180
o
A guide to what’s hot in the world of captives and ART
Inside This Issue
Small Captive Developments
Issue 42, Q3 2015
Industry News
Domicile News
Small Captive Developments
In last quarter’s newsletter we reported on two seemingly contrasting developments for small captives:

The passing of the House Finance Committee’s proposal to
raise the premium limit for the 831(b) election from $1.2 million annually to $2.2 million; and

The naming of small captives to the IRS dirty dozen tax scams.
the election. Increasingly, small SRS News
captives are being formed that
qualify for the election and where
the benefits of the election are a key determinant of captive feasibility. The growth has been driven by:

Changes introduced in the Pension Funding Act of 2004 (see
180o, Issue 3). These effectively eliminated the IRC 501(c)(15)
election for captives. This election had allowed for insurers
with less than $350,000 in premium to be exempted from US
taxes including tax on investment income and capital gains tax.
The 2004 changes also eliminated the minimum premium size
for the 831(b) election meaning that captives and service providers previously using the 501(c)(15) election are now focused
on the 831(b) election.

Improved risk management techniques in the middle market,
both the ability to recognize uninsured risks and the financial
tools to manage them including the use of captives.

Improved economic conditions leading to greater exposures
and more available capital since the financial crisis in 2008.
In this newsletter we look more closely at these developments and
where they stand. Readers may also wish to refer to our June webinar on this subject.
Background to the 831(b) Election
The 831(b) election was first introduced with the Tax Reform Act
of 1986. It was intended as an incentive for small or medium sized
businesses, particularly farmers cooperatives, to assume risk at a
time when the commercial insurance industry in the US was in a
time of crisis. This was the same period which led to the passing of
the Federal Risk Retention Liability Act. The 831(b) election allows
for small insurance companies to elect to be taxed on their investment income only. This structure was seen as being especially attractive for short-tail property lines of coverage, such as crop insurance, where significant losses may occur once every few years. By
not taxing the insurer on its underwriting income in the years where
no losses occurred, it allowed the insurer to more quickly build capacity to replace the commercial insurers who were leaving the
market. The tax was structured as an alternative tax structure to the
traditional tax on insurance companies contained in section 831(a)
of the Internal Revenue Code.
The election allows an insurance company other than a life insurance company to be taxed on its investment income only, if net
written premiums for the taxable year do not exceed $1.2 million.
There are several important provisos to the election that are designed to prevent moving between traditional and alternative tax
structures depending on whether the insurer has had losses or not in
the taxable year:

Once made the election can not be revoked except with the
approval of the Secretary of the Treasury.

Net operating losses can not be carried to or from a year in
which the election is made.

Net operating losses can not be carried forward or back across
a year in which the election is made.
The 831(b) Election and Captive Use
Since it was passed, captives and other small insurance companies
have taken advantage of the 831(b) election where it made sense for
them to use this alternative tax structure. It was never a driving factor for the formation of the captive and most captives did not take
IRS Concerns
With the growth in the number of captives taking the 831(b) election, the IRS has become increasingly concerned about abuses and
captives formed purely to obtain the tax benefits of the election.
The major areas of concern have been:

Coverages which cover ordinary business risks or esoteric,
implausible risks for exorbitant premiums.

Premiums where there is no or little actuarial substantiation for
the amounts charged.

Unscrupulous promoters charging excessive fees.

Captives purchasing life insurance as part of their investment
portfolio. As the cash value of life insurance grows tax deferred, captives could avoid tax on investment income as well
as underwriting income and mimic the benefits of the 501(c)
(15) election but with greater amounts due to the higher 831(b)
premium limit.
The extent to which the IRS is concerned about abuse of the 831(b)
election was shown by naming the use of captives to the dirty dozen
list of tax scams. It should be noted that the IRS has acknowledged
that a captive making a 831(b) election is a legitimate structure. It is
concerned about the abuse of the election, not the election itself.
Proposed Increase in the Limits
There have been several attempts in recent years to increase the
limit for the 831(b) election. The push for the increase has generally
come from senators from the Mid-West who support the increase
for the benefit of small rural property and casualty insurers, who
were the focus of the original legislation. It is supported by the National Association of Mutual Insurance Companies (NAMIC). The
1
$1.2 million limit has not been increased since 1986 and CPI inflation adjustment would put the limit in excess of $2.6 million in
2015 money. The most recent proposal was championed by Senator
Grassley (R-Iowa) and provides for an increase in the premium limit to $2.2 million indexed for inflation. The initial version of the
proposal contained two restrictions which would have made the
election unavailable for many captives:


