This is an old article that is still worth reading.

By Susanne Sclafane, Associate Editor
Mar. 20 (National Underwriter)With the class-action lawsuits and whopping tax penalties coming out of a U.S. Tax Court decision handed down against United Parcel Service of America last year, you wouldnt expect tax experts to be promoting the captive-like structure that got the shipping giant in trouble.

But at least one expert calls the structure "ideal."

Others say it wasnt the structure but the implementation of its insurance program that made UPS a target for the Internal Revenue Service.

In the early 1980s, officials of UPS, American International Group and insurance brokerage Frank B. Hall devised a structure enabling the nations largest package-delivery company to ship profits earned from the collection of certain delivery charges, called "excess-value charges," off to Overseas Partners Ltd., a Bermuda-based reinsurer owned by the shareholders of UPS.

Excess-value charges, a part of the tariff or rate schedule UPS was required to report to the U.S. Interstate Commerce Commission, were fees collected from shippers that declared the values of their packages to be over $100.

If a shipper didnt declare a value greater than $100, the liability of UPS for damage or loss of shipped items was limited to $100. If a shipper did declare an excess valueand paid an EVC of 25 cents per $100 of additional declared valueUPS was liable for the amount declared.

The EVCs added up to $77.7 million in profit for UPS for 1984 (one of the tax years in question). But in 1983 UPS had stopped recording such profit in income it reported to the Securities and Exchange Commission and the IRS.

In 1984, AIGs National Union, acting as a fronting carrier, passed on $60 million of that profit to OPL, after deducting expenses.

As a foreign corporation, OPL was not subject to U.S. tax. Since OPL was set up as a non-controlled foreign corporation, tax rules that existed then and that exist now allowed shareholders of OPLwho were also shareholders of UPSto defer income-tax payments on insurance profits recorded by OPL until they were repatriated, tax experts say.

UPS said the reason for the arrangement in the first place was not to escape or defer taxes. Instead, it was a concern over the possibility that insurance regulators might view its continued receipt of EVCs as unlicensed insurance activity, illegal under state insurance laws. The Tax Court, using the "assignment of income" doctrine, said the arrangement was a sham concocted to avoid taxes.

"It is fundamental to our system of taxation that income must be taxed to the one who earns it," Judge Ruwe wrote in his Aug. 9, 1999 opinion. He listed 17 insurance-related activities UPS engaged in both before and after setting up OPL as part of the evidence supporting a finding that UPS, not OPL, earned the income from shipping charges.

"The incidence of taxation cannot be avoided through an anticipatory assignment of income," the opinion said.

The ruling, which not only directed UPS to pay taxes it owed on diverted income but also found the company liable for penalties and penalty interest for "intentional disregard of rules and regulations," may cost UPS $2.35 billion, based on SEC filings.

While the ruling only covered the tax years 1983 and 1984, the $2.35 billion amount includes liabilities for 1985 through 1999, assuming the IRS will take similar positions in those remaining years. The IRS has already sent notices to UPS regarding the taxes it owes for 1985 through 1990.

Class-action lawsuits filed by UPS customers using facts of the tax case could end up costing UPS even more.

Unlike most past decisions related to captive insurers, the central question here was: "Who earned income?"

In contrast, past decisions have hinged on whether the defining characteristics of insurancerisk sharing and risk distributionexisted, and whether conditions existed to allow premium deductibility.

In fact, while OPL is often referred to as a captive, and although transactions with OPL did include the use of a fronting carrier, the arrangement departed from traditional captive arrangements in several ways.

For one thing, the "quasi-captive" wasnt set up to insure UPSs own risks, in the way traditional captives most often are, but those of its customers. (Later, UPS did retain part of its own workers compensation exposure in OPL, insuring the excess with Liberty Mutual.)

Further, while UPS officers first toyed with the idea of having an insurance operation that was a subsidiarylike a typical captiveOPL was not a subsidiary.

At a 1983 meeting, the UPS tax counsel suggested that the insurer be a Bermuda company owned by UPS employees, not UPS, so that it would be classified as a non-controlled foreign corporation, according the history given in the court decision.

Initially, UPS set up OPL (then called UPSINCO) as a wholly owned subsidiary, but UPS later transferred 98 percent of the stock of OPL to UPS shareholders by issuing a stock dividend, explained Roy Sedore, a partner with Baker & McKenzie in New York. The dividendone share of OPL capital stock for each outstanding share of UPS stockshifted majority ownership from UPS to its shareholders. UPSs shareholders were current and former UPS employees, Mr. Sedore noted, adding that UPS also put certain restrictions on the sale of OPL shares.

