4th Quarter Palmetto Captive Journal

The

Captive Insurance J O U R N A L

4th Quarter 2012

I N

T H I S

I S S U E

“Taxmageddon”

Page 2-3 Taxmageddon

Page 4-5 A Captive’s Guide to Selecting an Investment Manager

Will the Fiscal Cliff Cause Captive Owners to Jump?

— Dan Kusaila Tax Partner, Saslow Lufkin & Buggy

Page 6 SCCIA’s 2012 Lifetime Membership Award goes to Robert Johnson

Page 7 Committee Updates

As of late, it seems no matter what news channel you watch, the more it seems we hear the term “Taxmageddon” being thrown around. Unfortunately, the closer we draw to December 31, 2012 the more rhetoric this topic will generate. So what exactly is “Taxmageddon,” and why is it generating so much buzz?

Taxmageddon is a term being used to describe the tax increases that will take place if Congress does not act by December 31, 2012. These increases come from two main sources: the expiring Bush Tax Cuts and the Patient Protection and Affordable Care Act (commonly referred to as the “Affordable Care Act”). While these tax increases mainly affect individual taxes, the impact to some members of the captive insurance industry could be severe.

There are several components to the Bush Tax Cuts that, if left to expire, could significantly impact the captive industry.

These are: • The top marginal tax rate for individuals will increase from 35% to 39.6%; • The top marginal tax rate for dividend income for individuals will increase from 15% to 39.6%; and

• The current $5.12 million exemption for estate taxes will be reduced to $1 million, with a maximum estate tax rate of 55% for transfers exceeding $3 million.

These scheduled tax rate increases, coupled with an additional 3.8% Medicare tax on investment income imposed by the Affordable Care Act for individuals, trusts and estates (starting in 2013), could serve to slow growth in the captive insurance industry. The additional 3.8% Medicare Tax will apply to individuals with adjusted gross income (AGI) exceeding $200,000, or couples with AGI exceeding $250,000. A trust will be required to pay the Medicare surtax if its net investment income exceeds approximately $12,000. While on the surface, these changes do not seem likely to affect our industry, a deeper analysis proves otherwise.

It is true that “Taxmageddon” mainly focuses on individual taxation. Captives owned by Fortune 500 companies should not be directly impacted. If the captive pays a dividend to the parent company, the dividend will continue to qualify for the 100% dividends received exclusion from

The Captive Insurance Journal Fourth Quarter, 2012

“Taxmageddon”

Managing Editor Andi Rawl Design/Graphics Florence Design, Inc. Editorial and Advertising Office PO Box 1763 Columbia, SC 29202 855-CAPTIVE

SOUTH CAROLINA CAPTIVE INSURANCE ASSOCIATION 2012 DIRECTORS & OFFICERS Chairman of the Board Thomas A. Brumgardt Nelson Mullins Riley & Scarborough, LLP Treasurer/Corporate Secretary Andrea Bartlett Bartlett Actuarial Group, Ltd. Directors Randy Collins Koppers Assurance, Inc.

taxable income. Likewise, group captives or risk retention groups owned by CCorporations should not see a significant increase in their tax burden.

Captive programs that stand to lose the most are the small and middle market captive insurance companies owned by individuals or by flow-through entities that are ultimately owned by individuals. The additional income tax costs of owning and operating such captives is likely to increase, perhaps dramatically. We do not know whether Congress will act before the end of the year to extend some or all of the Bush Tax Cuts, although any action is unlikely until after the November elections.

Although many commentators are suggesting that some relief is likely, planning for the worst case scenario may be the best advice at this time. Now is the time for new and creative tax planning.

One possible planning technique may involve the formation and ownership of group captives and risk retention groups.

Rather than structuring group captives as

(continued)

stock companies, it might be more advantageous to structure them as traditional mutual insurance companies.

One of the distinguishing factors between a stock and a mutual company is the taxation of the return of profits to the individual policyholders. While policyholder dividends are deductible from taxable income for both stock and mutual insurers, stock companies run a greater risk of having the IRS recharacterize these payments as equity dividends, which are not deductible for tax purposes by the insurer. The loss of tax deduction by the captive, coupled with a tax rate as high as 43.4% for the recipient, results in true double taxation of the dividend. This double taxation might be easily avoided by forming as a non-stock mutual company. Furthermore, these non-stock entities might increase their underwriting of insurance policies with retro debit and credit features as a way to return value to the shareholder and minimize the risk of double taxation.

