Bermuda Captive Breakfast Seminar Philadelphia Marriott Downtown Philadelphia May 18, 2010

1. Bermuda Captive Breakfast Seminar Philadelphia Marriott Downtown Philadelphia May 18, 2010

2. Moderator Scott Gemmell Why companies form captives Thomas McMahon Latest ideas in captive use Susan Lane How to form a Bermuda captive Brad Adderley Captive Tax Update Bill Bailey KareyDearden Bermuda’s captive regulation Shelby Weldon

3. Why Companies Form Captives Thomas McMahon President Cedar Management Limited

4. Topics • What is a Captive • Types of Captives • Why form a Captive

5. What is a Captive? • Insurance subsidiary of a commercial/financial company, or a consortium or an association of individuals • Formed to primarily insure or reinsure the risks of its parent, or of a number of parties with risks in common or unrelated risks • Usually formed in a specialized environment or “domicile” – “onshore” or “offshore”.

6. Types of Captive • Single Owner • Multi-owner or Association • Rent-a-Captive – multiple non-owner • Protected or Segregated Cell Captive (PCC, SPC SAC) – any of the above

7. Why Form a Captive? • Information and Control • Risk Management Focus • Additional Capacity • Direct Market Access • Flexibility in Program Design • “Uninsurable” Risk • Financial Stabilizing • Profit Centre

8. 1. Information and Control • Influence program design and cost through progressive • retentions • Reliable data for reinsurance purposes • May assist with rating requirements • Access to loss data/reserving practice • Claims handling control • Image preservation • Avoidance of legal precedents • Out of court settlements • Negative publicity management • Damage limitation

9. 2. Risk Management Focus • As a separate subsidiary of the business, focuses senior • management attention on risk. • Risk manager can use risk management ranking methods • to influence premium allocation to business units/divisions • Use captive surplus to fund risk improvements • Ring-fence risk funding • Use contributions to fund loss control projects

10. 3. Additional Capacity • Can act as a direct insurer (where permitted) • Can act as a reinsurer behind a fronting company • Provides insurance coverage through fluctuating insurance • cycles = price stabilization • Reduces the dependency for obtaining risk transfer through • commercial markets • Strategic layer completion e.g. • Left with a gap unable to complete property layer at lead • underwriter premium • Captive used to write the gap at lead underwriter premium • thereby completing the layer • Captive purchased reinsurance at a higher premium, but • integrity of pricing for rest of the layer was maintained • Saved the increase layer pricing for the benefit of the insured

11. 4. Direct Market Access • Allows direct access to reinsurance markets & ART markets • Wholesale market cheaper than direct markets • Reinsurance markets less regulated, wider range of • solutions – better program design • May reduce/eliminate brokerage fees • Collection of reinsurance commissions

12. 5. Flexibility in Program Design • Acts as a negotiating tool in coverage and pricing with • markets • Allows for customized covers, broader wordings, “manuscript” • policy forms • Coordination of insurance programs throughout multiple • jurisdictions: (DIC/DIL covers, global programs)

13. 6. “Uninsurable” Risk • Such exposures carried on balance sheet • Create capacity above captive retention • Can become tax-deductible premium expense • Transfer liability off balance sheet • Turn a cost center into a potential profit center – e.g. gradual • environmental pollution

14. 7. Financial Stabilizing • Insulates owner from withdrawal of capacity by conventional • markets: pollution, asbestos, flood, windstorm, terrorism… • Uses its capacity and reservoir of earnings to stabilize • premiums during harder markets • Allows access to multi-year ART programs to spread losses • across time • Dividend release can be harmonized with parent’s capital • needs to reduced debt/equity ratios, tax loss offset…

15. 8. Profit Centre • “Offensive” not “defensive” use • Attract related third party business, e.g. customer insurance • programs • Diversify risk in captive • One corporate vehicle to measure risk management • performance

16. Latest ideas on Captive use Susan Lane Vice President Aon Global Insurance Managers

17. Current Environment • Continued soft market • Interest rates low • Below average ROI • Inflation on the rise • Cash/liquidity still an issue • Restricted credit, squeeze on collateral

18. Current Captive Market • Incorporations continue • Potentially tighter regulations introduced • Economic situation driving strategic review and uses • Owners are: • identifying untapped potential cost-saving mechanisms • increasing retentions • accessing excess capital • considering new lines of coverage