Mark Anderson, a partner in KPMGs alternative risk practice in Atlanta, said UPS was in a unique position to issue the stock dividend that made the shareholders of UPS and OPL essentially the same people because, until a recent initial public offering, UPS was a privately held corporation. He explained that for a large company traded in public markets, like General Motors, for example, shares could change hands at the moment of the dividend transaction. There would be no assurance of maintaining common shareholders in both companies at that instant, he said.

Mr. Anderson argues that not only could UPS create a non-controlled foreign corporation owned by its shareholders in this way, but they should have. "Any corporation in America would take the opportunity to set up a structure with the least tax," he said, calling the "sham" finding of the Tax Court an "overreaction."

In 1983 and 1984, it would have been impossible to set up a captive, he said. Those were the days of Revenue Ruling 77-316, when transactions made to transfer risk between related parties were deemed not to be insurance, he said. "It was not a good landscape for setting up a subsidiary," he said.

If a company faces the same situation today that UPS did then, how could it lessen the risk of an unfavorable tax decision?

"Probably the way they did it would still be best way," Mr. Anderson asserted. "They had it structured just perfect[ly] in terms of tax efficiency, [and] everything they did was within the law."

"We have encountered other privately held companies and looked to UPS-OPL as an ideal way to structure them. You try to make these as tax-efficient as possible. Thats what we get paid to do," he said.

The only other ruling on a similar structure tax experts could recall went in a way other than the UPS decision did. The ruling in Crawford Fitting v. United States, decided in the U.S. District Court for the Northern District of Ohio in 1985, dealt with an individual shareholder that owned the insured and the insurance company.

"If you have stick figure A, the insured, and stick figure B, the insurance company, and A hands premium to B, the court said thats deductible," Mr. Anderson said.

UPS is "one step better" in that OPL assumed business written by AIG, he said.

So what went wrong?

"UPS was a victim of the Tax Courts crackdown on tax shelters [that] have little economic purpose outside of a tax benefit," he said.

"Why would UPS take $100 million [of gross revenue] out of its books and put it on the books of OPL" other than for tax reasons, he said, articulating the Tax Courts basic question.

In recent months there have been several adverse rulings by the Tax Court on tax shelters, he said.

The UPS decision "is something that captives need to pay attention tonot because it changes captive law, but because it highlights a change in the IRSs focus," Mr. Sedore said.

"What it tells youand what most advisors have always told companies thinking of setting up captivesis that you need to have a legitimate business reason, you have to document it, and you need to follow through," he said.

If you state that your business purpose for setting up a captive is access to the reinsurance market, the IRS would want to see if you actually did that, he said. Your feasibility study shouldnt just have tax savings all over it, he added.

"The thing that yells out at you is that contemporaneous documentation of business purpose is critical. It has always been," said William Conroy, an attorney for Baker & Hostetler in Washington.

Such documentation was one thing UPS did not have. What it did provide was testimony about "a vague regulatory concern," Mr. Sedore said.

That testimony, recounted in the Tax Court opinion, revealed that UPS officials never asked in-house or outside counsel if there was a regulatory problem, he noted. Once the program was in place, they never asked for legal advice about regulatory issues, he said.


Here's another one:

United Parcel Service of America, Inc. v. Commissioner involved an attempt by the package delivery company to move certain income offshore. Under its arrangement with its customers, UPS was liable for damage to goods only up to $100. Customers could choose, however, to purchase "insurance" on the excess at the rate of $0.25 per additional $100 of declared value ("excess value charges"). Initially, UPS itself billed its customers and collected these charges. It saw an opportunity, however, to avoid U.S. federal income tax on such income by organizing an insurance company in Bermuda, which would collect the excess value charges and make good on any claims by customers. As UPS saw it, and accounted for it, this was a highly profitable operation.

UPS organized a Bermuda insurance subsidiary, Overseas Partners, Ltd. ("OPL"), capitalized it, and spun it off to its shareholders. (UPS was at the time a privately-held company, and its stock was held mostly by employees.) UPS then entered into an insurance agreement with National Union Fire Insurance Company, a subsidiary of AIG, which entered into a reinsurance agreement with OPL. In a sense, National Union could be viewed as a conduit and administrator for insurance provided by OPL. The excess value charges OPL collected always exceeded the amount of claims it paid out for lost or damaged packages, usually by $40,000,000 to $60,000,000 per year. In this manner, the income attributable to the excess value charges were directed to OPL for a net federal income tax savings of approximately $16,000,000 per year.