A limitation of 20% of premium from any one policyholder.
Related family members would be treated as one policyholder.
Neither of these limitations made it into the proposal passed by the
Senate Finance Committee in February. However Senator Grassley
did include a request that the US Treasury perform a study on the
abuses of captive insurance for estate planning purposes. This study
is currently being conducted and is due to be completed by February 11, 2016. Bills have been introduced in both the Senate and the
House to increase the premium limit under the 831(b) election to
$2.2 million. The House bill (HR 1788) is sponsored by Representative Erik Paulsen, Minnesota (R), and Representative Ron
Kind, Wisconsin (D). The Senate Bill (SB 905) is sponsored by
Senator Orrin Hatch, Utah (R).
Industry Response
The insurance and captive industries have been actively involved in
these developments. The Self Insurance Institute of America (SIIA)
has developed a position paper on the abuse of captives for estate
planning purposes and has proposed two limitations on the use of
831(b) captives for estate planning purposes:
 Restrict captives from purchasing life insurance on its direct or
indirect owners or primary insureds, and
 Restrict ownership structures that use irrevocable trusts to
avoid the estate tax.
In addition, it is requesting Congress include a there year sunset
provision for those who previously entered into captive arrangements within the parameters of the law. The National Association of
Insurance Commissioners has generally adopted the SIIA proposal,
though with a total prohibition on the use of irrevocable trusts and a
two year sunset provision.
Likely Outcome
The window is closing on the Senate and House bills and in reality
they will probably need to be attached to another piece of legislation to be passed. Prior efforts at raising the premium limit for the
831(b) election have failed due to the lack of offsetting revenue and
the current bills may face the same challenge. Tightening the use to
address perceived abuse in the use of captives for estate planning
purposes may achieve that offsetting revenue and alleviate some of
the current scrutiny on small captives.
Industry News
Montana Decision Upholds PCC Structure
In June, the US District Court in Montana issued a declaratory judgment in a case involving a protected cell captive (PCC) formed under Montana law. This is a significant ruling as it is the first reported court case involving a cell captive.
Key Facts
The case, Pac Re 5-AT v. AmTrust N.A., involved a dispute under a
reinsurance agreement issued by AmTrust North America to the
protected cell captive (Pacific Re) in respect of one of its cells, Pac
Re 5-AT (“Cell 5”). AmTrust invoked the arbitration clause under
the reinsurance agreement and sought to join Pacific Re as a party
to the arbitration. Pacific Re alleged that the cell was the proper
party to the arbitration and sought a declaratory judgement to that
effect.
Court Findings and Implications
The Court ruled that the captive was the correct party to the arbitration not the cell. In doing so it recognized that the liabilities and
assets of a protected cell are segregated from the other cells and
from the PCC, but a protected cell does not have a separate legal
identity from its cell captive. It can not sue or be sued.
This ruling effectively endorses the Montana statutory regime for
the segregation of assets and liabilities between cells of a cell captive. The ruling only addressed who is the correct party of the arbitration proceedings. The effectiveness of the segregation remains an
issue for the arbitration. However, it does mean that the core of a
protected cell captive cannot avoid being involved in a dispute between one of its unincorporated cells and a third party.
This case involves an unincorporated cell under Montana’s protected cell captive legislation. An incorporated cell or a series business
unit allowable under other captive legislation may have a different
outcome.
Court of Appeal Upholds Validus Decision
On May 26, the US Court of Appeals for the District of Columbia
upheld a District Court decision ruling that the IRS can not impose
excise tax on wholly foreign retrocessional coverages. The case and
this ruling has important implications in limiting the extent of cascading Federal Excise Tax (FET) obligations under IRC §4371.
Under Revenue Ruling 2008-15, the IRS had sought to collect FET
on not only the insurance or reinsurance transactions from US risks
to foreign reinsurers, but on all subsequent reinsurance of those
risks between foreign reinsurers. The Validus case involved a Bermuda captive reinsuring risk from the US and then laying off that
risk through retrocessional contracts with foreign reinsurers. The
court ruled that the IRS was not authorized to impose FET on the
premiums paid under the retrocession agreements as these were
wholly-foreign retrocessions. It is important to note that the appeals
court ruling was narrower than the lower court and applied only to
wholly-foreign retrocessions. Cascading FET may still apply if the
retrocession is from a US reinsurer to a foreign retrocessionaire.
US
Insured
US
Insurer
Foreign
Reinsurer
FET*
Foreign Reinsurer (Captive)
Foreign
Reinsurer
Not subject
to FET under Validus
ruling.
* Unless taking 953(d) election
180o, Issue 42, Q3 2015
2
6.
Domicile News
Vermont Passes New Captive Legislation
On May 7, Governor Shumlin signed Act 20 which enacted several
improvements to Vermont’s captive legislation. The changes include expanding the investment guidelines for minimum capital
requirements to allow marketable securities along with cash, trusts
and letters of credit to meet the minimum capital requirement. This
is a significant change increasing the liquidity options for captives.
Vermont is the first domicile to pass legislation allowing marketable securities as part of its minimum capital requirement. Other
changes included:
Each sponsored cell captive will be required to pay an annual
license renewal fee of $1,000 per cell.
Wide Reaching Changes to Delaware’s Captive Laws
Governor Markell signed an extensive list of changes to Delaware’s
laws effective June 24, 2015. The changes contained in House Bill
15 included:

