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					Captive Insurance Concepts for the Small Business-Person
Presented by: G. Thomas Roberts
&

John R. Patton
McCarran Ferguson Consulting, Inc. Consultants to the Insurance Industry Ligonier, PA

What is a Family Captive?
An insurance company organized offshore that is owned by the shareholder(s) of a highly profitable small business which insures Life and P&C policies on a low risk basis and pays US Income Taxes at low rates, 0% up to 15%,

and not a penny more. This is called Tax Arbitrage

Traditional Captive Insurance
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Most existing captives are designed to reduce the cost of insuring an enterprise. These include
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Homogeneous Group Captives and Risk Retention Groups . Single Parent Captives are common among Fortune 500 Companies.

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Fronting companies are used. Reinsurance is the vehicle to pass experience gains to the Captive owners. Focus is on claims management

Opportunities for Small Business through Captives???
Are there opportunities small business to use a CAPTIVE for :  Saving or Deferring Income tax?  Arranging for Asset Protection?  Arranging for Wealth Transfer?  Reducing Estate Taxes?
YOU BET THERE ARE!!!

Captive Insurance Owner Profile
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Family-owned , nonpublic business
Profitability high, large tax payments P&C Insurance cost for traditional business insurance exceeds $20,000

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Owner is motivated to:
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Accumulate pre-tax savings account Accumulate asset base outside the operating company Accumulate pre-tax assets for gifting at valuation discounts

Objectives of Family Captive Programs
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Creating a New Profit Center Diversification of Investments Favorable Income Tax Treatment

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Asset Protection Wealth Accumulation Wealth Transfer Estate Tax Abatement

Hypothetical Accumulations and Savings through Family Captive
Assume a client’s operating corporation has net, before tax income, of $500,000 and invests these “excess” funds each year in the market and realizes an average return on investment of 10% (7% after tax).

After 10 years:

Hypothetical Accumulations and Savings through Family Captive
The operating company will have: $500,000 Less- $225,000 Fed, State Tax(1) $275,000 to invest/year And compounded at 10% (7% after tax) gives client $4,065,490 after 10 years.(2)
(1) assumes 45% combined Federal, State and Local tax rate (2) assumes payments at beginning of each year

Hypothetical Accumulations and Savings through Family Captive
But if client has a Family Captive he will have: $500,000 -$ 0 Federal & State tax $500,000 to invest/year And compounded at 10% (8.5% after tax) gives client $8,048,041 after 10 years

Hypothetical Accumulations and Savings through Family Captive
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Investment account balance: With Family Captive $8,048,041 Without Family Captive $4,065,490 Increase $3,982,551 This is a 200% increase in the invested assets account using the Family Captive Insurance program.

Important Principles for Tax Arbitrage found only in Family Captives
Remember these three points -- Its the heart of the whole concept

1.Premiums are deductible expenses 2.Captive is a US taxpayer and does not file on a consolidated 3.Captive is taxed at 15% rate and parent is taxed at about a 45% rate Tax Arbitrage = 30% of funds moved from the operating company to the captive through the payment of tax deductible P&C insurance premiums

Details - Getting the Deduction
Are the premiums really deductible? Aren’t they self-insurance?? and nondeductible??
There now are the settled legal principles:

Bright Line Tests from the IRS Code, Regulations and Tax Court Cases

Remember Self insured funding is not deductible until losses are PAID

Details - Getting the Deduction
Are the premiums really deductible? Aren’t they self-insurance?? and non-deductible?? RULE 1. Premiums paid to a Captive are deductible IF Captive and Insured have Brother /Sister relationship to one-another.  Humana (Brother / Sister) 6th Circuit, 1995  Kidde Industries (Brother / Sister) Fed Ct. of Claims 1997  Hospital Corp of America (Brother/Sister) 6th circuit 1997

Details - Getting the Deduction
Are the premiums really deductible? Aren’t they self-insurance?? and non-deductible?? Rule 1(A). Premiums are Deductible Another way to get the deduction for the premium payments  The Captive must insure more than 33% of its policies on third party risks  There is a long line of cases on this point, including the leading case, Comm’r. vs. Americo ( the 33% rule) 9th Circuit, 1992

