By Paul Deloughery, Esq.
What is a Captive Insurance Program?
Captives provide insurance that might be commercially unattainable. It can also be used as supplemental insurance (to bolster an existing commercial insurance coverage portfolio). Here are some benefits that businesses realize from having an affiliated insurance company:
- tax advantages
- asset protection
- improved cash flow
- the ability to create significant equity
Notably, the captive insurer must be a bona fide insurer. To sell insurance, captives must get a license from the state where they operate.
Alternative to Self-Insurance.
To successfully form, manage and maintain a captive, Company X must be astute at a myriad of tasks and responsibilities, including:
- evaluating liability risks of its insured subsidiaries
- underwrite policies
- establish insurance premiums
- either return unused funds (in the form of profits), or invest them for future claim payouts
Risk and Reward of Captive Insurance.
A captive program’s most significant risk is running out of capital to pay claims. If the captive cannot pay claims, then Company X has exposure. The parent company could be wiped out with one or more uninsured or under-insured claims. For that reason, initially it makes sense to use a combination of traditional insurance plus a captive program. The captive insurance can also be written so it provides unlimited funds for legal defense.
History of Captive Insurance.
The concept arose in the early 1950s.
Frederic M. Reiss seems to be the founder of captive insurance. In the 1950s he introduced the concept to Youngstown Sheet & Tube Company. The Youngstown company had mining operations. Those operations sent ore products back to Youngstown’s mills. Youngstown’s executives referred to them as “captive mines”. Reiss helped the company incorporate its own insurance subsidiaries. These were called “captive insurance companies” (because they wrote insurance exclusively for the captive mines).
U.S. businesses soon realized they could create a profit center out of an ordinary business expense: insurance costs.
Reiss used and popularized the “captive” term. The policyholder owns the insurance company. In other words, the insurer is captive to the policyholder.
The most common captive arrangements are:
- pure captive: the captive insures its own parent and affiliates
- homogenous captive: the captive insures just one type of industry
- heterogeneous captive: the captive insures companies in diverse industries
There is another category where the captive is owned and controlled by different company which allows other companies to “rent” insurance. This is a complex topic that is beyond the scope of this article.
With a captive program, Company X can “lay off” (transfer risks) by accessing reinsurance markets. For example, Company X might not want to accept risks relating to:
- product liability
- general liability
- professional liability (errors & omissions; malpractice)
- directors’ and officers’ liability
Companies also use captive insurers to provide commercial auto coverage (property damage and liability).
Licensing and Regulation of Captive Insurance.
Captives may be licensed to directly write some business lines. In other cases, another insurer must write under its insurance license, which then reinsures to the captive. Workers compensation insurance is such an example. The original insurer earns a fee, usually somewhere between 5% and 15%, to provide this service.
Federal Income Tax Treatment.
Premiums paid to captives are generally tax deductible expenses. But, the insurance policy’s terms, and the premium amount, must be reasonable. A captive cannot set the premium amount for the sole purpose of generating an attractive deduction for its parent company. The captive must act as a bona fide insurer. This includes implementing procedures for how it sets premiums.
Management of Captive Insurance.
Captive insurance programs are complex undertakings. As a result, captive management is usually outsourced to a ‘captive manager’ located where the captive is primarily licensed. U.S. captive managers are mostly small administrative services providers, who do not:
- draft insurance policies (usually the province of an experienced attorney)
- price policies (usually preformed by a casualty/property underwriter)
- give tax guidance (the domain of accountants and tax lawyers)
A well-rounded captive insurance management firm provides the following services:
- forming and managing the captive insurer, and
- ongoing support with the right professionals who understand insurance, tax, and legal issues.
Captives are sophisticated structures. They rely upon experienced tax professionals in addition to captive managers who simply provide administrative services.
Congress Steps In.
Government statistics report that over 99%% of all jobs in America come from businesses with 500 employees or fewer. The growth of the captive insurance industry—particularly among small and midsized businesses—therefore benefits both business growth and the states sponsoring these captives.