Amending the definition of branch captive under Delaware’s
captive legislation to promote more branch captive formations.

Increases in the application and processing fees and in the annual licensing fees. The fees had remained unchanged for the
prior ten years.

Clarifying that a series may be licensed as a pure, association,
industrial insured, special purpose captive insurance company,
or series captive.

Providing liability protection to a person who communicates or
delivers information to the Commissioner pursuant to an examination, investigation, or regulatory inquiry conducted by the
Commissioner.

A reduction in the minimum capital requirement for cell captives from $500,000 to $250,000.

Adoption of the NAIC Model Governance Standards for Risk
Retention Groups.

Adoption of portions of the NAIC Protected Cell Model Act
language regarding the segregation of assets and liabilities,
contracting by/for cells, treatment of cells in the case of delinquency and the reach of creditors.

A reduction in the number of incorporators from 3 to 1 to be
consistent with most other incorporations under Vermont law.
SRS News

Adding the requirement to include the words “Incorporated
Cell” or “IC” in the naming convention for incorporated protected cells.
Client Symposium
The changes take effect immediately with the exception of the RRG
governance standards which will apply to existing RRGs one year
after the effective date of the Act, providing those RRGs a grace
period to come into compliance.
Montana Passes Two Captive Amendments
In April, Governor Steve Bullock signed two separate bills amending Montana’s captive legislation:

H.B. 536 authorizes public sector entities in the state to establish captive insurance companies.

