Captives 301

1. Captives 301 Peter A. Joy, ARMAon Captive & Insurance ManagersExecutive Vice President • Jim Kasprzyk • McDonald’s Corporation • Senior Director Corporate Insurance

2. 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

3. 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.

4. Types of Captives Pure Multiple captives Domicile importance Cell Captives Branch Risk Retention Groups Special Purpose Financial Captives

5. 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

6. Typical Cell Structure Insurance Shares (clients) Management Shares Bust 6 Cell 10 Cell 1 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

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

8. Cells to Segregate Liabilities Separate Insurable Risks Management Shares Cell 6 Cell 10 Cell 1 Cell 1 Cell 2 Cell 3 Cell 4 Cell 5 Cell 6 Cell 7 Cell 8 Cell 9 Cell 10 Cell etc... Captive 1 Captive 10 Captive 6 New owners Each cell holds a separate liability, eg a physician practice, a property subject to legal challenges, etc

9. 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

10. Typical Branch Structure Parent Specific line of insurance Branch Captive Majority of lines of insurance Branch results are reflected in captive since the branch is not an incorporated entity Captive

11. Branch to Write Employee Benefits Life or LTD Insurer Parent Employee Benefits Insurance Reinsurance Branch Captive Majority of lines of insurance Captive Branch results are reflected in captive since the branch is not an incorporated entity

12. Branch to Write Surety Surety insurance Parent HI or NV Branch Captive Certificates of Insurance Majority of lines of insurance 3rd-party Branch results are reflected in captive since the branch is not an incorporated entity Captive

13. 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

14. Risk Retention Group Typical Risk Retention Group Members One Time Capital OwnerA Annually Premiums OwnerB If necessary Surplus Assessments OwnerC Reinsurers A Reinsurance(if any) B C

15. Risk Retention Group Physician RRG Members One Time Capital DocA Annually Premiums DocB If necessary Surplus Assessments DocC Reinsurers A Reinsurance(if any) B C Profit/Dividends

16. Risk Retention Group Closed Trucking RRG Members One Time Capital SubA Annually Premiums SubB If necessary Surplus Assessments SubC FMCSA Evidence Insurance State DMV Customers

17. 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!

18. 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

19. WA VT NH MT ND ME OR MN IO WI MA SD NY WY MI RI IA PA NE NJ CT NV OH UT IL IN DE CO WV MD CA VA KS MO DC KY NC TN AZ OK NM AR SC GA MS AL TX LA HI FL Captive Legislation Alaska is not shown, but does not have legislation No Captive Legislation

20. 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

21. Third Party Business 50% 30% Case Law Humana/ Kidde IRS Safe Harbor RR2002-89

22. 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

23. Brother/Sister Model SUB SUB SUB SUB SUB SUB SUB SUB SUB SUB SUB SUB 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 All must have separate balance sheets No single member LLCs Subsidiary premiums are deductible

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

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

26. Pooling Captives $10m $15m $2m $5m $5m $8m $30m $25m Pay in first party premiums Pool Value $100m Receive reinsurance premiums First Party & Third Party $1m $9m $2.25m $12.75m $0.04m $1.96m $6.25m $18.75m $0.25m $4.75m $0.64m $7.36m $9m $21m $0.25m $4.75m $10m $15m 2% 5% 5% 8% 30% 25% 85% 98% 95% 95% 92% 70% 75% 3rdParty % 90%

27. Federal Tax Accounting

28. 831(b) Election - Example Difference = $351,000

29. Wealth Transfer Pops Co. 1 Insured deducts premium as expense (Tax Saving $350k) Trust 1 Pops Co. 2 Grandson Pops Co. 3 Inheritance Insurance Trust 2 Granddaughter Pops Co. 4 $1m No Claims $1m Dividend Auntie Mabel Captive Takes 831(b) election Pops Co. 5 Shareholders pay tax at their applicable rate Pops Co. 6 Pops Co. 7 Pops Co. 8

30. Putting all the Pieces TogetherMcDonald’s Corp - a Case study The size of the insurance needs Differing stakeholder needs Multiple Captives Multiple Domiciles Nothing stays the same…..

31. 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

32. 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

33. Multiple Captives Golden Arches Insurance Limited ( GAIL ) Golden Arches Re-Insurance Limited ( GARL ) McDonald’s Owner Operator Insurance Company ( MOOIC ) BRS Insurance Company

34. 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

35. 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”

36. 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

37. ? ANY QUESTIONS