Internal Revenue Service, Court Cases and Rulings.
The following table summarizes the most noteworthy cases, legislation and rulings:
|1941||Helvering v. Le Gierse (312 U.S. 531)||Established the principle that both (i) risk shifting and (ii) risk distributions are required for a contract to be treated as insurance.
Many court cases followed this initial decision, but clarity is still being sought, particularly as it relates to captive insurance. This is important because, as discussed below, almost every state government sponsors the development of captive insurance companies.
|1977||IRS Revenue Ruling 77-316||IRS questioned the concept of deductible “self-insurance”. This Ruling denied the deductibility of captive insurance premiums, based on what was referred to as the “economic family” doctrine.|
|1978||IRS Revenue Ruling 78-338||Defined the number of participants in a “group” captive that were needed to create deductible insurance premiums: “A ‘group’ captive is an insurance company formed by multiple corporations seeking to insure similar risk, i.e. … workers compensation, health insurance, employee benefits, etc.”|
|1991||Harper Group v. Commissioner (96 T.C. 45, 47||The IRS defines a captive insurance company as a “wholly-owned insurance subsidiary.” All captives must comply with the following three fundamental insurance factors: 1) the arrangement involves the existence of an insurance risk, 2) there is both risk shifting and risk distribution, and 3) the arrangement is for insurance in its common-accepted sense.|
|2001||Revenue Ruling 2001-31||The court battle over captive insurance continued for over 20 years after Revenue Ruling 77-316.
IRS finally acknowledges it will no longer evoke the “economic family doctrine” to challenge the deductibility of captive insurance premiums. Instead, it began to fight selective battles, believing that the basic premise of insurance as defined and understood by the courts needed further clarification.
|2014||Rent-A-Center, Inc. & Affiliated Subsidiaries v. Commissioner (142 T.C. 1); Securitas Holding, Inc. & Subsidiaries v. Commissioner (T.C. Memo 2014-225)||IRS suffered major defeats.
Following these setbacks, the IRS responds by placing captive insurance companies on its “Dirty Dozen” list of possible tax scams. (discussed further below)
|2016||IRS Notice 2016-66||IRS requires captives under IRC §831(b) to be treated as “transactions of interest”, requiring disclosure by owners, managers, and material advisors as to their role in all captive transactions.|
|2017||Benjamin and Orna Avrahami v. Commissioner (149 T.C. No. 7)||In Avrahami, the court denied deductions for premiums paid to an offshore insurance company and determined, among other things, that elections made under IRC section 831(b) were invalid and premiums paid did not qualify as insurance premiums for federal income tax purposes.
The Tax Court expanded the points made in its initial 1991 decision rendered in Harper, and provides consistent clarity/guidance for a compliant captive:
• Risk distribution is vitally important. Precluding or eliminating meaningful actual claims is not insurance in the commonly-accepted sense.
• A captive should have claims experience.
• Consistent and organized claims submission, review and approval procedures are needed.
• Actuarial experience, pricing and methodology is scrutinized.
• Encouraged the use of independent advisors, including tax advisors, legal counsel, actuaries, risk managers, and captive managers.
• Arms-length, bona fide arrangements and transactions must be used.
• Follow capitalization requirements of the domicile regulatory bodies
• loans are discouraged
IRS Warns of Abuses, Fraud and Scams.
A sampling suggests the following costs:
Start-up: $18,000 to $25,000
Request IRS Private Ruling: $30,000 (including IRS fee)
Annual Ongoing Operation: $24,000 to $30,000
Initial Capitalization: $100,000
Annual Reinsurance and Claim Costs: 6% to 8%
The costs must be weighed against anticipated future tax savings, and whether the captive insurance program sufficiently insulates the parent company from loss claims.
Who is a Good Candidate?
A captive insurance program will benefit a business whose annual insurance premiums range from $600,000 to $2.4 Million. This assumes a combined federal and state tax rates and “caps”, and assuming a 28% rate for simplicity. This is a generalization, and each company’s specific circumstances impact that guide.
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