H.B. 537 clarifies existing statutes to specify that captive insurance companies can be set up as limited liability companies.
Our fourth client symposium will be held at the Four Seasons hotel
in Atlanta, GA, October 7—8, 2015. The event will begin on
Wednesday October 7th with a welcome reception and dinner. For
new captive owners or board members we will have an optional “Basics of Captives” on Wednesday afternoon. Thursday will be
a full day of educational sessions followed by our client appreciation dinner being held at the High Museum of Art.
We are finalizing the program and it is shaping up to be an excellent
educational opportunity to learn from many thought leaders on various topics as well captive industry experts. We have a great panel
of nationally recognized speakers that will be joined by SRS staff
including:
1.
Utah Captive Changes
Following its 2015 Legislative Session, Utah implemented several
changes to its captive legislation effective May 12, 2015.
1.
2.
3.
4.
5.
Including language specifically addressing the use of limited
liability companies as a type of captive formation. Previous
language only addressed stock company formations.
The captive exam cycle has been increased from a three year to
a five year period.
The required minimum of $250,000 to be maintained as paid-in
capital and free surplus may be accomplished through any
combination of either. Prior language specified a paid-in capital
requirement of $100,000 and a free surplus requirement of
$150,000.
Capitalization of a cell captive sponsor remains $1,000,000.
However, the new language indicates that only a minimum of
$350,000 must be provided by the sponsor. The balance may be
provided by the cell companies.
Pooling can take place within the sponsor of a cell captive.
2.
3.
4.
5.
6.
7.
David Darst – Senior Advisor to and a member of the Morgan
Stanley Wealth Management Global Investment Committee
and former Managing Director and Chief Investment Strategist
of the firm.
Tom Jones - Partner, McDermott Will & Emery.
Stephen Sofoul – President, Benefits Science Technologies.
David Aughtry – Partner, Chamberlain, Hrdlicka, White, Williams & Aughtry.
Harlan Loeb – Global Practice Chair-Crisis & Risk, Edelman.
Chaz Lavelle – Senior Partner Greenebaum Doll & McDonald.
Captive Regulators from leading onshore and offshore domiciles.
We will also have industry specific (healthcare, construction, etc.)
and subject matter (employee benefits, small captives, etc.) workshops where we take a deeper dive on particular topics.
The event is for clients of SRS and we will be sending full details of
the program shortly. Registration is currently open. If you are a
client of the firm and have not registered or received the registration
details,
please
contact
Courtney
Flynn
at
[email protected].
3
180o, Issue 42, Q3 2015
Staff News
We are pleased to welcome several new members of staff during the
last quarter.
Liz Frederick joined the fir m on J une 22nd as Regional Dir ector—Southeast. In this role, she will lead the expansion of the
firm’s activities in the Southeastern United States. Liz joins SRS
from Aon Insurance Managers, where she was ILS Insurance Management Strategy Leader and most recently led captive business
development in the Mid-western United States. Prior to Aon, Liz
spent many years with Kane (formerly HSBC) Insurance Management.
Liz will initially be based in Houston, Texas before relocating to
SRS’s Charleston, SC office later this year. She will oversee staff in
both the Charleston, SC and Nashville, TN offices with responsibility for the firm’s activities in other domiciles in the Southeast. In
addition, Liz will work collaboratively with Ann Wick and other
SRS staff in the western region in support of the firm’s activities in
Texas and other domiciles.
Jennifer Meranda joined the fir m on J une 8th as Regional
Manager of our Tennessee operations, based in our Brentwood, TN
office. She was previously Senior Audit Manager with Crowe
Horwath LLP.
Jennifer is a Certified Public Accountant and has been with Crowe
Horwath for over 15 years. Her work at Crowe Horwath has included the audit of commercial insurance companies and captives. She
has been active in the development of Tennessee’s captive insurance industry and has worked closely with SRS on several of its
existing clients. Jennifer’s responsibilities will include overseeing
the servicing of clients domiciled in Tennessee and the expansion of
our Tennessee operations.
Theresa Holderbaum joined our Scottsdale, AZ office on J une
15 as an Office Administrator and Accountant. Theresa, who holds
a Bachelor of Science in Office Administration from Manchester
College, will be providing office administration, cash management
and general management support to our SRS West team.
Michael Boyland joined our Concor d, MA office on J uly 6th as
an underwriting analyst. Michael is a graduate of Bentley College
with a Bachelors of Science in Finance. He has been an intern with
SRS since February 2015.
Steph Lawson joined our Cayman office on J uly 7th as a Client
Accountant. Steph joins us from BDO Cayman where she was a
Senior Accountant. She holds an ACA designation from the Institute of Chartered Accountants in England and Wales.
Richard (Richie) Wells joined our Ver mont office on J uly 9th as
a Senior Account Manager. Richie has 8 years’ captive management experience with Marsh Management Services in Burlington,
Vermont where he was an Account Manager. He has a Bachelors of
Science degree in Accounting from Champlain College.
Allan Drost joined our Ver mont office on J uly 10th as a Senior
Account Manager in our medical stop loss trust business. Allan has
20 years’ captive management experience and was most recently
AVP and Account Manager III at Wilmington Trust. He has a
Bachelors of Science degree in Accounting from St Michaels College.
Industry Events
SRS will be participating in the following upcoming industry
events. Please contact us at [email protected] to arrange
meetings with our team at any of these industry events.
August 11-13, 2015 30th Annual VCIA Conference SRS will be
exhibiting at the conference at the Sheraton Hotel and UVM Davis
Center, Burlington, VT. Christopher Plumpton, Derick White and
Patricia Henderson will be presenting.
September 21-23, 2015, 16th Annual SCCIA Executive Educational Conference Liz Fr eder ick and Patr ick Ther iault will be
attending the conference to be held at the Mills House in Charleston, SC.
September 29 - October 1, 2015, National Risk Retention Association Conference: SRS will be attending the confer ence to be
held at the Sofitel Hotel, Chicago, IL
SRS Webinar Series
SRS hosts monthly webinars on topical issues affecting the captive
insurance industry. Upcoming webinars include:
 July 22: Segregating Liabilities in Captives and the Evolution of
Cells.
 August 26: Captive Strategic Planning.
 September 23, 2015: Captives and the Federal Home Loan
Banks.
Recordings - Recordings of prior webinars may be viewed at any
time at www.strategicrisks.com/webinars.
Recent webinars include:
 Small Captives - The Current Environment.


Agency Captives.
Captives 101.
Strategic Risk Solutions (SRS) is an independently owned captive management and consulting firm. The company is an approved manager of captive insurance companies in most leading onshore and offshore domiciles.
SRS is committed to being the premier provider of captive management and advisory services
in the territories in which we operate.
For more information on SRS, visit us at www.strategicrisks.com.
180o, Issue 42, Q3 2015
4