Captives Panel

Bermuda Financial Services Conference New York

September 30th 2008

Shanna Lespere, Director, Insurance

Bermuda Monetary Authority

Overview of Bermuda Framework for Insurance Regulation

The Bermuda Monetary Authority • Independent, single regulator of all markets within

Bermuda’s financial services sector; licensing, supervisory, enforcement powers for:

Banking, Trust and Investment, (BT&I) Insurance

• Promotes overall financial stability and soundness of financial institutions

• Assists relevant authorities with detection and prevention of financial crime

• Has pivotal role in maintaining Bermuda’s reputation as a high-quality international financial centre

• Committed to providing effective, risk-based, practical regulatory frameworks, consistent with international standards

Practical and Risk Based Regulation

• What do we mean by Risked Based Regulation? Risk Based Framework “Know your Customer” (KYC) Capital Adequacy On-site Programmes Legislation

• Risk Based Framework• Assess nature, scale and complexity of entities seeking to

be based in Bermuda, their related risk and level of sophistication of clients involved

• Apply progressively higher levels of scrutiny and more requirements when higher risk profile/exposure determined (e.g. financial, operational, reputational risk)

Bermuda’s Risk-Based Regulatory Approach

• Tailored regulatory regimes appropriate to the risk

• Encourages prudent corporate conduct and high standards - quality business environment

• Continual framework review, e.g. new Codes of Conduct, enhanced risk-based capital adequacy model

• Balance between practical and effective regulation

• Does not stifle innovation and business development

Bermuda’s Licensing Process

• Detailed and thorough

• Utilizes skilled resources that we have internally

• Extended scope externally for verification where necessary

• Framework consistent with international standards (IAIS Core Principles)

International Regulatory Initiatives

• Bermuda supports initiatives that promote quality regulation and consistent standards across jurisdictions

• Member of various international regulatory groups including the IAIS

• Active participation in some10 working committees within the IAIS

• Ensure ongoing constructive dialogue that supports practical regulatory developments

Development and Importance of Bermuda Market

• 1950s - establishment of first captive insurer in Bermuda

• 1978 - Legislative Framework – Insurance Act and related regulations effectively govern

conduct of re/insurance companies in Bermuda • 1990s – classification system applied to companies

– Consistent with risk based approach to regulation• Response to catastrophic events resulted in

significant growth in commercial market

The Bermuda Market – Developments

Captives

Excess Liability

LargeCats

9/11

Katrina (other storms)

Class Structure

Class 1: Single-parent Captives Insuring the risks of its owners or affiliates of the owners

Class 2: Group / Association Captives Writing less than 20% unrelated business

Class 3: General Commercial Companies Some captives writing >20% third

party

Class 4: Property Catastrophe / Excess Liability Companies

Long Term

Market Statistics by Class of Insurer

Class of Insurer

Class of Insurer

Number of

Co's

Gross Premiums Net Premiums Total Assets

Class 1 343 4,767,932,617 3,736,912,017 16,372,746,394 8,826,534,502

Class 2 353 9,029,304,772 7,996,529,146 38,771,246,705 15,026,866,687

Class 3 490 42,302,251,871 32,551,426,118 194,506,490,036 66,797,893,772

Class 4 38 32,216,627,481 28,608,102,943 135,164,514,497 57,173,776,362

Long-Term 81 27,467,484,474 27,467,484,474 55,581,998,659 9,985,652,707

Totals: 1,305 115,783,601,215 100,360,454,698 440,396,996,291 157,810,724,030

Sub-prime• Continue to monitor impact on BDA market• Funds

– Limited adverse impact• Banking

– Investment portfolio risks • Insurance

– Proactive approach – BMA surveys re investment portfolios and underwriting

exposures – Stress tests - solvency / liquidity positions – Enhanced monitoring of affected entities – financial

guaranty firms

Development and Importance of the Bermuda Market

• Symbiotic relationship between captives and commercial reinsurers

• Significant commercial reinsurance market provides captive owners access to open market underwriting capacity

• Extremely sophisticated market from both a captive and commercial perspective

• Clear commitment to quality business and practical, risk-based regulation

Captives and their Regulations

Janita Burke, Partner, Appleby

CAPTIVATION: Captives and the Legislation Governing Them

Principal Legislation

• Companies Act 1981

• Insurance Act 1978

Insurance Accounts Regulations 1980

Insurance Returns and Solvency Regulations 1980

• Segregated Accounts Companies Act 2000

CAPTIVATION: Companies Act

RECENT AMENDMENTS

• Memorandum of Association

• Bye-Laws

• Shareholder Written Resolutions• AGM• Treasury Shares• Bearer Shares Prohibited• Electronic Delivery of Documents• Annual Fees