The Tax Court had found that the restructuring was done for the sole purpose of avoiding taxes and that the arrangement between UPS, National Union Fire and OPL had no economic substance or business purpose. Therefore, the arrangement was an anticipatory assignment of income and a "sham." UPS was required to recognize all of the income earned by OPL.

The Eleventh Circuit reversed and remanded. The Court reasoned that the transaction simply altered the form of an existing, bona fide business arrangement with UPS's customers. Such business had real economic substance and a business purpose. OPL had to be respected as a separate entity. The Court held that the restructuring was not a sham. We believe that the Eleventh Circuit's holding is correct. There is little doubt that any court would have respected the arrangement had it been adopted by UPS from the inception of its excess loss coverage program. It is simply an efficient tax structure applied to a bona fide business transaction. There is nothing in the case law that says that a switch from an inefficient tax structure to an efficient structure, even if the switch is motivated solely by tax considerations, can be disregarded by the IRS.

Importantly, the Circuit Court decision is not a total victory for the taxpayer. The court remanded the case and directed the Tax Court to address certain arguments that the IRS had made, but the Tax Court did not consider because of the sweeping nature of its original decision. In particular, the Tax Court will now consider the IRS's arguments under section 482 of the Code that the way UPS and OPL accounted for the excess loss program resulted in excessive income being allocated to OPL. There are strong suggestions in both the Circuit Court's decision and the Tax Court's more complete Statement of Facts that the IRS could be successful in this approach.

Although UPS shifted all of the payments from customers from the excess value program to OPL, UPS retained all of the costs and expenses in reducing the occurrence of lost and damaged parcels, processing claims, and defending against lawsuits. UPS even implemented a program to reduce claims, including excess value claims. Its drivers paid extra attention to declared value packages. UPS incurred extra costs in handling such packages, including implementing procedures for segregating and tracking high-value parcels. UPS drafted a loss prevention manual and performed audits throughout its delivery operations to ensure the security of high-value packages. The UPS loss prevention program was apparently highly successful. But the costs and expenses of these programs reduced UPS's taxable income, not OPL's. Section 482 provides the IRS with ample authority to prevent taxpayers from distorting income in such a manner.


Bermuda tax sovereignty upheld by US court ruling

The 11th US Circuit Court of Appeals, in an important ruling last week, overturned a 1999 decision that United Parcel Service (UPS) had improperly tried to avoid federal income taxes when it restructured its program for providing extra package insurance to its customers.

In 1997 the IRS had argued that UPS had created a Bermuda based reinsurer Overseas Partners Limited (OPL) solely to avoid taxes. It therefore ruled, in 1997, that UPS must pay federal taxes on OPLs income even though it was established as a Bermuda company.

The appeals court last Thursday, though, said the IRS and Tax Court were wrong to brand UPS as attempting a "sham transaction" to avoid its tax obligations. After reversing the 1999 decision, the appellate court then remanded the case back to the US Tax Court, saying any claims by the IRS should be analysed under provisions of the Tax Code cited by UPS.

This case was much more to us than a dispute over tax regulations and Tax Code interpretations, because we hold nothing more sacred than our reputation, said UPS Chairman and CEO Jim Kelly. "So we are extremely pleased the original opinion has been reversed."

OPL was set up as a reinsurance company in Bermuda by UPS in 1984 to handle extra value insurance bought by UPS customers. OPL has subsequently taken its place amongst the worlds leading reinsurers.


The Reinventing of OPL
No longer the quiet company
By Duncan Hall

Jed Rhoads had been with Overseas Partners Ltd. for only a short time when a sign at Bermudas airport caught his eye. It read: Overseas Partners Ltd. - Quietly Reinsuring, cleverly defining the manner in which the company had positioned itself in the highly competitive world reinsurance market.

Turning to OPL Chief Executive Officer Mary Hennessy, Rhoads gave notice that OPLs future will bear little resemblance to its past. You know, Mary, Rhoads said, I dont want us to quietly reinsure anymore. I want us to be an in-your-face reinsurer. We have a lot to be proud of - our size, our rating, and the quality of staff that we are building. I dont want to quietly reinsure.

The reinvention of OPL is underway, with ex-Stockton Re boss Rhoads at the helm of its newest division, OP Finite. The re-building of OPL and its various divisions is as much a matter of necessity as it is a matter of choice. The company was formed in 1983 to provide reinsurance of packages shipped by customers of United Parcel Service (UPS). Owned by 97,000 current and former employees of UPS, the company was highly profitable. The shippers risk programme was a high frequency, low severity business that provided stable, predictable results and some $240 million of net income annually. OPLs initial capital base of $50 million has risen to some $1.75 billion based on the shippers risk programme and investment of profits, even after distributions to shareholders in excess of $1 billion. The company was very profitable, Rhoads says. It was making a bucket load of money every year.