Single parent captives taking advantage of the Section 831(b) election( that is, captives

Michael Coulter Aon Insurance Managers (USA) Gavin Foggon Marsh Management Services Inc. Margie Heggie SC Physician Assurance Co. / SCMA

Congratulations to captives licensed in 2012 Millbrook NMF Risk Retention Group

Chris Stormer Bauknight Pietras & Stormer, PA

Bridges Insurance Company, Inc.

Executive Director Andi Rawl

OrthoForum Insurance Company (A Risk Retention Group)

Old PICL Insurance Co. PICL Insurance Co. Bison Insurance Company Limited

Orthopedic Physicians Insurance Company © Copyright 2012 SC Captive Insurance Association

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NorthSouth Insurance Company Limited

The Captive Insurance Journal Fourth Quarter, 2012

“Taxmageddon”

electing to be taxed only on their investment income), may find the tax advantages once enjoyed quickly evaporating. Under the current tax law, affiliated insured entities would receive a tax deduction for the premiums paid to the captive, resulting in savings as high as 35% of the premiums paid. Premiums received by the captive would not be taxable, and any dividend paid to the individual owner of the captive would be taxed at a current rate of 15%. If the current tax rates are allowed to rise, the individual owners of the captive will become subject to a dividend tax rate as high as 43.4% (39.6% individual rate plus the additional 3.8% Medicare Tax imposed by the Affordable Care Act). The increase to the tax on the dividend would far outweigh any benefit received by the affiliated entity for the premium deduction paid to the captive.

Another negative consequence from rising tax rates is that we could see a rise in captive formations in offshore domiciles.

By establishing the captive in an offshore domicile, owners could take advantage of the existing controlled foreign corporation rules by essentially structuring their captives in such a manner as to gain flow-through treatment. This would enable captive owners to pay taxes on the captive’s current earnings at individual tax rates. The downside to the owner is that taxes will be paid on current earnings whether or not the actual cash was distributed from the captive. From a cash flow stand point this could create certain challenges. However, the benefit gained from a single level of taxation could far exceed the challenges posed by cash flows.

(continued)

effective January 1, 2013, we would expect to see a rise in captives being owned by family trusts. For a captive owned by a trust whose beneficiaries are the founder’s children over the age of 21, an opportunity exists to pass wealth outside the parent’s estate. By paying premiums to the captive, wealth is essentially transferred out of the operating business to the captive.

Premiums paid to the captive will reduce the federal tax liability of the operating business. Because insurance companies enjoy unique tax advantages, it is easier to mitigate the tax exposure to the captive.

By utilizing a trust, it is possible that every premium dollar paid would pass outside the parent’s estate to the children without creating any federal income or estate taxes.

While this article attempts to address the more severe issues facing the captive insurance industry, it does not encompass all issues at hand. Each captive owner must examine the potential affects and challenges that “Taxmageddon” poses to their respective captive. With much at stake, we can only hope that Washington acts quickly to address these issues.

A final way we might see captive owners combat rising tax obligations is by using one of the expiring Bush Tax Cuts to their favor.

With the lifetime estate tax exemption decreasing from $5.12 million to $1 million 3

The Captive Ins urance Journal Fourth Quarter, 2012

A Captive’s Guide to

S electing an Inves tm ent M anager — Derek Martisus, Head of US Insurance Solutions, Performa Limited (US), LLC

DONATE

NOW

As part of the SCCIA’s legislative efforts moving forward, CIPAC (Captive Insurance Political Action Committee) was formed in order to be collectively represented as an industry as it relates to legislative matters.

F or m ore inform a tion a nd Ple dge F orm go to our w e bs ite w w w .s c c ia .org or c onta c t the A s s oc ia tion Offic e a t 1-855-C A PTIV E .

Dona te online a t w w w .s c c ia .org.

