Captive Insurance Beat the Trend

1. Captive InsuranceBeat the Trend

2. WelcomePeter NivenGuernsey Finance

3. ChairmanAlan FlemingAIRMIC

4. Expert Panel Peter Child, Client Insurance Manager Jeff Soar, Tax Director Callum Beaton, Principal

5. Captive Strategy - Cost Control or Profit CentrePeter ChildHeritage

6. Content • Captive Benefits • Motivations for Captive use • Cost controller • Profit Centre • Conclusion

7. Captive Benefits • Stability: pricing & cover based upon performance • Increased awareness of & control of risk management strategy • Market leverage: negotiation tool with primary markets • Investment income and cash flow retention • Possible bespoke wordings and provision of cover often unavailable in the open market • Reduced insurance costs and/or underwriting profit

8. Motivating Factors • Insurers imposing large deductibles • Market rates force risk retention • Removal of cover • Premium increases • Smooth experience over a number of years • Tax and / or accounting status

9. Cost Controller • Reduced insurance spend in the medium term • Rating according to individual loss experience • Access to reinsurance markets • Smoothing the insurance cycle • Investment income and cash flow benefits • Strategy: break even, premiums set on burning cost basis, attritional costs covered by investment income

10. Case Study 1: A P.I. Captive • Accountancy Practice purchases PI cover • £10m of coverage purchased • Imposed deductible of £10,000 in place • Layered programme with total premium spend £675,000 split: • Primary £1mn: Annual Premium £350,000 • £4mn xs £1mn: Annual Premium £200,000 • £5mn xs £5mn: Annual Premium £125,000 • 5 year claims good other than 1 large loss of £750,000 • Annual cost of claims below deductible £25,000 (mostly gestures of goodwill) • Client has interest/appetite to take some of the risk exposure

11. Case Study 1: Continued ACCOUNTANCY PRACTICE £10mn PI insurance £700,000 Spend, Nil Deductible Share Capital £625,000 BROKER Insurer 1 Insurer 2 CAPTIVE INSURANCE COMPANY £4mn xs £1mn £200,000 £5mn xs £5mn £125,000 Primary £1mn £350,000 + £25,000

12. Case Study 1: Continued Over a period of 7 years to date: • Captive gradually increased its retentions • Deductible premium remained consistently cheaper than the third party market equivalent • A small amount of profit built up in the captive • The accountancy practice enjoyed certainty of claims payments • Investment income on loss reserves used to meet claims costs in worst loss making years

13. Profit Centre • Diversion of profitable insurance spend to the captive • Market rates retained • Arbitrage of the reinsurance vs the insurance markets • Hardening cycles used to increase captive rates • Profits used to support future underwriting • Affiliated business • Strategy: to write own insurance risks with a view to making a profit for further investment in the business

14. Case Study 2: An Aviation Cell • Airline purchases hull & liability cover • Insurance spend to market is USD250,000 • Insurance spend diverted to captive • Captive receives USD231,250 net of 7.5% brokerage • Captive reinsures 100% for a premium of USD200,000 • Guaranteed profit of USD31,250

15. Case Study 2: Continued AIRLINE USD110m Hull & Liabs USD250,000 Spend Share Capital £100 BROKER USD18,750 commission CAPTIVE INSURANCE COMPANY USD31,250 retention USD200,000 reinsurance Reinsurer 1 Reinsurer 2

16. Case Study 2: Continued • Extreme example of guaranteed profit • Can also participate in the risk for a greater potential upside • Any profit may be subject to CFC legislation • Possible to use structures such as PCCs to retain profit in the captive vehicle and increase retentions • Profit / excess funds can be loaned back to parent to minimise lost opportunity costs

17. Conclusion • Cost Control or Profit Centre? • Not necessarily a question of either / or, very often a careful blend of both

18. Captives, PCCs and the Taxation of Foreign ProfitsJeff SoarErnst & Young

19. Captives, PCCs and the Taxation of Foreign Profits Current application of UK corporation tax to captives.

20. The UK corporation tax net. • UK corporation tax is charged on: • UK incorporated or resident companies; • Non UK resident companies trading here; and • Controlled Foreign Companies (CFCs). • A CFC is an overseas company controlled by UK residents that pays less than three quarters of the tax which it would have paid on its income had it been UK resident. • The UK controller (>25% interest) of a CFC is subject to UK tax on the profits of the CFC. • Control extended to include 25% interest in profits as well as voting rights.

21. Exemptions from the CFC provisions • There are exemptions from the CFC provisions: • De-minimis; • The Excluded Countries Regulations (“ECR”); • The Exempt Activities Test (“EAT”); • The Motive Test; and • The Acceptable Distribution Policy (“ADP”). • Captive locations (including Guernsey) are not on the ECR list. • EAT not normally available as more than 50% of business from connected/associated persons. • The Motive Test (i.e. not for tax avoidance) is difficult to apply in practice. • ADP is a typical method of tax planning.