Details - Tax status of the Captive
Rule 2. The Captive and Operating Company do not file Consolidated Tax Returns
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Consolidation NOT PERMITTED for the first 5 years, is elective thereafter This gives real value to the deduction for premiums paid

Details - Tax status of the Captive
Rule 2(A). Captive pays US Income taxes.
The Sec. 953(c)(3)(C) and(d) election The Captive is an offshore domiciled insurance company No income or other taxes are imposed by the Domicile nation Sec. 953 election to be taxed as a USA Insurance Company has these advantages:  Captive is NOT a Controlled Foreign Corporation  USA tax rates for Insurance Companies are as low as 15%  No Federal excise Tax, Pass-through of income or Branch Profits Taxes

Details - Tax Rate of 0% to 15%
Rule 3. Small Insurance Companies are tax advantaged
as a matter of public policy

Small P&C Companies
– Have less than $350,000 premiums - tax exempt, IRC Section 501-C (15)

Large P&C and Life Companies do not receive a break in tax rates Nominal rate is 45%

Details - Tax Rate of 0% to 15%?
Medium Size P&C Companies
Have $350,000 to $1,200,000 Premiums. Are taxed on either investment income or totla income, including underwriting profits - Tax rate is 45%. See IRC Section 831. For most medium sized companies, this means only investment income is taxed.
Large P&C and Life Companies do not receive a break in tax rates Nominal rate is 45%

Details - Tax Rate of 0% to 15%?
Small Life Companies
Have less than $500,000,000 asset base and Profits are less than $3,000,000 tax rate is 15%. See IRC Section 806 and 816.

Large P&C and Life Companies do not receive a break in tax rates Nominal rate is 45%

What is a Captive anyway?
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The Family Captive program involves formation of a fully Licensed Insurance Company in the British Virgin Islands. The Captive is owned by the Owner (or members of her/her family) to qualify as an insurance company under the US Tax Code. The Captive’s tax rate is 0 - 15%. The Owner or his/her business deducts premiums paid to the Captive. These amounts would otherwise be taxed at personal or corporate tax rates. This sets up a tax arbitrage that permits the Owner to accumulate investment assets at an accelerated rate, resulting in wealth accumulation and giving rise to numerous estate planning opportunities.

Single Parent Captive ( Brother Sister Type )
Parent Company

Captive Insurance Company

Operating Subsidiary

Subsidiary A

How Captives Work The Picture Before the Captive
$1,500,000 set aside from operations for Insurance costs and excess cash flow

$250,000 Insurance Premium for WC, GL & Auto

$1,000,000 cost of WC, GL & Auto

$750,000 Self Insured cost for WC, GL & Auto
$500,000 excess cash from Profits
(Taxable, current year)

How Family Captives Work The Picture after the Captive
$1,500,000 set aside from operations for insurance costs and excess cash flow
$250,000 Insurance Premium for WC, GL & Auto
$750,000 Self Insured Retention for WC GL & Auto

$1,000,000 cost of WC, GL & Auto

$500,000 cost of Excess Liability Policy

C A P T I V E

$500,000 Reserve (not income until earned)

Operating Company - to - Fronting Company - to -Captive Premiums Flow
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Premiums for WC, GL & Auto flow from operating company to Fronting Company and are then passed on to Captive. Premiums for Excess Liability flow directly to Captive
WC, GL & Auto

Operating Company
Excess Liability

Captive

C L A I M S

Fronting Company

How the P&C Captive Becomes A Life Company
If the Captive is too large to be a small P&C company,  The Family Captive maintains its self-insurance business  The Line Slip is a reinsurance pool that offers participating interests to Family s  Sufficient reserves are acquired to represent 51% of total reserves  The Captive is treated as a life insurer, subject to the 15 % tax rate

How the P&C Captive Becomes A Tax Qualified P&C Company
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The Family Captive Acquires P&C Reserves through a Line Slip Participation
The Line Slip is a reinsurance pool that offers participating interests to Family Captives. Sufficient reserves are acquired to represent 33% of total reserves.

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Line Slip Operation
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The Captive purchases the desired reserves from the Line Slip. Reserves can be transferred to another Captive in the pool, adjusting reserves upward or downward. Premiums, claims expenses and profits of the pool are distributed to Participating Captives, pro-rata, annually. Costs of Line Slip are about 4% of reserves.

