IBC’S 7TH ANNUAL EXECUTIVE FORUM ON CAPTIVES The Fog Lifts on Tax Definition of “Insurance”

1. IBC’S 7TH ANNUAL EXECUTIVE FORUM ON CAPTIVESThe Fog Lifts on Tax Definition of “Insurance” Main Conference - Marriott Resort - Grand Cayman December 6, 2001 Thomas M. Jones 227 West Monroe Street Chicago, Illinois 60606 U.S.A. 312 984 7536 e-mail tjones@mwe.com

2. Why “Insurance” Matters? • Tax Deduction for Premiums Paid to Captive by Policyholder • Favorable Insurance Tax Treatment of Captive (Deduction for Insurance Reserves, Unearned Premiums) • Offshore CFC Captives - Subpart F income • Domestic Captives - Direct Federal Income Tax • Offshore Captives • Federal Excise Tax on Insurance • Possible IRC Sec. 953(d) Onshore Tax Election

3. Tax Definition of “Insurance” • To find insurance, the IRS and the courts have historically required the presence of both risk shifting and risk distribution • The first criterion connotes the transfer of the risk to separate party • The second mandates that enough independent risks are being pooled to invoke the “actuarial law of large numbers”

4. Tax Definition of “Insurance” • In Rev. Rul. 77-316, the IRS first announced its position that risk shifting and distribution do not exist in the context of a single economic family (see below) • In Rev. Rul. 78-338, the IRS conceded that sufficient risk shifting and distribution are present to constitute insurance where 31 unrelated parties pool risks

5. Tax Definition of “Insurance” • No statutory or regulatory definition of “insurance” - only cases and rulings • A gray area exists between 1 and 31 insureds, but a rule of thumb has been developed that 10 or more insureds pooling risk should create insurance • Case law has further liberalized the tax definition of insurance • Unrelated Risk • Brother-Sister Theory

6. Definition of “Insurance”For Tax Purposes Sears, Roebuck and Co. v. Comm’r. • Computation of Allstate’s Income Using Favorable Insurance Company Provisions • Tax Deductibility of Sears’Premiums Paid to Allstate NYSE Shareholders Sears 100% Stock Owned <1% Sears Risk >99% Unrelated Risk Allstate

7. Definition of “Insurance”For Tax Purposes AMERCO Program Pure Third-Party Risk* Parent Company Risk Captive Customer/ Investor Risk* Brother/ Sister Risk * The Tax Court and Ninth Circuit aggregated customer/investor risk and pure third party risk to test whether AMERCO’s captive qualified as an insurance company. The courts did not reach the issue of whether the brother/sister risk was insurance risk because 30% “outside” risk was enough to find “insurance.”

8. Definition of “Insurance”For Tax Purposes Humana, Inc. v. Comm’r. • No tax deduction for Payments from Parent to Subsidiary • Tax Deductibility of Subsidiaries’ Premiums Paid to Captive (Brother - Sister Premiums) NYSE Shareholders Humana Foreign Holding Co. 100+ Subs Colorado Captive

9. Tax Definition of “Insurance” Kidde Industries, Inc. v. Comm’r. • 3 Part Test • “Insurance risk” / Not a Sham Corporation • Commonly Accepted Notion of Insurance • Risk Shifting & Risk Distribution • Parent’s Guarantee Caused Deduction to be Denied for Period it was in Existence • Bermuda Regulatory Regime Accepted • Brother-Sister Applies to Subsidiaries, but Not Divisions

10. IRS Ruling Concedes “Economic Family” Theory • In Rev. Rul. 2001-31, issued in June, the IRS abandoned its position that risk shifting and distribution do not exist in the context of a single economic family • It now appears arm’s length premium and loss reserve deductions attributable to brother-sister risk (i.e., other affiliates of the parent) will be accepted by the IRS • But premium and loss reserve deductions attributable to parent risk will not be allowed without presence of significant (30%?)(50%?) unrelated party risk measured by premiums

11. Post - Rev. Rul. 2001-31 Caveats The following factors still will impair ability to claim favorable “insurance” tax treatment: • Parent guarantees, “comfort letters” etc. to the captive or to its “fronting” carrier • Captive under-capitalization (maximum 5:1 premium/surplus ratio recommended) • Lack of valid non-tax business purpose for forming and operating the captive • Substantial loan backs of captive assets to parent or affiliates (“circularity of cash flow”) • Formation of captive in a weakly or non-regulated offshore domicile

12. UPS -- Facts SHs EVCs UPS (U.S.) OPL (Ber) Cust. Insurance $$ (EVCs) Ins. Policy • Reinsurance • OPL Assumed NU’s Risk • NU Paid OPL EVC’s • Less Comm’s & Costs National Union

13. 1999 UPS Tax Court Decision - Round 1 for the IRS • Judge: “Sham” Transactions without Business Purpose Other Than Tax Avoidance • An “Anticipatory Assignment of Income” Case • Little Direct Impact on Captives/RRGs • One Benefit: OPL Not a “Sham” Corporation • Two Lessons for Everyone: • ALWAYS Document Non-Tax Reasons for Forming a Captive at Time It Is Established • ALWAYS Be Able to Demonstrate Transactions with Related Parties are on Arm’s Length Basis

14. UPS Decision - Taxpayer Victory on Appeal • Appeals Court Reversed Tax Court 2-1 • Full Appeals Court Denied Rehearing • Valid, Enforceable Contracts among Unrelated Parties Cannot Be Disregarded as “Shams” • Then Applicable “Subpart F” Tax Rules Clearly Permitted the Deferral Claimed • Case remanded to Tax Court with Instructions to Consider Application of Related Party Inter-Company Arm’s Length Transfer Pricing Rules