CAPTIVATION: Insurance Amendment Act 2007 and 2008

2007 AMENDMENTS

• Minimum Criteria

• Supervisory Functions and Duties of the BMA

• Statement of Principles

• Guidance Notes

CAPTIVATION: Insurance Act

2008 AMENDMENTS

• Reclassification of Class 3 InsurersDistinguish between captives and

commercial insurersClass 3, 3A and 3B

• New Category - Special Purpose Insurers

• Section 6A orders

• Principal Representative Responsibilities

CAPTIVATION: SAC Act Summary

• Establish system of public voluntary registration

• Creates statutory regime governing record keeping

• Incorporates principles of US business trust legislation

• Enables combinations of client relationships

CAPTIVATION: SAC Act – Crucial Aspects

• Registration under the SAC Act

• Segregated accounts are not legal persons

• Attributes portions of an asset/liability

• Any type of securities

• Sets conditions for dividends or distributions

• Permits inter account transactions

Establishing a Captive in Bermuda

Neil Horner, Senior Counsel, Attride-Stirling & Woloniecki

Captive definition

A captive insurance company in its purest form is an insurance company established to insure the risks of its non-insurance parent company and/or its affiliates.

Classification of Bermuda Insurance Companies

Class 1 - Pure Captives

Class 2 - Group/Association Captives writing less than 20% unrelated business

Class 3 - General Commercial companies whose unrelated business is more than 20% but less than 50%

Class 3A - An insurance company whose percentage of unrelated business exceeds or is expected to exceed 50% of net premium written and/or net loss and loss expense provisions, and where the unrelated business premium does not, or is not projected to,

exceed US $50 million.

Class 3B- An insurance company whose percentage of unrelated business exceeds, or is projected to exceed, 50% of net premium

written and/or net loss and loss expense provisions, and where the unrelated business premium does exceed or is projected to

exceed US $50 million.

Class 4 - Property/Catastrophe/excess liability companies

SINGLE PARENT CAPTIVE

Captive

Owner/Insured

Captive

O/I

O/I

O/I O/I

O/I

O/I

ASSOCIATION/GROUP OWNED CAPTIVE

Insurance Shares (clients)

Cell1

Cell2

Celletc..

ManagementShares

Cell3

Cell4

Cell5

Cell6

Cell7

Cell8

Cell9

Cell10

RENT-A-CAPTIVE/SAC COMPANIES

Why form a captive?

•Insulates against fluctuations of commercial market

•More cost-effective coverage catering to precise insurance needs of its parent

•In respect of each $ of premium, 60% covers risk and 40% commercial insurer’s overheads – by using a captive, can reduce that 40% by 50%

•More precise coverage

•Greater control

•Access to reinsurance market

Why form a Bermuda captive?

•Bermuda continues to be world’s leading captive domicile

•Facilitative but responsible regulation

•Highly sophisticated Bermuda insurance and reinsurance market

•Stable political and legal environment

•Strategic geographical location of Bermuda

The Application Process

Receive Client Instruction

• Completion of Client Questionnaire

Reservation of Name

• Registration of Companies

Pre-Incorporation Submission

Documents:

• Pre-Incorporation Information Form

• Business Plan

• Five year Financial Projections

• Supporting documentation including actuarial analysis if possible

Pre-Incorporation Submission

Simultaneously Submit to:

• Registrar of Companies; and

• Bermuda Monetary Authority

-Authorisation and Compliance Division

-Insurance DivisionAssessment and Licencing Committee

(ALC)Technical Advisory Group (TAG)

Incorporation

Registar of Companies

•Issue consent to incorporate

•Apply to Incorporate

-Immediately; or

-Delay incorporation for up to six months from the date the consent is issued

Organization

• Receive funds to pay up the minimum authorized share capital

• Convene initial meetings

-Provisional Directors Meeting

-Statutory Meeting

-First Board of Directors Meeting

Licensing

• Apply for insurance licence

• Captive registered as an insurer within 10 days of application

-Licence will be issued as of the date of application

• Commence writing business from the date that the license application is submitted

Taxation of a Bermuda Captive

Richard E. Irvine, Partner, PricewaterhouseCoopers

Taxation of a Bermuda Captive Insurance Company

• Bermuda does not impose any taxes on income or capital gains

• In general, a Bermuda Captive is not subject to direct taxation by the US

• A US shareholder(s) of a Bermuda Captive may be subject to current taxation on their pro rata share of the profits

• The key factors in determining the US taxation of the Bermuda Captive are– Do the contracts qualify as “insurance”,– Where does the Captive “do business”, and– What is the ownership structure of the Captive

Taxation of a Bermuda Captive Insurance Company

From a US tax perspective, premium deductibility for the insured, at the time of payment and deductibility of an insurance reserve has been the primary goal of a captive insurance arrangement; however the primary benefit is the ability to currently deduct loss reserves

Taxation of a Bermuda Captive Insurance Company

• FAS 5 Standard for accruing liabilities– “Estimatable and Probable Standard”

• US C-Corporation Tax Standard for deducting accrued liabilities– IRC §461 “Economic Performance Standard”

• Fixed and determinable• Economic performance occurs w/in 8 ½ months

(i.e., payment) restrict deductibility to ‘cash method

– Reg. Sec. 1.162-1(a) “Business expenses deductible from gross income include the ordinary and necessary expenditures including insurance premiums...”