The United States Tax Court in August 1999 delivered a verdict that prompted the current restructuring initiative. In United Parcel Service of America v. Commissioner of Internal Revenue, the Court held that UPS could not assign its rights to a revenue stream to a third party. The shippers risk programme lacked substance, the Court ruled, and it ordered UPS to include the shippers risk profits as taxable income. UPS recorded a second quarter charge of $1.8 billion. The decision is under appeal. Although OPL is not a party to the lawsuit and is not obligated to pay any amounts to UPS, the U.S. Company cancelled the shippers risk programme effective September 30, 1999.

OPLs business lines had gone beyond shippers risk since the mid-1990s. It wrote a meaningful amount of accident and health, marine and aviation, workers compensation, and finite/capital markets business as well. But the company lacked sufficient underwriting depth, and did not command a level of respect in the industry that was commensurate with a company of its size. The steady stream of income from the shippers risk programme had flowed into the company for so long that OPL saw no reason to become an aggressive, acquisitive market leader. OPL had capital in excess of $2 billion, a real estate portfolio (a convention hotel and five major office buildings in Atlanta, Boston and Chicago) with a value of $1.5 billion and a liquid, diversified investment portfolio in excess of $2.5 billion. We had become a highly capitalised financial institution, says George Morton, who joined the company in November 1997.

After the Tax Courts decision, however, OPL was a financial institution without a reliable stream of income. Change was necessary, and it began in November 1999 when OPLs subsidiary, Overseas Partners Cat Ltd. (OPCat) entered into an agreement with Renaissance Re Holdings Ltd. to underwrite worldwide property cat reinsurance programmes. Ren Re became the exclusive underwriter for OPCat, using its proprietary REMS system.

On January 1, 2000, industry veteran Hennessy came aboard as president and chief operating officer. Chief underwriting officer Mike Cascio, a co-founder of Stockton Reinsurance with 20 years senior management experience specialising in finite risk, also joined in January, while Mark Bridges, with 16 years of reinsurance experience, had also recently joined as chief financial officer. The accumulation of human capital was underway.

Hennessy, who began her career in 1974 at Crum and Foster Insurance as a trainee actuary, had for some time wanted to run her own company. She got her chance when Harold Tanner, a director at her former employer TIG Holdings Inc., recommended her to OPL board member Bob Clanin, now the chairman of the board. Hennessy had joined TIG as executive vice-president and chief operating officer before becoming president and chief operating officer. She is widely credited with the restructuring and sale of TIGs insurance operations. Before the end of the first quarter, Hennessy had assumed the chief executive officers position at OPL from Scott Davis, who returned to the United States.

At TIG, I felt I didnt get the chance to finish the job I started, Hennessy says. Insurance stocks got hammered, and a decision was made to sell the company. At OPL, I was able to get in at an earlier stage of the re-structuring. The cancellation of the shippers risk programme was a defining moment for OPL. Here was a company at a crossroads, unsure of what it wanted to do. For me, it was a chance to get behind the wheel and drive the car. It was like joining a start-up company, but one with $2 billion and an existing infrastructure. It was the career opportunity of a lifetime. I could never have turned it down.

Hennessy was at the helm of a company whose profit figures, of course, had plummeted. Whereas net income for the quarter ended March 31, 1999 had been $105.5 million, net income for the same period in 2000 was $20.1 million. Gross written premiums declined to $285.5 million for the first quarter 2000, compared to $425.4 million for the same period in 1999. The primary reason for the decrease was the cancellation of the shippers risk programme that had contributed $90.6 million of premiums written in the first quarter of 1999. The news got worse. The company reported a net loss for the six months ending June 30, 2000 of $477.2 million, primarily as a result of an increase in OPLs reserve for accrued loss and loss expenses totaling $460 million. The reserve strengthening was based on a quarterly actuarial review, and related primarily to business written from 1997-99.