19. Global Captive Market Growth # of Global Captives

20. Most Common Uses Liquidity Tax Strategy New Product Offerings Risk Transfer Financial Risks Corporate Discipline E-Commerce Risks Acquisitions Loss Reduction Reinsurance Marketplace Risk Retention Allocation

21. Common Uses • Traditional Captives • Traditional risks e.g. WC; Auto; GL; • Long tail covers seeking tax advantages • Typically $1m+ in expected losses • New Captives • Used to create income e.g. selling insurance on products (cell phones, extended warranties, tenants insurance) • Used to resolve problems e.g. lack of capacity/rising costs for Californian earthquake • Used to insure the uninsurable e.g. emerging liabilities for high tech companies, products liability for pharmaceutical • Used to enhance cover e.g. employee benefits

22. Latest Uses • Trade credit • Legacy liabilities • Non-US employee benefits • Customer/Supplier risk • Group captive participation • Segregated account conversions • 831(b) formations • Wealth management/transfer

23. Group Captive Participation • Usually lowers cost of insurance • Risk sharing may provides tax benefits • Owners benefit from returned premiums (dividends) after a defined period • Group meetings can create beneficial forum discussions

24. Segregated Account Conversions • Use captive to provide customers/suppliers with insurance capacity • Insulate risks • Isolate run-off or legacy risks from current risk portfolio • Asset protection

25. 831 (b) Captives • Commonly known as “Wealth Captives” • Premiums below $1.2m then election opts not to pay income tax on the underwriting profit (have to pay on investment income) • Purpose is to allow start up companies the opportunity to get established • The entity MUST qualify as an insurance company for tax purposes to take this election • Captives in common ownership are added together to see if $1.2m is exceeded

26. Wealth Management/Transfer • Use of a captive to transfer wealth between generations through structuring captive ownership • Applicable to privately held companies only • Can be a tax effective way of transferring wealth • Underwriting profit is received by heirs, not business owners

27. Wealth Management/Transfer: Example 1

28. Wealth Management/Transfer: Example 2 Insured deducts premium as expense (Tax Saving $350k)

29. Program Design Consideration • Understand the capacity and appetite to assume more risk • Determine future expected losses • Gauge market response • * Consider the Total Cost Of Risk *

30. 2010 Outlook • Indications that P&C market will stay soft • Organizations continue to assess the value of every $ spent • Focus on optimizing risk • Evaluate placing less coverage in the commercial insurance market and increasing retentions • Combat high cost and availability of collateral • Increase in global regulation

31. Conclusion • Captives as a strategic risk financing tool are continuing to evolve and deliver benefits to the parent company in many areas, not just insurance and tax.

32. How to Form a Captive Brad Adderley Partner Appleby

33. Preparation • Receive Client Instruction • Completion of Client Questionnaire • Reservation of Name • Registrar of Companies • Engagement Letter & Retainer • KYC

34. Insurance Submission • Simultaneously Submit to: • Incorporation Submission • Registrar of Companies; and • Bermuda Monetary Authority: • Authorisation and Compliance Division Insurance Submission • Bermuda Monetary Authority: • Insurance Division • Assessment & Licensing Committee (ALC) • Technical Advisory Group (TAG)

35. Insurance Submission • Business Plan • Pre-incorporation Information Form • Five Year Financial Projections • Director Information • Shareholder Information • Supporting Documentation

36. Incorporation Bermuda Monetary Authority • Issue consent to incorporate Registrar of Companies • Apply to incorporate • Immediately; or • Delay incorporation for up to six months from the date the consent is issued

37. BMA Review Process Request more information until satisfied Rejected Insurance Program Foreign Exchange letter issued to Registrar of Companies Review of Application by ALC & BMA Insurance Division Approved Incorporate Company Shareholders Rejected Provide more information on owners

38. Organisation • Review funds to pay up the minimum authorised share capital • Convene initial meetings • Provisional Directors Meeting • Statutory Meeting • First Board of Directors Meeting

39. Insurance Licensing • Apply for insurance license • Form 1B • Service Providers • Capital NB: License will be issued as of the date of application Commence writing business from the date that the license application is submitted

40. Post Organisation Service Providers: • Corporate Secretary • Principal Representative/Insurance manager • Auditor • Loss Reserve Specialist • Banks

41. Captive Tax Update Bill Bailey Sr. Manager & Tax Leader Ernst & Young, Bermuda Karey Dearden Sr. Manager FSO Insurance Ernst & Young, New York

42. Current Environment • CFOs are constantly looking for ways to improve cash flow, to reduce expenses and to maximize the use of capital. • CFOs and Risk Managers are seeking to maximize coverage options while reducing the overall cost of risk. • Tax Directors of inbound organizations are exploring methods to move funds within the global organization in a tax efficient manner.