Selecting an investment manager can be a time consuming and frustrating process for captive owners and managers whose expertise more likely is focused on insurance and accounting. Captive stakeholders can feel uneasy during the selection process as investment management firms seemingly speak a different language. Interpreting what is style versus substance is not easy, but knowing the critical questions to ask will go a long way towards finding the best fit for a Captive. A short article on the topic can only scratch the surface, however the synopsis presented here should start a captive and their manager on the right track.

quality investment manager should possess. A full explanation of the depth of the firm’s expertise and the quality of the individuals is paramount. The investment management industry has one asset – the people that work there. Embedded within this line of questioning is an attempt to determine what asset classes the manager covers. A very quick review of efficient frontier analysis will remind you that the risk-return profile of a portfolio can be improved with the addition of asset classes that are less than perfectly correlated. Is the investment manager in a position to offer full asset allocation services or a specialist in a given area, such as fixed income or equity only?

Does the investment manager know what a captive is? While all captives may not require that their investment manager understand the intricacies of captive insurance, it may be a wise choice to find one who has more than just some passing knowledge or none at all. This is partly a communication issue. If the Captive and the investment manager are not in sync, problems will arise quickly. From a practical standpoint, the captive may have additional service needs that go unmet because of manager’s lack of knowledge of the industry. Larger, or specialized investment firms, will employ resources to cover these items such as actuarial assistance.

What is the firm’s track record and how was it attained? It is wise to look at track records as far back as is available for each prospect but perhaps not for the reason most people think. Managers who cannot show you a track record for an extended period of time, say five to ten years, must have other great factors that offset continuity. However, the track record is a starting point for drilling deeply into the firm’s investment philosophy and process.

What style do they prescribe to – fundamental or macro? How is the decision making process run? Track records will always be delivered relative to a benchmark, but capital preservation is a very important issue for captives. This begs the question of absolute versus benchmark returns and how comfortable the investment manager is at running a dual mandate. It is important to make sure that a captive’s individual benchmark is one that the investment firm can manage against.

What investment expertise does the investment manager possess? Let’s cut right to the chase. A firm of one portfolio manager trading bonds from an office with no support is probably not going to provide a captive what they need. While this may seem extreme it gets to the heart of what characteristics an institutional 4

The Captive Insurance Journal Fourth Quarter, 2012

A Captive’s Guide to

Selecting an Investment Manager (continued)

Will there be access to the decision makers? Investment firms may set macro-economic views that drive strategy and then utilize fundamental research that directs specific bond or stock selection.

Will you have access to the necessary portfolio managers or research analysts when it comes time for their help?

Senior management at the captive’s sponsor may require in depth explanations on strategy and particular trades.

Additionally, captive auditors frequently require support for items on the balance sheet as well as valuations. Being able to go directly to those that can speed up the process is critical.

What ancillary services does the investment manager provide? For some captives, such as risk retention groups, NAIC schedules dictate reporting from their investment managers to be more sophisticated and timely. Asset managers specializing in servicing the insurance industry will typically have solutions for these captives. Smaller entities or those without an insurance focus will frequently pass the responsibility on to the captive manager. While captive managers are staffed with capable accountants, completing Schedule D on an NAIC quarterly statement can be timeconsuming and profit-killing. Additionally, asset-liability management, cross-over analysis for use with tax exempt bond strategies, and peer analysis are all services that captives commonly find of use from their investment manager.

What is the real cost for investment management services? Here is where the rubber meets the road and hidden costs become difficult to ferret out. In the current low interest rate environment,

captives should strive to keep every basis point of return. An unknown fee structure can strip hard-earned returns.

Stakeholders should pay close attention to the explicit fees charged, as well as more subtle ones. Fees as a percentage of assets under management should be the requirement and the easiest way to compare competitors. Additional performance fees and commissions should be carefully analyzed for both risk/return benefits as well as transparency. In a commission environment, especially within the bond world, these fees can be on top of a mark-up on the cost of a particular security. The commission is a known quantity but the mark-up is not.

Investment managers that have size and scale can significantly reduce the latter as they transact for multiple clients simultaneously. Some firms are brokerdealers and others are registered investment advisors. Either type can assist a captive in a variety of forms.

The significant differences are typically transaction execution, fee structures and fiduciary roles.

