Recommending a Strategy

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The Association Annuity Company, Ltd.a District
of Columbia Licensed Insurance Company Captive
Insurance Solutions for the Holders of Large
Annuities
Presented by G. Thomas Roberts and
John R. Patton
of McCarran
Ferguson Consulting, Inc. Consultants to
the Insurance Industry
Ligonier, PA

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What is Association Annuity Company?

• The Association Annuity Company is a District of
  Columbia domiciled insurer organized on a
  separate account (Cell) basis.
• The Company issues life annuities to owners of
  the separate account Cells
• The Company also offers life insurance
  reinsurance programs to owners of separate
  account Cells.

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The Problem

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The Large Annuity Problem

• Holders of 1,000,000 annuities have a Tax
  Problem. Taxes may consume up to 76 of values at
  death.
• Holders have a second problem they cannot use
  the funds held inside the annuity.
• Estate Taxes will take 50 of the annuity value
  at death of the annuitant.
• Income Taxes of 26 will be due on the inside
  buildup on the death of the annuitant.
• The annuitant cannot use the funds held inside
  the annuity. These are invested by the annuity
  companys investment manager.

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The Large IRA Problem

• Holders of 1,000,000 IRAs and Qualified Plans
  have the same Tax Problem. Taxes may consume up
  to 76 of values at death.
• Holders cannot use the funds held inside the IRA.
• Estate Taxes will take 50 of the IRA value at
  death of the owner and his spouse.
• Income Taxes of 26 will be due on total value on
  the second death.
• The holder cannot use the funds held inside the
  IRA. These are invested in marketable securities.

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The Solution

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Opportunities for Solving these Problems through
a Cell Insurance Company

• The Association Annuity Company Program solves
  these problems by issuing Life-only annuities
  which
• Reduce Estate Taxes on annuities to ZERO.
  
• Reduce Income Taxes on annuities to ZERO.
• Permit the Family to borrow funds from the
  annuity.
• Facilitates life insurance on the
  Principals
• Improves the investment mix inside
  annuities

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Cell Owner Profile

• Owner of a Commercial Annuity valued at more than
  1.0 Million.
• Owner of an IRA or Qualified Plan Asset of more
  than 1.0 Million

• Owner is motivated to
• Withdraw minimum annuity or IRA payments for
  life.
• Manage the annuity or IRA investment portfolio
• Pass on the residual value of the annuity or IRA
  to family members at death

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The Basic Principles of the ProgramAnnuities

• Any USA annuity may be rolled over from one
  company to another via IRS Sec. 1035

• An annuitant who elects a life-only annuity
  benefit incurs no estate or income tax on death
  since there is no residual value of a life-only
  annuity to the estate

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The Basic Principles of the ProgramIRAs and
Qualified Plans

• Any USA IRA may purchase a Single Premium Annuity
  to fund its obligations to the IRA Owner
• Withdrawals from a Qualified Annuity issued by a
  USA insurer satisfy the Minimum Distribution
  Requirements of IRAs

• An annuitant who elects a life-only annuity
  benefit incurs no estate or income tax on death
  since there is no residual value of a life-only
  annuity to the estate

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Hypothetical Accumulations and Savings through
Association Annuity Company

• Assume the client is age 71 and that the spouse
  is also age 71.
• Assume a clients annuity has a value of
  3,000,000 and realizes an average return on
  investment of 7.
• Assume the tax basis of the annuity is
  1,000,000.
• Assume the client annuitizes the contract and
  draws out 192,862 for 21 years (their
  joint-life expectancy).

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Hypothetical Accumulations and Savings through
Association Annuity Company

• The Annuity Value will be
• 3,042,402 at the second death
• Less- 1,521,201 Fed. Estate Tax (1)
• Less- 531,024 Lump Sum Income Tax (2)
• Leaves 990,177 Payable to Family (32)
• (1) Assumes Estate Tax rate of 50
• (2) Assumes 26 combined Federal, State and
  Local Income Tax rate on gain of 2,042,402.

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Hypothetical Accumulations and Savings through
Association Annuity Company

• But if clients family is the owner of a Cell of
  The Association Annuity Company he will have
• 3.042,402 in the Cell
• - 0 Fed. Estate and Income Tax
• 3,042,402 inside the Cell (100)
• And if the Family decides to liquidate the Cell,
  there will be a 20 long term capital gain tax of
  608,480, which gives clients Family 2,433,922.