43. Potential Benefits of a Captive Insurance Arrangement A properly structured captive insurance arrangement may provide the following benefits: • Expense reduction leading to improved cash flow • Minimizing capital to fund certain risk exposures by pooling risks • Centralized management of risk within an organization • A vehicle to move funds within a global organization in a tax efficient manner • A profit center for accepting profitable third-party insurance business

44. How is this accomplished? • Reserves for retained risks are not deductible for U.S. Federal income tax purposes. • Insurance premiums paid to a properly structured captive insurance company to fund retained risk should be deductible. • A captive insurance company can set up deductible insurance reserves. • A pool of risks is less volatile than a single risk, so less capital is needed to support risk exposures. • Certain third-party insurance business, e.g., extended warranty insurance, may be profitable business thereby creating a profit center. • Insurance premiums can generally be paid across borders to fund risk exposures.

45. Definition of Insurance for U.S. Federal Income Tax Purposes • “Insurance” is neither defined in the statute nor the Treasury regulations. • Judicial precedent provides the following framework for evaluating whether a scenario is an insurance arrangement (LeGierse): • Presence of insurance risk • Risk shifting • Risk distribution • Commonly accepted notions of insurance • Three Common Structures • Parent/Subsidiary (Carnation, Clougherty Packing) • Brother/Sister (Humana, Kidde, Malone) • Third-party risk (AMERCO, Harper, Sears)

46. Definition of Insurance for U.S. Federal Income Tax Purposes • Parent/Subsidiary • Premiums • Parent has not shifted its risk to Captive. • Balance sheet approach • Premiums paid from Parent to Captive are not deductible. • Captive is not considered an insurance company. Parent Captive

47. Definition of Insurance for U.S. Federal Income Tax Purposes • Brother/Sister • Parent • Parent has not shifted its risk to Captive. • Balance Sheet approach • Premiums paid from Parent to Captive are not deductible. • Subs • Subs generally shift risk to captive. • Premiums paid from Subs to Captive are generally deductible provided certain bona fides are satisfied: premiums are arm’s length, the Captive is adequately capitalized, and the Captive is not propped up. • Captive • Generally treated as an insurance company. Parent Premiums Subs Captive Subs Premiums

48. Definition of Insurance for U.S. Federal Income Tax Purposes • Third-Party Risk • Parent • Parent generally shifts its risk to Captive, provided sufficient third-party risk is present. • Third-party risk benchmark > 30% of total premium • Premiums paid from Parent to Captive are generally deductible, provided bona fides are satisfied. • Subs • Subs generally shift risk to Captive. • Premiums paid from Subs to Captive generally deductible, provided bona fides are satisfied. • Captive • Generally treated as an insurance company. Third-party Risk Premiums Parent Premiums Subs Captive Subs Premiums

49. Examples • Summary • Scenario should qualify as a brother/sister insurance arrangement provided the bona fides are present. • Premiums paid from U.S. Subs to Captive should be deductible. • Captive should be treated as an insurance company for U.S. federal tax purposes. • Primary Benefits • Capital is minimized by pooling risks. • Management of risk is centralized. • U.S. federal and state tax deductions should be accelerated creating increased cash flow. • Investment earnings not subject to U.S. federal or state taxation. • Funds are moved from the U.S. to a tax efficient jurisdiction of the Foreign Parent. Foreign Parent Subs Captive Non US Domicile U.S. Subs * Premiums * Note: U.S. federal excise tax likely to apply.

50. Examples • Summary • Scenario should qualify as a Third-Party risk arrangement provided the bonafides are present. • Premiums paid from U.S. Subs to Captive should be deductible. • Captive should qualify as an insurance company for U.S. federal income for purposes. • Primary Benefits • Captive acts as a profit center for profitable third-party insurance risks, e.g. extended warranty. • Capital is minimized by pooling risks. • Management of risk is centralized. • U.S. federal and state tax deductions should be accelerated creating increased cash flow. • Investment earnings not subject to U.S. federal or state taxation. • Funds are moved from the U.S. to a tax efficient jurisdiction of the Foreign Parent. Foreign Parent Fronting Company Customers’ Premium Subs Captive Non U.S. Domicile • Third-party reinsurance premiums • 30% of total premium in Captive • *Note: U.S. federal excise tax likely to apply U.S. Subs *Premiums