As mentioned, the process of determining the right investment manager for a captive can be complex and more detailed than presented here in the quarterly SCCIA newsletter.

However, using this roadmap as a starting point for discussions, a captive and their stakeholders should be able to find an investment manager with the structure and capabilities that best match their own needs.

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The Captive Insurance Journal Fourth Quarter, 2012

SCCIA Awards the 2012 Lifetime Membership Award to

Robert Johnson

The South Carolina Captive Insurance Association (SCCIA) held its 13th Annual Executive Educational Conference September 17-19, 2012, at the Charleston Place Hotel in Charleston, SC. The Lifetime Membership Award was presented to Robert Johnson, Managing Director for Aon Insurance Managers (Bermuda) Ltd. The SCCIA Lifetime Membership Award was created in 2012 and recognizes an individual who has given countless hours to the advancement of the SCCIA and showed exemplary efforts within the captive industry and South Carolina as the leading domicile.

Robert Johnson, Managing Director for Aon Insurance Managers (Bermuda) Ltd.

Robert served as the Chairman of the Board through his departure from South Carolina in 2012, at which time he left the South Carolina Captive Insurance Association. Prior to serving as Chairman of the Board, he served as President and Secretary/Treasurer along with serving on various committees for the Association.

Robert was instrumental in the growth and success of the South Carolina domicile both in his service to the SCCIA and as a respected captive manager. His contributions to South Carolina are many and his involvement will be missed.

Robert opened the Charleston branch of Marsh Management Services Inc. in 2003 and served as a Managing Director and Head of Office. He was responsible for client development, strategic planning, regulatory interaction and customer service. He also had overall operational responsibility for the service office Robert is currently managing director of Aon Insurance Managers (Bermuda) Ltd. with full management responsibility for the day to day operations of the Bermuda office. Robert’s experience in onshore and offshore jurisdictions gives him a unique perspective of the global captive market and how best to strategically place a captive resource to achieve maximum benefit to all stakeholders.

Robert graduated from Radford University, Radford Virginia with a Bachelor of Science degree in Business Administration, and then obtained a Masters of Business Administration with Honors from Kennesaw State University in Atlanta, Georgia. Robert began his insurance career with Alexander & Alexander, Inc., spending ten years in various client service roles such as client advisory, third party administration and risk management consulting.

About SCCIA The South Carolina Captive Insurance Association exists to enhance the captive industry within South Carolina and promote South Carolina as the leading domicile within the United States.

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The Captive Insurance Journal Fourth Quarter, 2012

Committee Updates SCCIA Committees are in integral part of the growth and visibility of the SCCIA. These following new Committee Chairs took effect October 1, 2012, and are seeking volunteers to serve on the committees. If you would like to volunteer please contact the appropriate committee chair or Andi Rawl toll free 855.CAPTIVE (227.8483) or arawl@sccia.org.

Convention Committee

Marketing Committee

The Convention Committee is responsible for planning the agenda for the Annual Executive Educational Conference held in September of each year.

Chair: Bryan Hudson, CPA Senior Audit Manager Bauknight Pietras & Stormer, P.A. 1517 Gervais Street Columbia, SC 29201

The Marketing Committee is responsible for identifying opportunities and developing materials for the SCCIA. Chair: Linda Danna, Senior Vice President, Account Executive, Captive Solutions Marsh Management Services, Inc. 151 Meeting Street, Suite 301 Charleston, South Carolina 29401

Education Committee The Education Committee is responsible for putting together educational webinars and trainings for the purpose of educating the members.

Chair: Liz Flood, Assistant Vice President, Senior Financial Advisor Dennis Johnson Folline King Group Merrill Lynch 1224 Sumter Street Columbia, SC 29201

Membership Committee The Membership Committee is responsible for prospect recruitment and member retention efforts within the captive industry and the SCCIA. Chair: Laura Roemer, Senior Account Manager Strategic Risk Solutions (SC), LLC 360 Concord Street, Suite 106 Charleston, SC 29401

Government Affairs Committee The Government Affairs Committee is responsible for discussing and advising the SCCIA Board of Directors on potential issues.

Chair: Steve Dyer, Esq. Stevens & Lee 6650 Rivers Avenue Charleston, SC 29406 7