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Hypothetical Accumulations and Savings through
Association Annuity Company

• Comparison of Annuity Account Balances, After
  Taxes
• With Cell Program 2,433,922
• Without Cell Program 990,177
• Increase 1,443,745
• This is a 245 increase in the after-tax asset
  values using The Association Annuity Company
  Program.

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The Cell Captine

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What is a Cell Captive?

• The Cell Captive concept was devised in the Isle
  of Gurnsey several years ago. The District of
  Columbia enacted Cell Legislation in 2001.
• Each Cell is a separate entity for purposes of
  its liabilities Cell assets are not subject to
  the claims of any other Cell, and are therefore
  protected by statute.
• The Company as a whole will report and pay taxes
  as a single taxpayer.
• To protect the Company and all Cell Owners,
  actions of the Cell Directors must be approved by
  the Common Shareholder to be effective.

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Separate Account (Cell) Captive Structure
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Details - Organizational matters relating to the
Cell Captive

• The Common Shareholder is responsible for
  operating the Home Office of the Company. General
  expenses are allocated to the individual Cells,
  pro-rata.
• License Fees
• Local Manager Fees
• Accounting Fees for Certified Audit
• Legal Fees
• Actuarial Fees
• Rent and direct expenses of the Home Office
• Expense Allocations will not exceed 0.6 of
  assets of a Cell. Excess expenses are absorbed by
  the Common Stockholder.

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Details - Organizational matters relating to the
Cell Captive

• Association Annuity Company is a D.C. Insurer.
  The Company can only insure risks of its
  shareholders.
• An investor has purchased the common stock of the
  Company and has contributed 600,000 of capital,
  enough to permit licensing of the Company as a
  captive insurer.
• Each Cell is represented by a series of Preferred
  Stock.
• Each Cell has a Board of Directors, elected by
  the Cell Owner and its own officers who conduct
  its affairs.
• Shares of Preferred Stock are redeemable at net
  asset value, after request by the Cell Owner and
  at the option of the Common Stockholder.

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Details - Organizational matters relating to the
Cell Captive

• All owners of stock of the Captive must be
  approved by the Insurance Department of the
  District of Columbia.
• The Cell Owner is usually a family limited
  partnership or a trust controlled by the Client.
• An Application for each owner must be filed which
  includes
• Background information about the owner
• A Business Plan for the Proposed Cell
• Financial Projections for the Cell
• Information in the application becomes public
  information when approved by the Department
• On approval, the Cell Owner purchases a series of
  Preferred Stock. The Capital Contribution
  (purchase price) is 10,000.

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Details - Organizational matters relating to the
Cell Captive

• After approval, the Cell will receive the asset
  value of the annuity in a Sec. 1035 Exchange and
  issues an annuity to the annuitant.
• The Cells Board of Directors invests the assets
  according to their business judgement.
• The Annuitant(s) elect a life-only settlement
  option and begin receiving annual (or semi-annual
  or quarterly) payments from the Cell.
• This election removes the assets of the annuity
  from the estate of the annuitant and the spouse.

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Details - Organizational matters relating to the
Cell Captive

• Investment income earned is used to provide funds
  to make annuity payments in future years. This
  interest income is not taxable to the cell.
• Excess investment income earned is taxable to the
  Cell and the Federal Taxes are 15. For most
  annuities, an investment return of 7 is needed
  to fund the annuity.
• The District of Columbia imposes a Premiums Tax
  of 0.2. This, and Federal Income Taxes, are the
  only taxes that are payable by the Cell.

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Third Party Business

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Third Party Business Line Slip Operation

• Each Cell is separate from the other Cells. In
  order to be treated as an insurance company, for
  U.S. tax purposes, each Cell must have at least
  one-third of its business from third parties.
• The Company has made arrangements with Trenton
  Line Slip Reinsurance Company to provide third
  party annuity and life insurance business to each
  Cell.
• The ratio of third party business to the direct
  business should be 13.
• The cost of third party business is 1.3 of
  annuity values each year.

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Third Party BusinessLine Slip Operation

• The Cell Owner determines the amount of life
  insurance reserves that are needed to continue
  the Cells status as a life insurance company.
• The Captive purchases reserves from the Line
  Slip.
• Reserves can be transferred back to the pool,
  adjusting reserves upward or downward.
• Premiums, claims expenses and profits of the pool
  are distributed to Participating Cells, pro-rata,
  annually.
• Costs of Line Slip are about 4 of reserves
  purchased, which is 1.3 of annuity values.

