General Questions About Reinsurance
Captive insurance involves the formation of an insurance company that can directly insure business risk. A captive insurance company is essentially an insurance company in form and in fact. This brings all of the complexity of an insurance company that is licensed to issue policies directly to an insured business. These complexities include, for example, operating risk pools, building actuarial models, setting underwriting protocols, etc.
Creation of a captive insurance company is a complex and expensive undertaking. Formation of a captive insurance company involves the work of attorneys, actuaries, underwriters and other professionals. Large non-deductible capital contributions are also required. Furthermore, the captive must satisfy “insurance” requirements, including risk pooling or risk sharing, and must qualify as an insurer under the appropriate sponsoring legislation. This is an expensive solution when used in isolation. The expense of a captive insurer arises from its role as a direct insurer of risk. The captive takes on the role of the front-line insurance company. Nevertheless, the formation of a regular captive insurance company may be justified in some circumstances.
Reinsurance is distinct from captive insurance. A reinsurance company is reinsuring one or more risks already covered by a business casualty policy. This means that the work of quantifying risk, setting underwriting guidelines, paying claims, etc. is already being handled. The reinsurance company does not need to replicate these efforts. Establishing and operating a reinsurance company is much simpler and much less expensive than creating a captive insurance company.
What are the types of businesses that can benefit from the use of supplemental business casualty insurance and reinsurance?
Supplemental business casualty coverage complements the existing business casualty insurance of a business. Any operating business that has casualty risks that cannot be adequately covered with regular commercial insurance can consider supplemental coverage and reinsurance.
The use of business casualty insurance and reinsurance spans all types of businesses and industries including Car Dealerships, Construction companies, Dairies, Distributors, Energy Industry, Equipment Dealership, Farm and Ranch, Healthcare, Hospitality, Manufacturing, Mining & Exploration, Physicians and Medical Groups, Professionals, Real Estate Development, Restaurants, Service providers and many more.
Risks that can be considered for supplemental insurance and reinsurance must be business casualty risks that cannot be adequately covered by regular commercial insurance. These risks include—but are not limited to—the following:
- Brand protection
- Business interruption
- Construction defects
- Cyber risk
- Data Breach
- Employment practices
- Exclusions in policy
- Food-borne contaminants
- Independent contractor
- Legal expenses for a variety of issues
- Litigation defense
- Loss of Key Customer
- Loss of Key Employee
- Loss of Key Supplier
- Products liability
- Professional liability
- Regulatory risk
- Reputation risk
- Supply chain interruption
Risks that can be considered for supplemental insurance and reinsurance must be business casualty risks. Personal risks cannot be covered by business casualty policies. Employee risks, such as disability, cannot be covered since this is personal in nature. Additionally, routine business decisions cannot be insured as casualty risks. These would include, for example, inaccurate bids, poor hiring decisions, and engaging the wrong marketing agency. Furthermore, life insurance and health insurance are not candidates for business casualty insurance and reinsurance.
An independent actuary will review the risks and exposures to determine which risks are appropriate for captive insurance. The actuary will determine the appropriate amount of premium for each risk being insured. A report will be issued by the actuary detailing the risk analysis.
Should I cancel my existing business casualty policies after the supplemental casualty insurance and policy is issued?
No, do not cancel your existing business casualty policies. They are still important for your protection and management of your business risks. Coverage provided by the supplemental casualty insurance and reinsurance will complement your commercial business casualty policies. The supplemental insurance can fill the gaps arising from deductibles, exclusions, and limitations of your regular commercial policies. It would be patently inappropriate to cancel your commercial coverage for the sole purpose of inflating premiums to a captive insurer for the same coverage.
The benefits of forming a reinsurance company include better control of risks, an incentive to control losses, access to expanded insurance coverage, diversification of risk, enhanced capacity to honor warranties and the establishment of a fund for potential future casualty losses.
No. Although there are potential estate planning benefits that arise from ownership of a reinsurance company, that alone is not adequate to justify the formation of a reinsurance company. The decision of whether to form a reinsurance company is focused solely on the management of business casualty risks, not other criteria. Estate planning benefits, if any, are incidental to the insurance purpose.