15. Tax Issues - Offshore Captives • Subpart F Rules • General Subpart F Rules • RPII Rules • Passive Foreign Investment Company Rules • U.S. Trade or Business Rules • Making an IRC Sec. 953(d) Onshore Tax Election • Federal Excise Tax Rules

16. Federal Excise Tax - The Basics • Applies to premiums paid to foreign insurers/reinsurers covering U.S. risks • 4% on “direct” property & casualty policies • 1% on life policies and all reinsurance • Withheld and remitted (quarterly on IRS Form 720) by payer of premium • If not a deductible “insurance” premium, then FET N/A - Rev. Rul. 78-277 • Also N/A if onshore tax election is made

17. Major 2001 Tax Unknowns for Captives • How will “segregated cell” companies be treated for U.S. tax purposes? • Will reinsuring employee benefits in captives become popular after the favorable DOL Columbia Energy ruling? A path to more unrelated risk (see Rev.Rul. 92-93 holding employee group life is unrelated)? • Will Bush Administration pursue proposals limiting “abusive” tax benefits for “small” P&C insurers under IRC Sec. 501(c)(15) and Sec. 831(b)?

18. More Captive TaxDevelopments • In Utah Medical Insurance Association, (T.C. Memo 1998-458), Tax Court approved insurance company’s deduction of conservative loss reserve funding • But IRS won more recent loss reserve over-funding case - Minnesota Lawyers Mutual Insurance Co., (T.C. Memo 2000-203) • TAM 200115002 (12/21/00) appears to take a strong pro-taxpayer position in condoning an aggressive use of loss reserve rules

19. More Captive TaxDevelopments • Key to Loss Reserve Deduction Success - Good Actuarial Backup • IRS Proposed “Line of Business” Theory on Risk Distribution (e.g., Life insurer writing Earthquake Coverage) • As usual, Treasury Dept. “2001 Priorities for Tax Regulations and Other Administrative Guidance” (released 4/27/01) includes “Guidance Concerning Captive Insurers”

20. More Captive Tax Developments • FSA 200023010 - “deposit vs. insurance” issue • Limits of coverage and aggregate stop loss protection attachment points allegedly set so virtually certain to be reached • IRS: a “financing deal,” not “insurance” so no premium deduction; captive not an “insurance company” so no loss reserve deduction and IRC Sec. 953(d) onshore election invalid • IRS: under UPS must weigh the “considerable” tax benefits against the “minimal” risk shifting

21. Employee Benefits in Captives:Columbia Energy Ruling • U.S. Dept. of Labor Issued Favorable Ruling on 8/17/00 Re Long Term Disability Coverage in a Captive • Risk Insured by Liberty Mutual Affiliate and Reinsured by Employer’s Bermuda Captive • Captive Formed Branch in Vermont to Meet ERISA Requirement of U.S. Regulation • Independent Fiduciary Hired and Coverage Scope Sweetened to Protect Employees • Contingent on the Above, DOL Allowed Even Though Captive Wrote Over 50% Parent Related Risks

22. “Harmful Tax Competition” • Initial Concept: EU/OECD/G7 Global Tax Rate Harmonization - Now Discredited, but Anti-Secrecy/Tax Evasion Initiative Still Alive • OECD “Hit List” - First Released in June 2000 • 11 of 35 Countries/Territories on List Complied • Bermuda and Cayman Avoided List with Written Undertakings Signed in May 2000 • Captive Domiciles Out of Compliance: Barbados, BVI, Guernsey, Panama, Turks & Caicos, USVI • On 5/10/01, U.S. Withdrew Support for the OECD Attack on Low Corporate Tax Rates

23. Future of Offshore Initiatives • Picture is Emerging that Deferred 2/28/02 Compliance Deadline to Avoid “Defensive Measures” (i.e., Sanctions) against Non-compliers Again Will Be Postponed • Imposition of As Yet Unspecified Sanctions Delayed Until 2006 • Events on 9/11 Have Refocusd Anti-Money Laundering & Terrorism Efforts; USA “PATRIOTS” Act Signed 10/26/01; Sweeping Anti-Secrecy Legislation Impacts Insurance • Prognosis for Captives - Monitor the Situation; No Real Threat; Captives Care about Taxes - Not Bank Secrecy or Exchange of Tax Data

24. Update - U.S./Cayman Tax Information Exchange Agreement • Signed by U.S., U.K. and Cayman on 11/27/01 • Effective 2004 for criminal tax matters and 2006 for civil and administrative tax matters • Aimed at deterring both evasion of Federal income tax and money laundering • Conforms to Cayman’s commitment to OECD • Requires Cayman to turn over all information regardless of form or nationality of suspect • Legality under Cayman law or fact that tax is in dispute is irrelevant • Administered by new “Cayman Tax Cooperation Authority”

25. U.S./Cayman Tax Agreement • Covers banks and anyone else, including fiduciaries, trustees and nominees • Broad definition of “information” - “facts, statements, documents or records” • Information under legal privilege excluded • No “probable cause” of a crime required - requester need only disclose the tax purpose • Anti-delay feature: must respond ASAP and notify of response difficulties within 60 days • Contemplates on-site Cayman visits by IRS • Information must be kept confidential

26. 24 Years of Captive Taxation • 1977-1991: IRS Doctrine of “Economic Family” (Officially Rejected in Court) Prevails • 1992-2000: Taxpayers’ Revenge (30% Unrelated Risk; Brother/Sister Risk) • 2001 Forward: Appeals Court in UPS Reversal Accepts “Profit Seeking” Motive as Sufficient Economic Substance; Rev. Rul. 2001-31 Concedes Brother-Sister Coverage Constitutes Valid Insurance