Hennessy, widely respected for her strategic acumen, began to re-position OPL. Numerous accident and health, aviation, marine and multi-line programmes were not renewed because they did not meet the companys revised return requirements. OPL also cancelled a number of existing property programmes to avoid an aggregation of exposure with its new property catastrophe risks. On June 30, the last day of the second quarter, OPLs strategic re-engineering continued with the announcement of the acquisition of Reliance Re, including a team of some 50 professionals and staff who had managed that companys operations in Philadelphia. Reliance had the authority to write reinsurance in all 50 states, and insurance in more than 40 states. OPL had quickly and neatly acquired a people and licenses presence in the U.S. at a time of improving conditions in the insurance and reinsurance markets. Crucially, the acquisition provided OPL with access to the technical underwriting, claims and actuarial expertise that would allow it to expand its partnerships with key clients in the worlds largest reinsurance and insurance market. Reliance Re was re-named Overseas Partners US Reinsurance Company (OPUS Re).

The third quarter of 2000 brought improved results, with net income of $2.4 million on gross written premiums of $93.9 million. Allowing for the cancellation of the shippers risk programme, the companys underwriting, investment and real estate activities actually performed better in the third quarter 2000 than they did in third quarter 1999. More importantly, the reinvention of OPL continued with the sale of two office buildings, one in Atlanta and the other in Chicago, for total consideration of $217.7 million, which was pumped into OPLs U.S. reinsurance operation.

OPLs strategic initiatives continued in November, 2000 with the acquisition of a team of finite risk professionals from Stockton Re, a recognised leader in the finite risk market. Rhoads, formerly president of Stockton, was a key acquisition. Ex-Stockton colleagues William Guffey and Chris Jacks joined him. In addition, Malcolm Furbert joined OPL as General Counsel. More senior Stockton people are also expected to make the move. With the companys existing finite risk underwriters, the additions provide OPL with an experienced, disciplined, and creative team. Stockton will continue its presence in the Bermuda finite risk market through a strategic partnership with OPL wherein it will provide retrocessional support on designated finite risk programmes, and where certain types of finite risk business identified by OP Finite will be underwritten on Stocktons behalf.

In her first year at the helm, Hennessy - in conjunction with independent consultants - had successfully re-invented OPL. She and her team had completed a thorough assessment of operations, product lines, opportunities for growth, and loss reserves. On the basis of that review, she had developed a strategic plan and began to implement it. She had overseen a series of strategic alliances and acquisitions that provided access to key markets, and had hired the underwriting intellectual capital that is required to survive and prosper in the highly competitive global reinsurance market. She also discontinued the companys property and marine lines. OPL is expected to sell off its real estate holdings as well when the time is right.


OPL To Go Into Runoff, RenRe Takes Over OPCat
February 14, 2002
In a move which took the insurance world by surprise, Bermuda-based Overseas Partners Ltd. announced its decision to stop writing new business immediately, to place its Bermuda operations into "an orderly runoff," and to transfer its OPCat business to RenaissanceRe.

The decision affects OP Re, OPAL and OP Finite, the Bermuda operations which will go into runoff, while operations at the U.S. division, OPUS Re, will continue while OPL searches for a buyer. RenRe, which is already the exclusive underwriter for OPCat, will assume full control of the operation.

OPL, with $1.3 billion in capital, was seen as well positioned to compete in today's market, and had recently brought in new top management following its acquisition of Stockton Re. Paul Walther, the Principal Consultant and CEO of Reinsurance Directions was as surprised as everyone else. "I thought OPL was really well positioned to take advantage of the hardened market," he said.

The company's announcement indicated only that following a thorough strategic review of its operations, "the Board has concluded that despite its management and reserve strengths, OPL's current capital structure will not allow it to continue to grow and compete effectively in today's reinsurance market."

OPL also cited the desire of its some 98,000 shareholders for more liquidity in their investment, noting that "there is no trading market and no present prospect of such a market," and that OPL's capital requirements have "constrained its ability to offer regular redemption of shares to its shareholders for several years."

RenRe stated that its "assumption of the OPCat premium will be effectuated through a reinsurance contract effective February 15, 2002. OPCat premiums were underwritten by Renaissance Underwriting Managers Ltd. according to RenaissanceRe's underwriting standards. During 2001, OPCat wrote over $60 million of catastrophe reinsurance premium."

Standard & Poor's concluded that RenRe's "lead operating company, Renaissance Reinsurance Ltd. can readily assume this book of business, and will be provided with sufficient capital by end of February 2002 to ensure that capital adequacy remains within the existing rating tolerance."


I hate to sound like an idiot, but how are we affected by this?


On a related note, as a UPS shipper, I recieved a postcard in the mail on the 1st that stated I was part of a class action suit that is filing against UPS and OPL. The numbers I have seen run into ten figures.

If there is a way to post it here I will, or you can send me an Email and I will send it to you.