A reinsurance company seeking the special tax treatment of Internal Revenue Code section 831(b) cannot receive more than $1.2 million of annual premium in 2016 or $2.2 million of annual premium beginning in 2017 (indexed for inflation). The $1.2 million limit through 2016 was first made effective in 1986 and was not changed for 30 years. Note that for any year that the annual premium exceeds this limit, the special tax treatment of section 831(b) is not available (meaning a tax on insurance profits for that year). IRC section 831(b)(2)(A) provides:
(b) Alternative tax for certain small companies
(1) In general
In lieu of the tax otherwise applicable under subsection (a), there is hereby imposed for each taxable year on the income of every insurance company to which this subsection applies a tax computed by multiplying the taxable investment income of such company for such taxable year by the rates provided in section 11(b).
(2) Companies to which this subsection applies
(A) In general. This subsection shall apply to every insurance company other than life if—
(i) the net written premiums (or, if greater, direct written premiums) for the taxable year do not exceed $2,200,000,
(ii) such company meets the diversification requirements of subparagraph (B), and
(iii) such company elects the application of this subsection for such taxable year. The election under clause (iii) shall apply to the taxable ear for which made and for all subsequent taxable years for which the requirements of clauses (i) and (ii) are met. Such an election, once made, may be revoked only with the consent of the Secretary.
If an insurance or reinsurance company qualifies for federal taxation under IRC section 831(b), then the only federal income tax it will pay is a tax on investment income. Underwriting profits are not taxed. This allows the insurer to develop its insurance reserves.
Subchapter L of the Internal Revenue Code governs the taxation of reinsurance companies. The Code provides incentives that allow insurance companies to accumulate reserves for the payment of future claims. For example, insurance premiums of qualifying companies are not counted in taxable income. The insured company receives a tax deduction for the payment of insurance premiums to the direct insurer. A portion of those premiums will be ceded to the reinsurer. Those ceded premiums will not be included in the taxable income of a qualifying reinsurance company.
A reinsurance company is taxed pursuant to Internal Revenue Code section 831(b). That section provides that the reinsurance company will pay income tax only on its investment income using C corporation rates. It will not pay tax on premiums. Neither will it pay income tax on insurance profits (premiums minus claims). Here are the key provisions of Code 831(b):
A reinsurance company will be a Subchapter C corporation for federal tax purposes. All of the tax benefits of a C corporation are available to shareholders of the reinsurer including preferential rates for dividends; section 243 dividend deductions, capital gains treatment upon dissolution of the reinsurer; compensation and fringe benefits for directors, officers, and employees.
A reinsurance company is required to file an annual federal income tax return using Form 1120PC. This is a specialized return for insurance companies. The election for the special tax treatment under Internal Revenue Code 831(b) must be made in the initial 1120PC filing.
There are no direct tax implications regarding ownership since any legitimate individual or corporate entity can own the company. As in any multi-company structure, the taxpayer should be aware of potential opportunities and consequences relative to ownership.
From an insurance premium deductibility perspective, there are certain corporate structures to be avoided. The Internal Revenue Service has attempted to deny the deductibility of premiums paid by a “parent” company to a wholly owned “subsidiary” company, therefore it is preferential to avoid a parent/subsidiary (or child) structure. A type of corporate structure that has been accepted to create deductibility is a brother/sister type of relationship. Results have been mixed.
A brother/sister relationship exists when two organizations have a common parent. For example, in an automobile dealer situation, this is fairly easy to accomplish because the dealer principal (or other entity) would normally own both the premium payor (such as an automobile dealership) and the reinsurance company (who is the ultimate payee). Instead of a parent/child relationship, this creates a brother/sister relationship which has been upheld as creating a transfer of risk. Court cases supporting this position are Humana, Inc. vs. Commissioner, Kidde & Co. vs. Commissioner and Hospital Corp of America vs. Commissioner.
Can premiums be varied in December each year in response to changes in taxable income of the insured company?
Premiums are based on risk. Premiums are never based on the net income of the insured company. Consequently, premiums cannot be altered late in the tax year of the insured company based on its net income projections.
New ownerships rules were introduced in IRC section 831 in December 2015 and made effective January 1, 2017. Under the new ownership rules, there are limitations when family members are involved in ownership. In a nutshell, if family members are involved in ownership of the captive, then the ownership of the captive insurer must mirror the ownership of the insured operating company plus or minus two percent. This ownership limitation is found in IRC section 831(b)(2)(B) which provides:
(B) Diversification requirements
(i) In general. An insurance company meets the requirements of this subparagraph if—
(I) [“20 Percent Test”] no more than 20 percent of the net written premiums (or, if greater, direct written premiums) of such company for the taxable year is attributable to any, one policyholder, or
(II) [“Ownership Test”] such insurance company does not meet the requirement of subclause (I) and no person who holds (directly or indirectly) an interest in such insurance company is a specified holder who holds (directly or indirectly) aggregate interests in such insurance company which constitute a percentage of the entire interests in such insurance company which is more than a de minimis percentage higher than the percentage of interests in the specified assets with respect to such insurance company held (directly or indirectly) by such specified holder.
