Captives 301

Peter A. Joy, ARM Aon Captive & Insurance Managers Executive Vice President Jim Kasprzyk McDonald’s Corporation Senior Director Corporate Insurance 1

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 2

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 Captives Branch Risk Retention Groups Special Purpose Financial Captives 4

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

Management Shares Insurance Shares (clients) Cell 1 Cell 2 Cell 3 Cell 4 Cell 5 Cell 6 Cell 7 Cell 8 Cell 9 Cell 10 Cell etc...

PROTECTED PROTECTED 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 6

Cell to Access Reinsurance

INSURED Management Shares Insurance Shares (clients) Cell 1 Cell 2 Cell 3 Cell 4 Cell 5 Cell 6 Cell 7 Cell 8 Cell 9 Cell 10 Cell etc...

REINSURER 7

Cells to Segregate Liabilities

Separate Insurable Risks Management Shares Cell 1 Cell 2 Cell 3 Cell 4 Cell 5 Cell 6 Cell 7 Cell 8 Cell 9 Cell 10 Cell etc...

New owners Captive 1 Captive 6 Captive 10 Each cell holds a separate liability, eg a physician practice, a property subject to legal challenges, etc 8

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 9

Parent

Majority of lines of insurance

Captive

Typical Branch Structure

Specific line of insurance

Branch Captive

Branch results are reflected in captive since the branch is not an incorporated entity 10

Branch to Write Employee Benefits

Parent

Majority of lines of insurance

Captive

Employee Benefits Insurance

Life or LTD Insurer Branch Captive

Reinsurance Branch results are reflected in captive since the branch is not an incorporated entity 11

Parent

Majority of lines of insurance

Captive

Branch to Write Surety

Surety insurance Branch results are reflected in captive since the branch is not an incorporated entity

HI or NV Branch Captive

Certificates of Insurance

3 rd -party

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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 13

Typical Risk Retention Group

Members Owner A One Time Capital Owner B Annually Premiums Owner C If necessary Surplus Assessments

Risk Retention Group

Reinsurance (if any) Reinsurers A B C

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Members Doc A One Time Capital Doc B Annually Premiums Doc C If necessary Surplus Assessments Profit/Dividends

Physician RRG

Risk Retention Group

Reinsurance (if any) Reinsurers A B C

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Closed Trucking RRG

Members Sub A One Time Capital Sub B Annually Premiums Sub C If necessary Surplus Assessments

Risk Retention Group

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 Insurers Efficient way to remove redundant statutory reserves from balance sheet Many states have specific laws to attract such transactions

Some 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 Convenience Dodd Frank Act – Self Procurement Tax

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WA MT OR IO WY CA NV UT AZ CO NM HI ND SD NE TX KS OK VT NH ME MN IA MO AR WI IL MS MI PA IN OH WV VA TN KY AL GA SC NC NY NJ DE MD DC MA RI CT LA FL Captive Legislation No Captive Legislation

Alaska is not shown, but does not have legislation 19

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 3 rd -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 20

Third Party Business

50% 30%

Case Law Humana/ Kidde IRS Safe Harbor RR2002-89 21

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 Programs Employee Programs 

Pooling

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Brother/Sister Model

Safe Harbor

– 12 entities RR2005-40 (5% - 15% premium range)

Case Law

– 8 entities Malone & Hyde Parent

Proportion of parent risk insured is not deductible

CAPTIVE SUB SUB SUB SUB SUB SUB SUB SUB SUB SUB SUB SUB

All must have separate balance sheets No single member LLCs Subsidiary premiums are deductible

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Pooling

 Sharing in risks of others   Controlled Reduces volatility  Source of third party business 24

$10m $15m $2m $5m

Pooling

$8m $30m $25m Captives $5m Pay in first party premiums Pool $100m Own proportion of pool: Premium Total Pool 10% 15% 2% 5% 5% 8% 30% 25% 25

$10m $15m $2m

Pooling

$5m $5m $8m $30m $25m

Captives

Pay in first party premiums Pool Value $100m Receive reinsurance premiums First Party & Third Party $1m $9m $10m $2.25m

$12.75m

$15m $0.04m

$1.96m

2% $0.25m

$4.75m

5% $0.25m

$4.75m

$0.64m

$7.36m

5% 8% $9m $21m $6.25m

$18.75m

30% 25% 3 rd Party % 90% 85% 98% 95% 95% 92% 70% 75% 26

Federal Tax Accounting

Premium Deduction Premium Income Loss Reserve Deduction Net Captive Income Net Consolidated Deduct Tax Benefit @ 40%

Insured

($10)

Captive

$10 ($ 8) $ 2

Consolidated

($10) $ 2 ($ 8) $3.2

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831(b) Election - Example

Premium Claims Underwriting Profit/Loss Investment Income Total Income Taxable Income Tax @ 35% Net Income Insurance Company Without Election $1,200,000 $200,000 $1,000,000 $10,000 $1,010,000 $1,010,000 $353,500 $656,500 Insurance Company With Election $1,200,000 $200,000 $1,000,000 $10,000 $1,010,000 $10,000 $3,500 $1,007,500 Difference = $351,000 28

Pops Co. 1 Pops Co. 2 Pops Co. 3 Pops Co. 4 Pops Co. 5 Pops Co. 6 Pops Co. 7 Pops Co. 8

Wealth Transfer

Insured deducts premium as expense (Tax Saving $350k) Inheritance Insurance

$1m

Captive Takes 831(b) election No Claims $1m Dividend Trust 1 Grandson Trust 2 Granddaughter Auntie Mabel Shareholders pay tax at their applicable rate 29

Putting all the Pieces Together McDonald’s Corp - a Case study

     The size of the insurance needs Differing stakeholder needs Multiple Captives Multiple Domiciles Nothing stays the same…..

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McDonald’s Corporation Inc.

     $75 Billion in System-wide Sales 32,500 Stores Operations in almost 120 Countries 81% of locations franchised % of Profits by Area of the World  47% US   37% Europe 16% APMEA 31

Scope of RM Operations

 Property & 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 33

Creativity Needed for Health Insurance

     MIP offers a ‘ limited benefit ‘ plan with three medical options: Basic, Mid 5 and Mid 10 Mini Med Plan Basic Plan  Maximum Annual Benefit $2,000 per person  $150 Annual Outpatient Deductible Mid 5 Plan has $5,000 per person benefit Mid 10 Plan a $10,000 per person benefit 34

The Latest: BRS Insurance Company

   Arizona captive A 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” 35

Nothing stays the same…..

     Solvency II impacting Dublin captives New capital requirements, new costs New Treasurer asking “Why?” Justify purpose and domicile all over again Stay ahead of the curve 36

ANY QUESTIONS

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