Captives 301

1

Peter A. Joy, ARMAon Captive & Insurance Managers

Executive Vice President

Jim KasprzykMcDonald’s Corporation

Senior Director Corporate Insurance

Purpose of this Session

Give an appreciation of the advanced uses of captives Cell captive Branch RRGs Special Purpose Financial Captives Domicile Selection Tax Pooling Arrangements 831(b) Small Insurance Companies

Case Study – McDonald’s Corp

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What is a Captive?

A captive is an Alternative Risk Transfer vehicle

It transfers premium from the insurance marketplace to an alternative vehicle

It is a special form of insurance company that insures or reinsures the risks of related entities and closely managed business partners.

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Types of Captives

Pure Multiple captives Domicile importance

Cell CaptivesBranchRisk Retention GroupsSpecial Purpose Financial Captives

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Cell Captives

Various names, eg segregated cell, protected cell, etc Core is owned by one entity, and ‘cells’ are rented to

others Activity in cell is governed by contractual agreement or

preferred share arrangement ‘Capital’ (in the form of cash, LOC, parental guarantee,

reinsurance) must cover the maximum risk written by cell

Usually formed for a specific purpose and can be a short-term reaction to the marketplace

Easy exit if the market softens or a pure captive is pursued

Can be incorporated or non-incorporated

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Typical Cell Structure

Cell1

Cell2

Celletc...

Management

SharesCell3

Cell4

Cell5

Cell6

Cell7

Cell8

Cell9

Cell10

Insurance Shares (clients)

Cell10

Cell1

1. Each cell has legal segregation and protection of assets and liabilities

2. Legal segregation and contractual segregation

3. Management shares MAY be at risk

Bust6

PROTECTED PROTECTED

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Cell to Access Reinsurance

Cell1

Cell2

Celletc...

Management

Shares

Cell3

Cell4

Cell5

Cell6

Cell7

Cell8

Cell9

Cell10

Insurance Shares (clients)

Cell10

INSURED

REINSURER

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Cells to Segregate Liabilities

Cell1

Cell2

Celletc...

Management

SharesCell3

Cell4

Cell5

Cell6

Cell7

Cell8

Cell9

Cell10

Separate Insurable Risks

Cell10

Cell1

Each cell holds a separate liability, eg a physician practice, a property subject to legal challenges, etc

Cell6

8

Captive 1

Captive 6

Captive 10New

owners

Branch

Formed by a pure-captive for a specific purpose in another domicile

It is not an incorporated entity and so the D&O’s are the same as the parent

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Typical Branch Structure

Parent

Captive

Majority of lines of insurance

Specific line of insurance

Branch Captive

Branch results are reflected in captive since the branch is not

an incorporated entity

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Branch to Write Employee Benefits

Parent

Captive

Majority of lines of insurance

Employee Benefits Insurance

Branch Captive

Branch results are reflected in captive since the branch is not

an incorporated entity

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Life or LTD Insurer

Reinsurance

Branch to Write Surety

Parent

Captive

Majority of lines of insurance

Surety insurance HI or NVBranch Captive

Branch results are reflected in captive since the branch is not

an incorporated entity

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Certificatesof

Insurance

3rd-party

Risk Retention Group

Operates similar to a group captive yet is regulated under federal legislation

Can write direct – no front company needed Can operate in a state after it ‘registers’ Can only write liability lines of risk – no WC or property It is regulated very similar to a regular insurance company Subject to a great deal of scrutiny Insureds must be owners and owners must be insureds

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Risk

Retention

Group

Typical Risk Retention Group

SurplusAssessments

Capital

Premiums

If necessary

One Time

Annually

Owner

A

Owner

B

Owner

C

Members

Reinsurance(if any)

A

B

C

Reinsurers

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Risk

Retention

Group

Physician RRG

SurplusAssessments

Capital

Premiums

If necessary

One Time

Annually

Doc

A

Doc

B

Doc

C

Members

Reinsurance(if any)

A

B

C

Reinsurers

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Profit/Dividends

Risk

Retention

Group

Closed Trucking RRG

SurplusAssessments

Capital

Premiums

If necessary

One Time

Annually

Sub

A

Sub

B

Sub

C

Members

Evidence Insurance

FMCSA

State DMV

Customers

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Special Purpose Financial Captive

Primary example is the XXX Securitization Captive

Highly valued by Life InsurersEfficient way to remove redundant statutory

reserves from balance sheetMany states have specific laws to attract

such transactionsSome states have simpler, similar laws

that allow the captive to reinsure unrelated business

Used to capture another source of income!