(ii) Definitions. For purposes of clause (i)(II)—
(I) Specified holder
The term “specified holder” means, with respect to any insurance company, any individual who holds (directly or indirectly) an interest in such insurance company and who is a spouse or lineal descendant (including by adoption) of an individual who holds an interest (directly or indirectly) in the specified assets with respect to such insurance company.
(II) Specified assets
The term “specified assets” means, with respect to any insurance company, the trades or businesses, rights, or assets with respect to which the net written premiums (or direct written premiums) of such insurance company are paid.
(III) Indirect interest
An indirect interest includes any interest held through a trust, estate, partnership, or corporation.
(IV) De minimis
Except as otherwise provided by the Secretary in regulations or other guidance, 2 percentage points or less shall be treated as de minimis. [emphasis and bracketed titles added]
The diversification rules are alternatives. A taxpayer may satisfy either the “20 Percent Test” rule or the “Ownership Test.”
If family members are involved in ownership of the insured operating company and the captive insurer, then the “Ownership Test” will be satisfied if the ownership of the two entities does not vary by more than two percent. For example, if Father and Daughter each own 50 percent of Widget Corp, then their ownership of a captive insurer that insures risks of Widget Corp must also be 50 percent each plus or minus two percent. Note that attribution rules apply for ownership of an entity through trusts or other entities.
Non-family members that are owners of the insured operating company and a captive insurer easily meet the requirements of the “Ownership Test.” This is the case because they will not be tripped up by the “specified holder” language which is focused on ownership by a spouse or lineal descendant. A “specified holder” is an individual who holds an interest in the insurance company and who is a spouse or lineal descendant of an individual who holds an interest in the specified assets of the insurance company.
The special tax treatment under IRC 831(b) is not automatic. The reinsurance company must file an 831(b) election with its initial income tax return (Form 1120PC) to receive the 831(b) tax treatment. The Insurance Manager will oversee the process for making this election.
The election need only be made once. However, the requirements of IRC 831(b) must be met each year to receive the elective treatment. For example, the premium limitation must be adhered to each year in for which the 831(b) elective tax treatment is sought. See IRC section 831(b) for requirements relating to the election.
IRC Section 953(d) allows a controlled foreign corporation (CFC) engaged in the insurance business (an electing corporation) to elect to be treated as a U.S. corporation for purposes of imposing United States income tax. An electing corporation agrees to compute its U.S. income tax liability as if it were a domestic corporation.
For example, reinsurance company may be formed in Turks & Caicos due to that jurisdiction’s favorable insurance laws and regulations. That same reinsurance company may file an IRC section 953(d) election to be treated as a US corporation for tax purposes.
This election need only made once. The Insurance Manager will oversee this process. See IRC section 953(d) for requirements relating to the election.
Investments & Accounts
A reinsurance company is a corporation with a board of directors and officers. The officers make day-to-day decisions for the company. The board oversees the efforts of the officers. The officers will select one or more suitable investment advisors to assist with management of the portfolio of the reinsurance company. So the real question is who selects the board of directors. The owners of the reinsurance company elect the board.
A reinsurance company must maintain sufficient liquidity to pay claims. Premiums received by the reinsurance company should be liquid during the period of time those premiums may be called upon to satisfy claims pursuant to the insurance ceding agreements with primary insurers.
The types of investments that can be utilized in a reinsurance company are:
- Government bonds
- Corporate bonds
- Preferred shares
- Common shares
- Letters of credit
- Certificates of deposit
- Money market funds
Note that the aggregate amount invested in the obligations and stock of any one issuer cannot exceed 10 percent of the market value of the portfolio. Reinsurance companies must follow the National Association of Insurance Commissioners (NAIC) for maintaining adequate liquidity and safety for paying insurance claims on a timely basis. NAIC is the U.S. standard-setting and. regulatory support organization created and governed by the chief insurance regulators from the 50 states, the District of Columbia and five U.S. territories.
No. A reinsurance company should not purchase life insurance. Life insurance is not an appropriate investment for the reinsurer. The purchasing of life insurance using assets of the reinsurance company may impede the reinsurance company’s ability to pay claims due to a lack of liquidity.
