ENTERPRISE RISK CAPTIVE INSURANCE COMPANIES: RISK MANAGEMENT TOOLS FOR FAMILY HELD BUSINESSES AFHE 2018 ANNUAL CONFERENCE APRIL 20, 2018 Jeffrey K. Simpson Gordon, Fournaris & Mammarella, P.A. JSimpson@gfmlaw.com (302) 652-2900 www.gfmlaw.com @JeffreyKSimpson David M. DiMayo Oxford Risk Management Group DDiMayo@OxfordRMG.com (410) 472-6490 www.OxfordRMG.com

Objectives: Define and describe Enterprise Risk Captives Show how they can help family held enterprises Explain how they work Discuss tax issues and how to avoid them

What is a Captive? Property & Casualty Insurance Company A risk management tool utilized to cover the unique risks of an operating company Provides coverage for specialized risks which may not be available or may be too costly to obtain through traditional insurance providers A bona fide insurance company, subject to approval and regulatory oversight by the insurance regulators in a chosen domicile

Common Types of Captive Member Owned Group Risk Retention Group Traditional Pure Captive Enterprise Risk Captive Today’s Focus!

What is an Enterprise Risk Captive? Serves private company/family held business Covers non-traditional risks and gaps in commercial coverage Elects special treatment under IRC Section 831(b) Also may be called Small Captive Micro-Captive 831(b) Captive

What are non-traditional risks? Traditional Risks – things typically covered Workers Comp Auto General Liability Professional Liability Property Damage Non-Traditional Risks – things NOT typically covered Exposed but uninsured Loss of business income Gaps in commercial coverage Deductibles Exclusions

Insurable Risks That May Result in Loss of Business Income Mechanical Breakdown Loss of Key Employee Loss of Licensure Legislative and Regulatory Changes Reputational Risk Suppliers/Supply Chain Interruption Business Interruption Contract Penalty and Failure to Perform on Contract Deductible Reimbursement Defense Cost Reimbursement Difference in Conditions

Basic Captive Structure Shareholders Operating Company Insurance Premium Captive Insurance Company Insurance Coverage

Why Implement a Captive? Risk Management and Other Benefits Greater Control over Claims Fill Gaps in Existing Coverage Underwriting Flexibility Incentive for Loss Control Reduced Insurance Costs Capture Underwriting Profit Pricing Stability Purchase Based on Need Investment Income Access Reinsurance Market Improved Claims Review and Processing

Underwriting Assemble Current Insurance Information Review Current Policies and Endorsements Analyze Five Year Loss Runs Three Year Summary of Coverage Identify Trends in Premium History Underwriting Understanding the operating company Discuss reasonable coverage applicable to industry and unique business Identify Self-Insured Exposures Identify Uninsured Loss Experience Adequacy of Policy Limits

Third Party Review and Analysis Independent Third Party Risk Analysis Coverage Chart Gap Identification Total Cost of Risk (TCOR) Analysis Enterprise Risk Exposure Review Risk Selection Review by Independent P&C Broker Identify Relevant Coverage Avoid Duplicate Coverage Independent Third Party Actuarial Analysis Rate Promulgation Peer Review of Pricing Methodology Feasibility Study

Flexible Ownership Options Operating Company Insurance Premium Fronting Carrier Underwriting Profit * Insurance Policy Premium Reinsurance Captive Captive Owner Dividend Distributions Flexible Ownership Options *After Claims less Expenses

Claim Example: First dollar risk sharing Fronting Carrier $1,000,000 Claim from Participant Insured $1,000,000 Claim Captive which filed the Claim $200,000 20% of Claim $800,000 80% of Claim All Other Captives Share Risk Your Captive $1,600 Assumptions: Your Captive Premium is $1,000,000 Total Written Premium = $500MM Your Portion of Claim = 0.2% Your Captive is Responsible for $1,600

Tax treatment How does 831(b) work? Current IRS environment Managing to be conservative and avoid abuse

How does 831(b) work? Insurance company taxed only on investment income and not on premium income, if: No more than $2.3 million annual premium ($2.2 Million Plus Inflation index) AND 2. One of two diversification tests: No more than 20% of risk from a single policy holder OR No estate planning ownership structure (Generally, no wealth transfer, lineal descendants cannot own more of captive than insured enterprise)

Current IRS Environment Abuses? What the IRS Doesn’t Like Deferral + Conversion = Recipe for Mischief Premiums No Actuarial Support Inflated Coverages Business Risk Bogus Risk Pools Low Loss Ratio Premium Allocation Tax Motivation Promoters Estate Planning

Current IRS Environment IRS Activity Dirty Dozen List Evolving Language Notice 2016-66 Overbroad? Audits Owners and managers Tax court cases Avrahami 100s to follow

Current IRS Environment Industry is engaged – ongoing dialogue Educating IRS and DC on insurance Results PATH Act increased limit and restricted only estate planning PATH Act clarifications passed in March, 2018 Notice 2016-66 filing deadline delayed

Enterprise Risk Group Captive Solution Alternative Risk Finance Solution to 831(b) Coupling a Traditional Captive Insurance Design with ERM Provides a Mechanism to Achieve Similar Risk Management and Economic Goal/Objectives Pros and Cons

IRS Scrutiny AVOID DOING THESE THINGS! Not Following the Safe Harbor Guidelines No Real Distribution of Risk No Claims Experience or Claims Layering High Deductible Risk Pools or Retroactive Policy Issuance Lack of Business Purpose Lack of Independent Actuarial Analysis Paying Excessive Premium for your Coverage Insuring Unreasonable Risks Treating Captive Assets as a Personal Checkbook Circular Transactions Investment Plans that Don’t Make Sense

Implementation Process Initial Consultation Informal Feasibility Analysis Engagement Process Risk Analysis, Underwriting and Compliance Domicile Selection Complete Study Application to Insurance Regulators Approval Process Closing Procedure

*Advisors are independent of Oxford Captive Manager Legal Counsel P&C Broker and Risk Analysis Firm* Financial Advisor* Tax Counsel* Audit Firm Actuarial *Advisors are independent of Oxford

Across All Industries: Significant Annual Recurring Revenue Enterprise Risk Exposure Willing to invest time to explore risk management solutions Sophisticated business owner Across All Industries: Agriculture Transportation/Logistics Construction Entertainment/Professional Athlete Medical Real Estate IT Oil Drilling Manufacturing

How to Build a Conservative Captive Design with risk management as the primary focus Adhere to IRS Revenue Rulings and all available guidance Assure that the captive is operated as a bona fide property & casualty insurance company with meaningful claims Underwrite policies that offer coverage at appropriate premium levels Avoid structures that are “too good to be true” in order to generate predictable results

Questions? Jeffrey K. Simpson David M. DiMayo Gordon, Fournaris & Mammarella, P.A. JSimpson@gfmlaw.com (302) 652-2900 www.gfmlaw.com @JeffreyKSimpson David M. DiMayo Oxford Risk Management Group DDiMayo@OxfordRMG.com (410) 472-6490 www.OxfordRMG.com