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Domicile Selection

Domicile decision criteria: Capitalization requirements Costs – premium taxes vs license fees Receptiveness & stability of regulatory environment Quality of local infrastructure & expertise – or can I use

outside vendors? Flexibility as respects investment portfolio, loan backs,

etc Ease of doing business Convenience of travel if an annual domicile Board

meeting is mandated Acceptance of non-admitted reinsurance

Geographic ConvenienceDodd Frank Act – Self Procurement Tax

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WA

CA

IO

NV

MT

OR

WYSD

UTCO

ND

HI

NMAZ

TX

AR

KS

NE

OK

MS

LA

OH

NC

MO

IA

MN

ME

FL

TN

NY

PA

KY

IN

MI

IL

WI

GA

MA

NH

WVVA

AL

SC

DE

RI

CTNJ

VT

MD

DC

No Captive Legislation

Captive Legislation

Alaska is not shown, but does not have legislation

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Tax: to Achieve Insurance Company Status

There must be risk shifting and risk distribution The risk is shifted from the balance sheet of one entity

to the balance sheet of another A loss passed from the parent to the captive is not

shifted, because upon consolidation the loss is returned A loss passed from one subsidiary to another is shifted,

because the subsidiaries are not consolidated together - known as the Brother-Sister Structure

A loss passed from a 3rd-party entity to the captive is shifted because clearly the entities are not consolidated together

Risk distribution invokes the law of large numbers – the premium collected from many is used to pay the losses of the few

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Third Party Business

IRSSafe HarborRR2002-89

Case LawHumana/

Kidde

30%

50%

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Sources of Third Party Business

Unaffiliated Sources (potentially high risk and may be discouraged by captive regulator)

Affiliated Business Minority owned joint ventures Suppliers

Customer ProgramsEmployee Programs

Pooling

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Brother/Sister Model

CAPTIVE

Proportion of parent risk insured is not deductible

Subsidiary premiumsare deductible

Safe Harbor – 12 entitiesRR2005-40(5% - 15% premium range)

Case Law – 8 entities Malone & Hyde

SUB

All must have separate balance sheetsNo single member LLCs

SUB SUB SUBSUBSUBSUBSUBSUBSUBSUBSUB

Parent

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Pooling

Sharing in risks of others Controlled Reduces volatility Source of third party business

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Pooling

$10m $5m $5m $8m $30m $25m$2m$15m

10% 5% 5% 8% 30% 25%2%15%

Pool$100m

Pay in first partypremiums

Captives

Own proportion of pool:PremiumTotal Pool

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Pooling$10m $5m $5m $8m $30m $25m$2m$15m

$10m 5% 5% 8% 30% 25%2%$15m

Pool Value$100m

Pay in first partypremiums

Captives

Receive reinsurance premiums

First Party & Third Party

$1m$9m $0.04m

$1.96m $0.25m$4.75m

$0.64m$7.36m

$9m$21m

$6.25m$18.75m

$2.25m$12.75m $0.25m

$4.75m

3rd Party % 90% 85% 95% 92% 70% 75%98% 95%

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Federal Tax Accounting

Insured Captive Consolidated

Premium Deduction ($10) ($10)

Premium Income $10

Loss Reserve Deduction ($ 8)

Net Captive Income $ 2 $ 2

Net Consolidated Deduct ($ 8)

Tax Benefit @ 40% $3.2

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831(b) Election - Example

Insurance Company Without Election

Insurance Company With Election

Premium $1,200,000 $1,200,000

Claims $200,000 $200,000

Underwriting Profit/Loss

$1,000,000 $1,000,000

Investment Income $10,000 $10,000

Total Income $1,010,000 $1,010,000

Taxable Income $1,010,000 $10,000

Tax @ 35% $353,500 $3,500

Net Income $656,500 $1,007,500

Difference = $351,000

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Wealth Transfer

Trust 1

Grandson

Trust 2

Granddaughter

Auntie Mabel

InheritanceInsurance

Pops Co. 1

Pops Co. 2

Pops Co. 3

Pops Co. 4

Pops Co. 5

Pops Co. 6

Pops Co. 7

Pops Co. 8

Insured deductspremium as expense(Tax Saving $350k)

No Claims$1m

Dividend

$1m

CaptiveTakes831(b)

election

Shareholders paytax at their applicable

rate

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Putting all the Pieces TogetherMcDonald’s Corp - a Case study

The size of the insurance needsDiffering stakeholder needsMultiple CaptivesMultiple DomicilesNothing stays the same…..

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McDonald’s Corporation Inc.

$75 Billion in System-wide Sales32,500 StoresOperations in almost 120 Countries81% of locations franchised% of Profits by Area of the World

47% US 37% Europe 16% APMEA

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Scope of RM OperationsProperty & Casualty Coverage for: US &

International Company, Owner Operator and JV Stores

Corporate Insurance Programs such as excess liability, aviation, D & O, Fiduciary etc.

US Owner / Operator Health & Welfare Plan

Estimated Total Insurance Cost: $500 Million

Multiple Captives

Golden Arches Insurance Limited ( GAIL )

Golden Arches Re-Insurance Limited ( GARL )

McDonald’s Owner Operator Insurance Company ( MOOIC )

BRS Insurance Company

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Creativity Needed for Health Insurance

MIP offers a ‘ limited benefit ‘ plan with three medical options: Basic, Mid 5 and Mid 10

Mini Med PlanBasic Plan

Maximum Annual Benefit $2,000 per person $150 Annual Outpatient Deductible

Mid 5 Plan has $5,000 per person benefitMid 10 Plan a $10,000 per person benefit

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The Latest: BRS Insurance Company

Arizona captiveA new ‘ Risk Management Tool ‘ for use on

future employee benefit programs such as MIP

In the meantime, US Property Insurance Program and re-insurance for US Ronald McDonald House Charity: “package insurance policies”

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Nothing stays the same…..

Solvency II impacting Dublin captivesNew capital requirements, new costsNew Treasurer asking “Why?”Justify purpose and domicile all over againStay ahead of the curve

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ANY QUESTIONSANY QUESTIONS?37