A reinsurance company is a corporation. The documents typically required to open a corporate account will be necessary for opening an account for the reinsurance company. This would include:
- Article of Incorporation
- Certificate of Incorporation
- Organizational Minutes
- Employer Identification Number (“EIN”)
- Possibly Stock Transfer Ledger
The reinsurance company is reinsuring one or more risks covered by a business casualty policy. The business casualty policy is typically issued in the jurisdiction where the insured business has its primary or home office. The reinsurance company is not a party to that primary insurance contract. The reinsurance company cannot issue a policy directly to the insured business.
The reinsurance company can only reinsure the risks of an existing insurance contract. This involves a contract between the insurance company (i.e. the insurer that issues the policy to the insured business) and the reinsurance company. The reinsurance transaction takes place in Turks and Caicos.
Reinsurance is the transfer of insurance risk (and associated insurance premiums) from one insurance company to another insurance company. The company that receives (or “assumes”) the insurance risk (and associated reinsurance premiums) is called the “Reinsurance Company” and the company that transfers (or “cedes”) the risk (and associated premium) is called the “ceding company”.
Reinsurance is insurance for insurance companies. More specifically, reinsurance involves the transfer of risk from a direct insurer to a secondary insurer (the “reinsurance company”) that receives both premium and a transfer of risk. The reinsurer has no direct contractual relationship with the insured. Reinsurance expands the ability of the direct insurer to provide coverage. The reinsurer also allows the direct insurer to spread risk more appropriately.
Why should I consider forming a reinsurance company rather than a regular captive insurance company?
Creation of a regular captive insurance company is an expensive undertaking. Formation of a captive insurance company involves the work of attorneys, actuaries, underwriters and other professionals. Large non-deductible capital contributions are also required. Furthermore, the captive must satisfy “insurance” requirements, including risk pooling or risk sharing, and must qualify as an insurer under the appropriate sponsoring legislation. This is an expensive solution when used in isolation. The expense of a captive insurer arises from its role as a direct insurer of risk. The captive takes on the role of the front-line insurance company. Nevertheless, the formation of a regular captive insurance company may be justified in some circumstances.
This burden can be almost entirely avoided by transferring the primary insurance function to a direct insurer. The direct insurer is a fully qualified insurance company that satisfies the insurance element of the arrangement by working with many insureds and many reinsurance companies. Multiple reinsurers can enter into contractual agreements with a single direct insurer. The reinsurers do not need to meet the burdensome requirements of the direct insurer such as excessive reserve requirements, over-burdensome regulatory filings, and invasive oversight. These requirements are already met by the direct writer of the insurance.
This depends upon the negotiations between the insurance company and the reinsurance company. Even though it might seem like the reinsurance company should take as little risk as possible, this would mean that the reinsurance company would get as little of the associated premiums as possible.
If the reinsurance company has determined that the business is (or should be) profitable, then it would be in the reinsurance company’s best interest to “assume” as much risk and associated premiums as possible (or “Ceding Fee”).
The cost of reinsurance varies greatly, and it is based upon both industry standards and the negotiating skills among the two companies involved, the insurance (or ceding) company and the reinsurance (or assuming) company. The cost of reinsurance is described as a “Ceding Fee” or “Ceding Allowance”, and consists of the payment from the reinsurance company to the insurance company as compensation for “assuming” the transferred risk.
A reinsurance company needs an insurance license. The license is limited. It allows a reinsurance company to take on risks and premiums from a commercial casualty company pursuant to an insurance ceding agreement. A reinsurance company cannot issue an insurance policy directly to the public.
A reinsurance company can be owned by any individual or entity other than the company being insured. Owners may include the owners of the company being insured, an asset protection trust, another corporation, limited liability companies, limited partnerships and other entities.
