversification requirements of §831(b) resulting from the PATH Act. Enactment of the PATH Act provided a welcome increase in the maximum net written premiums that will allow an insurance company to elect to be taxed solely on its 2 . views investment income. However, this comes with a set of criteria that is strict and complex. The captive must meet one of the two tests below: impacts many different departments: risk management, accounting, finance, treasury, legal, etc. Each department needs to be responsible for ensuring that the captive is providing the benefits as expected and to analyze results to anticipate any unexpected claims or results in the future. Companies that fail to do this analysis run the risk of not having a successful captive program. • Test #1 – No more than 20 percent of the net written premiums (or, if greater, direct written premiums) of the captive for the taxable year is attributable to any one policyholder. Captives domiciled in countries without audit requirements • Test #2 – The owner of the captive must have essentially the same ownership percentage in the captive as it does in the parent company (within a 2 percent margin of difference). To save on administration expenses, some captives are established in offshore jurisdictions that do not have annual audit requirements.

Although this approach is a valid cost saving measure, you must be sure this approach is not being used to avoid additional scrutiny of a potentially aggressive captive structure. The specific application of these tests is complex and requires analysis of ownership attribution as well as direct ownership. Upon enactment, little application guidance was provided by Congress – it is expected that administrative guidance will surface as Treasury considers the new rules. What Can DHG LLP Do To Help? At DHG, we have seasoned tax, audit and advisory personnel that have deep experience in advising clients on many facets of the captive insurance industry. We offer the following captive services: Therefore, we recommend if you are considering an §831(b) captive, to consult with DHG’s captive insurance specialists to walk you through these complexities and find the right solution for you. • Captive Feasibility Study • External Audit Account for expected claim and administration expenses • Tax Provision Preparation • Tax Return Preparation There are meaningful costs associated with the operation of a captive insurance company. The captive insurance company must pay a captive management company to manage the day to day activities of the captive, including coordinating with the claims administrator, investment manager, investment custodian, actuarial firm and audit firm.

These expenses can be standard on a year over year basis and therefore can be typically anticipated in your cost-benefit analysis. The most significant variable in the cost benefit analysis is claims frequency and severity, which further highlights the significance of a robust feasibility study. • Tax Consulting • Internal Audit Assessments • Risk Governance Assessments • Accounting Policy and Control Services • Financial Reporting Outsourcing • Transaction and Accounting Analysis • Training and Education Let us help you through your captive insurance company considerations. You might see pro-forma financials without claim expenses or very low claim expenses, giving the false impression that there will be no insurance losses suffered by the captive. That is not always the case and you need to be prepared for ups and downs of owning an insurance company. The insurance business is a long-term business, where the goal is to produce a net underwriting gain when considering the positive years as offset by the negative years. About the Author Brian Kilbane, a senior manager on the firm’s Assurance Services team, has more than 15 years of experience in the insurance industry.

His extensive experience includes leading domestic and international insurance audits with complex and diverse issues within property, casualty, life, reinsurance, captive and catastrophe insurance companies. Proper oversight of captive operations Brian Kilbane Senior Manager, Assurance 404.575.8954 brian.kilbane@dhgllp.com From a parent company’s perspective, it is easy to allow the captive managers to run the day to day operations of the captive, or leave it up to one individual at the company to oversee the captive. However, the captive insurance company Assurance | Tax | Advisory | dhgllp.com • IT Risk Consulting 3 .