• US Freightways• US Insurance Company Tax Standard for deducting loss reserves

– May establish (i.e., deduct) a reserve which is ‘fair and reasonable’

• Creates US GAAP/Tax Parity for financial reporting

US Tax Definition of Insurance

• Neither the Internal Revenue Code or the regulations thereunder define the term “insurance” or “insurance contract”

• Funding of self insurance not deductible for Federal income tax Spring Canyon Coal Co.

• Helvering v. LeGierse, 312 U.S. 531 (1941)

• IRS issued three revenue rulings which provide “safe harbors” for certain fact patterns– Brother/Sister insureds (RR 2002-90)– Parent/Subsidiary insureds (RR 2002-89)– Group Captive (RR 2002-91)

US Tax Definition of Insurance

• Presence of Insurance Risk (not merely investment risk)

– RR 1996-89– RR 2007-47

• Presence of Risk Shifting• Presence of Risk Distribution• Common notions of insurance

US Taxation of Captive/Shareholder

Tax the Captive–Bermuda captive elects to be taxed as a US property and casualty insurance Company

•No withholding tax•No Federal Excise Tax (FET)

–Eligible for special company provisions

•IRC 831(b) taxed on ‘investment income’ only•IRC 501(c)(15) tax exempt insurance co.

–Files Form 1120PC, Form 1120L, or Form 990

Tax the Shareholders–Controlled Foreign Corporation

•10% voting stock•>25% vote or value

–Related person insurance income rules

•10% rule replaced with “any”

–Deemed dividend under Subpart F–Certain investment income may be subject to withholding–US Shareholder files Form 5471–US FET on premiums

•4% on direct•1% on reinsurance, life and health

US Taxation of Captive/Shareholder

• “non insurance” captive may be considered a Passive Foreign Investment Company or “PFIC”

Revenue Ruling 2008-08

The IRS provided guidance through examples of when a cell of a protected cell company can enter into a transaction which is treated as insurance for federal income tax purposes, and when amounts paid to these cells is deductible as “insurance premiums” under Section 162.

• Example 1: X, a corporation that owns Cell X, enters into a contract whereby Cell X insures professional liability risks of X. Cell X does not enter into any arrangements with entities other than X.

– IRS finds the arrangement between X and Cell X is akin to a parent and its wholly owned subsidiary, and in the absence of unrelated risk, lacks the requisite risk shifting and risk distribution to constitute insurance.

– Consistent with Parent/Subsidiary case law and Revenue Ruling 2002-89

• Example 2: Y, a corporation, owns all stock of Cell Y, as well as all the stock of 12 subsidiaries. (Mirrors facts of Rev. Rul. 2002-90). The 12 subs have a significant volume of independent, homogenous risks, insured into Cell Y. No sub has coverage for less than 5% nor more than 15% of the total risk insured by Cell Y.

– IRS finds the subsidiaries have shifted the liability risks to Cell Y. The premiums are pooled such that a loss by one sub is not in substantial part paid from its own premiums. Had the subs of Y entered into identical arrangements with a sibling corporation that was regulated as an insurance company, the arrangements would constitute insurance and the premiums would be deductible under Section 162

– Consistent with Brother/Sister case law and Revenue Ruling 2002-90

IRS Notice 2008-19

• In conjunction with Revenue Ruling 2008-8, the IRS issued the Notice to request comments on further guidance to address issues that arise if those arrangements do constitute insurance, specifically, the status of such a cell as an insurance company within the meaning of §§ 816(a) and 831(c), and some of the consequences of a cell’s status as an insurance company.

• The Notice puts forth proposed guidance that would address (a) when a cell of a Protected Cell Company is treated as an insurance company for federal income tax purposes, and (b) some of the consequences of the treatment of a cell as an insurance company.

• The proposed guidance would include a rule to the effect that a cell of a Protected Cell Company would be treated as an insurance company separate from any other entity if: – the assets and liabilities of the cell are segregated from the

assets and liabilities of any other cells and from the assets and liabilities of the Protected Cell Company

– based on all the facts and circumstances, the arrangements and other activities of the cell, if conducted by a corporation, would result in its being classified as an insurance company within the meaning of §§ 816(a) or 831(c).

IRS Notice 2008-19

– Effect of insurance company treatment at the cell level under the proposed rule:

• Any tax elections that are available by reason of a cell’s status as an insurance company would be made by the cell;

• The cell would be required to receive an employer identification number (EIN) if it is subject to U.S. tax jurisdiction;

• The activities of the cell would be disregarded for purposes of determining the status of the Protected Cell Company as an insurance company for federal income tax purposes;

• The cell would be required to file all applicable federal income tax returns and pay all required taxes with respect to its income; and

• A Protected Cell Company would not take into account any items of income, deduction, reserve or credit with respect to any cell that is treated as an insurance company under the proposed rule making