The Insurance Manager provides a variety of essential insurance services to the reinsurance company, including:
- Providing expertise in the areas of insurance, risk management, and underwriting expertise to the reinsurer
- Hiring an independent actuary to review risks and exposure and to establish appropriate levels of premiums
- Developing business plans and preparing pro forma financial statements that are filed with Turks and Caicos’ Insurance Commissioner
- Working with the regulators in Turks and Caicos to secure the reinsurance license and the annual renewal of the license
- Developing equitable premium allocations
- Issuing and monitoring policies and premium invoices
- Obtaining certificates of insurance for insured companies
- Monitoring and reconciling investments records and bank statements
- Maintaining the reinsurer’s financial and operational records
- Serving as the primary contact for regulatory agencies and assisting in regulatory compliance
- Filing insurance regulatory reports
- Preparing and filing annual tax returns (IRS Corporate Income Tax Form 1120PC)
- Handling claims processing
- Serving as a liaison between the commercial insurance and the reinsurance company
Our third party Insurance Managers are nationally known and manage the insurance process, including collecting premiums, paying claims and other operational matters. In this way, its functions are akin to a TPA (third-party administrator) of a tax-qualified retirement plan. However, the role of LodeStar Re goes further. It also prepares reinsurance company financial statements, business plans, license applications and annual tax returns.
Insurance claims occur and are paid weekly from the insurance pools managed by the third party Insurance Manager. The claims paying process is robust and active.
Why Domicile in Turks and Caicos Islands
The Turks and Caicos Islands offer a link between European, Caribbean, North & South American and Asian financial centers. They are in the same time zone as the US Eastern seaboard and only a 75-minute flight from Miami. In addition, they are easily accessible by frequent direct flights from Atlanta, New York, and London, among others.
As a UK overseas territory with its own constitution and Government, the Turks and Caicos benefit from the use of English Common Law supported by local Ordinances.
The local currency is the US Dollar, and there are no exchange control regulations.
There are no local sales, income or corporation taxes in the Turks and Caicos Islands, incorporating a TCI company can, therefore, bring tax planning advantages.
The financial services sector in the Turks and Caicos is characterized by several long-standing practitioners who provide high-end service to all sizes of clients, supported by experienced accountants, lawyers, bankers and insurance managers.
Legislation for financial services has existed in the Turks and Caicos Islands since the 1970s. In fact, the jurisdiction was the first to introduce international business companies and is now a world leader in niche hybrid reinsurance companies. However, the TCI has never been listed on any official international blacklists.
Modern legislation: An updated insurance Ordinance
The insurance laws in TCI are widely recognized as innovative in their approach. The Insurance Ordinance of 1989 (amended subsequently) permits the creation of purpose designed insurance programmes to fit the precise needs of the captive client and therefore allows for a range of structures to be created.
Nonetheless, the Insurance Ordinance is currently under further review. The updated Insurance Ordinance will ensure the continuation of a competitive legislative framework for domiciling captives and other insurance formations regulated in keeping with international best practices.
The Superintendent of Insurance and the staff of the Financial Services Commission is easily accessible to industry and in constant exchanges with practitioners.
The costs of incorporation, the insurance licensing fees and capitalization costs are quite attractive when compared with other jurisdictions.
Timely application procedures
The requirements for setting up as a service provider or for setting up a captive in the TCI are very convenient, subject to the submission of complete, acceptable application documentation on behalf of qualified principals who are verified to be fit and proper. The FSC will work with all interested parties to facilitate prompt responses and procedures.
Reasonable local requirements
For example, directors are not required to be TCI residents and board meetings can be held anywhere in the world.
A sector for growth
The TCI currently has 62 Captives and 107 restricted Captives. Since 2003, 36 new captives and restricted captives have been domiciled in the TCI and we expect to see strong growth in this area. This is a result of today’s challenging insurance market and also thanks to a number of forward actions being taken by the Government and private sector including:
- a review of the legislative framework,
- increasingly resources in the regulatory structures and
- additional marketing and communication efforts to establish the TCI as a preferred captive destination.
Turks and Caicos is the world’s leading domicile for a specific reinsurance programme the Niche Hybrid Reinsurance Company (previously known as the Producer Owned Reinsurance Company or PORC).
A niche hybrid reinsurance company is similar to a Captive, but the insurance operations associated with its business are mainly controlled by the Direct Writing Company from which it receives business.
The niche hybrid reinsurance company is effectively a captive reinsurance company, registered in the Turks & Caicos Islands and regulated by the Insurance legislation, owned by an entity engaged in supplying or producing insurance business through a strong well-regulated primary writer.
The primary writer then reinsures a portion of that insurance business with the captive, enabling the producers to participate in the underwriting profit.
Usually takes the form of an agreement between the primary writer and the captive, whereby assets of the captive are maintained by the primary writer equal to the amount of the reserve liability.
Premiums are paid into a Custodial Trust Account under the control of the Direct Writer and maintained in that account at an amount which covers the required reserves for liabilities regarding unearned premiums and claims with a small margin for fluctuations.