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Family Ownership of the Cell

• Most Cell Shareholders are Family Limited
  Partnerships or Family Trusts.
• Any form of ownership is acceptable, but the
  ownership structure should limit Estate and Gift
  Tax implications to family.
• Children and grandchildren can be owners of Cell
  and they can serve as officers and directors.
• In this way the family controls the invested
  assets of the Cell.
• Assets can be invested in Family business
  ventures, as mortgage loans or other secured
  investments.

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Cell Investments and Withdrawals

• What will happen to all this money accumulated
  inside the captive?
• - The annuity payments must be paid regularly.
  These will be partly return of basis and partly
  ordinary income to the annuitant.
• - The Cell may invest its funds in businesses
  controlled by the family as well as other
  investments selected by the Board.
• - The family members may withdraw excess funds
  as dividends or salaries, which will create
  ordinary income.
• - The family may ultimately sell or liquidate
  the Cell, which will create long term capital
  gains.
• BUT, THERE MAY BE ANOTHER OPTION

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Asset Utilization Life

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Asset Utilization Life

• The Cell pays out the accumulated earnings,
  including the earnings realized from the death of
  the annuitant, as tax free life insurance
  proceeds at death of client.
• Client buys a commercial policy with a face
  amount equal to the accumulated investment gains
  plus the annuity value.
• This policy is reinsured to the Cell in a
  standard reinsurance transaction between the
  Commercial Insurer and the Cell.
• At the death of the Client (or his spouse), the
  Family receives tax free life insurance proceeds
  from the Commercial Insurer and the Cell pays its
  share of the reinsured benefits to the Commercial
  Insurer, leaving only the original capital in the
  Cell which is withdrawn as a tax free
  distribution.

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Asset Utilization Life

• We have converted the entire annuity balance at
  death to Tax Free money in the hands of the
  family members.
• No income tax to captive
• No income tax to client
• No dividends or capital gains to client
• No estate tax to client on annuity
  
• ALL THIS with an annuity that otherwise presents
  a large tax liability to the estate

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Asset Utilization Life Premiums Flow

• Premiums for Life Policy are paid by client to
  Life Company and are reinsured to captive.
• Cost of Life Insurance may be prohibitive in
  cases where Client is rated or uninsurable.

D e a t h B e n e f I t
Captive
Life Premiums
Client
Commercial Life Company
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Other Considerations

• Costs
• Estate Planning
• Asset Protection

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Cell Costs

• Start-up (first year) costs (20 Cells)
• Investment (capital) 50,000
• Professional Fees 75,000
• Management Fees 25,000
• Cell Management Fees 4,000/ Cell
• General Expense 12,500
• Premiums Tax 20,000
• Income Taxes 30,000
• Total Expenses 167,000
• Annual Costs, Second Subsequent Years
• Investment (capital) 0
• Management Fees 25,000
• Cell Management Fees 4,000/ Cell
• General Expenses 24,000
• Premiums Tax 20,000
• Income Taxes 32,000
• Total Expenses 181,100

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Estate Planning Captives
Captive shares may be gifted efficiently

• Captives are closely held entities with
  restricted shares. Estate and Gift tax valuations
  will reflect discounted values.

• Insurance Company valuations often reflect
  discounts from book values.
• Captive reserving techniques are subjective,
  often resulting in low book values.

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Asset Protection Captives

• Captive is not owned by Client but is controlled
  by Client through Family Limited Partnership or
  Trust
• Assets of the Captive are separate from the
  Client and his operating company

• Transfer of assets to the captive is by payment
  of arms-length premiums
• Investment of assets by captive back to
  operating company makes captive a secured
  creditor in bankruptcy of operating company

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Who Is a Candidate for a Cell Captive?

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Cell Owner Profile

• Owner of Commercial Annuity valued at more than
  0.25 Million.
• Owner of IRA or Qualified Plan Asset of more than
  0.25 Million

• Owner is motivated to
• Withdraw minimum annuity or IRA payments for
  life.
• Manage the annuity or IRA investment portfolio
• Pass on the residual value of the annuity or IRA
  to family members at death

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for more information concerning Captive Insurance
Solutions for the Holders of Large Annuities
contact G. Thomas Roberts, or John R. Patton
McCarran Ferguson Consulting, Inc. 218 West Main
Street, Suite 200 Ligonier, PA 15658 724-238-8000
fax [phone] e-mail info_at_MFConsulting.net