22. Acceptable Distribution Policy • ADP applies if: • distribute at least 90% of profits to UK residents; and • make the distributions within 18 months of the end of the accounting period. • The ADP usually taxed in the hands of the UK parent company. • An ADP allows the parent to: • defer UK tax on 90% of the profits for 18 months; and • permanently defer UK tax on the remaining 10%. • Other planning available to mitigate the UK tax payable on receipt of an ADP.

23. Other jurisdictions • The UK is not the only country with CFC rules: • some tax “bad companies” – UK; • some tax “bad income” – US. • Several jurisdictions have no CFC rules i.e. Ireland. • Arbitrage opportunities may arise as a result of the lack of consistency.

24. Captives, PCCs and the Taxation of Foreign Profits Proposed changes to the UK treatment of captives.

25. Introduction to changes to Taxation of Foreign Profits • Original consultation document issued in July 2007 • Pre-budget Report on 24 November 2008 announced: • An exemption for foreign dividends; • Worldwide debt cap; • Unallowable purpose rule; • Abolition of Treasury Consent; and • Consequential changes to CFC rules. • Draft legislation issued 9 December 2008 • Provisions will be enacted as part of the Finance Act 2009.

26. Changes to the CFC provisions First the bad news….. Two changes to the CFC rules have been proposed, pending a new regime: • Repeal of ADP exemption (with a participation exemption, many dividends would no longer be taxable in the UK); and • Repeal of Holding company exemption as part of the Exempt Activities Test (EAT).

27. Effective date: Accounting periods of CFCs beginning on or after the appointed day (1 July 2009). Transitional rules exist where a company’s accounting period straddles the appointed day. pre appointed day profits - ADP exemption stands BUT only where ADP paid in for the whole period. No dividend exemption on post appointed day profits and on other profits from an ADP period. Repeal of ADP

28. Captives, PCCs and the Taxation of Foreign Profits Impact of proposed changes and what can be done.

29. Now the good… Planning is available to mitigate the additional tax exposure: • International structures; • Apportionment planning; • Making sure that the UK company does not “control” 25% or more of the CFC • Protects captives’ profits from UK tax • Opportunities with PCCs

30. Captives, PCCs and the Taxation of Foreign Profits Protected Cell Companies

31. PCCs • Previously not likely to be a CFC due to no voting control. • Rules changed to include control of >25% of profits but may still not a CFC. • Very good commercial reasons for using a cell rather than an individual company. • Ease of start up • Regulatory approval • Cell as a captive. • Not a CFC? • Tax free dividend? • Deferral of taxes

32. Captives, PCCs and the Taxation of Foreign Profits Recent update – Captives and transfer pricing

33. Transfer pricing • Recent transfer pricing case in the UK (DSG Retail and others v Commissioners of HMRC). This case involved a captive insurance structure. • Arrangements between captives and parent need to be arm’s length and evidence of arm’s length pricing is vital. • Indicators of arm’s length price: • comparable data is useful; • internal comparables to be adjusted to reflect external factors; and • strength of the bargaining position of the parties is important.

34. Captive Insurance & The Credit CrunchCallum Beaton FCIICallum Beaton (Insurance Consulting)

35. Discussion points Current market situation Are there driving forces at play or just inertia? Are we seeing new strategies or is the cartwheel being reinvented? Where has Guernsey delivered success? Where will Guernsey’s development go now? The sole purpose for establishment of a captive is the development of long term shareholder value

36. Current market situation Real growth has been stagnant, but Cell numbers are not reported in all domiciles so actual figures may be clouded Parent company failures will impact on captive numbers – solvent run-off will be essential A few new domiciles are emerging but in many cases they offer nothing new Absence of investment returns has prompted a return to pure insurance underwriting

37. Inertia was never at play in Guernsey The captive concept is counter cyclical Thorough research is paramount Good quality reinsurance is essential Now is not the time to be risk averse Nor is it the time to be complacent Job security may yet be a key inhibitor to new risk management initiatives

38. Credit crunch risks Directors’ & Officers’ liability Third party deductible exposures Warranty programmes Collapse of the holding structure Corporate governance failure Investment exposures Traditional insurance risks

39. Added credit crunch pressures Demand for new strategies Corporate cost cutting Increased pressure on shareholder value Pressure on underwriting returns Pressure on reserving policies Pressure for dividend returns Increased regulatory scrutiny

40. Where has Guernsey delivered success? Sound management practices Robust and objective regulation Creativity with a focus on risk management PCC and ICC legislation Corporate governance codes Pro-active stance in advance of Solvency II Insurance sector development Ease of access to insurance and reinsurance markets

41. Where will Guernsey go now? If you accept the market is counter cyclical, then now is the time to see development Regulation has developed during times of the soft market; use it to assist corporate development not to stifle it Use of the captive concept stands to deliver greater benefit now than at any time in the last twenty years

42. How will Guernsey keep delivering? PCC and ICC structures allow effective ring-fencing of self-insured risks without reliance on the external market Captive strategies worked in spite of a soft market; they will work better because of a hard market Creative development during the soft market has positioned the captive concept so it can beat the present credit crunch

43. Q&AAlan FlemingAIRMIC

44. Drinks Receptionsponsored by

45. Presenter