After Line Slip: Operating Company-to-Fronting Company-to-Captive Reinsurance, Cash Flow
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Premiums for WC, GL & Auto flow from operating company to Fronting Company and are passed on to the Captive. Premiums for Excess Liability flow directly to the Captive Life Reinsurer Line Slip Reinsurance Premiums flow from Life Reinsurer
WC, GL & Auto

Fronting Company

Operating Company
Excess Liability

Captive

C L A I M S

Single Parent Captive
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The traditional model is to reduce P&C premiums
Involves reinsurance of P&C risks of the client’s operating company This is what the risk managers and P&C agents offer This is NOT the Family Captive Program

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The Family Captive
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The non-traditional model is to insure risks not presently insured, creating a contingency fund for future catastrophic losses These captives do not reinsure all P&C risks of the client’s operating company
The Family Captive focuses on investment of excess funds of the client’s operating company, using tax arbitrage, to create wealth

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Family Captive
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Focus on the investment function of insurance company operations. Insures a previously uninsured risk of the operating company. Does not reinsure traditional p&c policies of the operating company. Uses tax arbitrage to accumulate savings at an accelerated pace. Reinvests reserves back into operating company at competitive rates of return.

Example
What will the Client do with all this money accumulated inside the captive?
- Withdrawal as dividends or payment of salaries will create ordinary income. - Sale or liquidation of the captive will create capital gains - Holding until death will trigger estate taxes

IS THERE A BETTER WAY???

Asset Utilization Life
This is an exclusive feature of the Family Captive Program.  The Captive pays accumulated earning out as tax free life insurance proceeds at death of client.  Client buys a commercial policy with a face amount equal to the accumulated investment gains in the Family captive.  This policy is reinsured to the Family Captive.

Asset Utilization Life
We have converted the entire investment account to Tax Free money in the hands of the family members. No income tax to captive No income tax to client No dividends or capital gains to client No estate tax to client on investment account in captive

ALL THIS WITH BEFORE TAX OPERATING COMPANY $$$

Asset Utilization Life Premiums Flow
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Premiums for Life Policy are paid by client to Life Company and are reinsured to captive Premiums for Excess Liability flow directly to Captive
Life Premiums

Client Commercial Life Company Operating Company
Excess Liability

Captive

D e a t h B e n e f I t

Other Considerations
Estate Planning Wealth Transfer Asset Protection

Estate Planning & Captives
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Captives are closely held entities with restricted shares. Estate and Gift tax valuations will reflect discounted values.

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Insurance Company valuations often reflect discounts from book values. Captive reserving techniques are subjective, often resulting in low book values.

Wealth Transfer & Captives
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Captive stock can be gifted to some family members (to the exclusion of other family members)
This allows client to transfer values unrelated to the core business to some children And the core business can go to the children who will remain with the company

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Asset Protection & Captives
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Captive is organized in a Brother -Sister arrangement Assets of the Captive are separate from the operating company

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Transfer of assets to the captive is by payment of arms-length premiums Investment of assets by captive back to operating company is as secured creditor in bankruptcy of operating company

Captive Costs
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Start-up (first year) costs  Investment (cash &/or investment grade securitiesno junk bonds please) - $300,000 Minimum  Prof. & Mgmt. fees - $85,000 to $100,000  License fees - $4,500 Annual costs, second & Subsequent years  Professional & Management fees - $35,000 to $50,000  License fees - $3,500

Who Is a Candidate for the Family Captive?
Any profitable business

Captive Insurance Owner Profile


Family-owned , nonpublic business
Profitability high, more than $500,000 income before income taxes P&C Insurance cost for existing business insurance is $20,000

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Motivated to:
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

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Accumulate tax deductible savings account Accumulate asset base outside the operating company Accumulate pre-tax assets for gifting at valuation discounts

for more information concerning

Captive Insurance Strategies
contact: G. Thomas Roberts

or
John R. Patton McCarran Ferguson Consulting, Inc. 218 W. Main Street, Suite 200 Ligonier, PA 15658 724-238-8000 fax 724-238-8400 e-mail: info@mfconsulting.net


				
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