Is Captive Insurance Right for You?

Captive Insurance Programs

By Paul Deloughery, Esq.

November 2019

What is a Captive Insurance Program?

Let me explain captive insurance by using a simple example. Company X creates a wholly-owned subsidiary to serve as an insurance company. The primary purpose is to insure Company X’s risks. Company X benefits from the captive insurer’s underwriting profits. In effect, because it is wholly owned, that insurance company is Company X’s “captive”.
 
Once formed, the captive must follow regulatory requirements as a licensed insurer. After that, Company X pays premiums to the captive. The captive invests the premium payments, and uses them to pay possible future claims. After paying claims, Company X can claim any excess investments as “profit”.
 
Captive insurance programs provide property and casualty insurance to affiliates. Although the affiliates can still use other insurance products.  In effect, captive insurance is a variation of “self-insurance”. The captive concept developed in the 1950s, and large businesses have used it for decades.
 
The costs and regulatory hurdles have decreased over the years. For that reason, smaller businesses are taking advantage of captive insurance programs. Does your company spend between $1.5 to $10 Million per year for insurance premiums? If so, a captive insurance program may be a good option.

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.

Captive insurance is an alternative to self-insurance. The parent company creates a licensed insurance company to provide coverage for itself.
 
Why would Company X entail creating a captive program? It may want to have control over how much it pays in premiums. The company can avoid future price increases. Also, traditional insurance products may not meet Company X’s needs.
 
By creating its own captive insurance company, Company X may lower its costs. It can also insure difficult risks. It can gain direct access to reinsurance markets. It can also increase cash flow.

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.

Cost/Benefit.

Businesses buy insurance in the marketplace to mitigate risks (potential liabilities). Those premium payments are deductible expenses.
 
With a captive insurance program, the company has a dual benefit. Company X can deduct insurance premium expenses. But, premiums that the captive receives are not taxable income. (The captive insurer is only taxed on investment profits). The non-taxability on the captive side is one of the most significant economic benefits. Because of the risk of abuse, the IRS has extensively weighed in (discussed in detail below).
 
Companies form captive insurance companies to supplement commercial insurance. This gives companies flexibility. They can keep monies that they would otherwise spend for insurance premiums.

Risk.

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.

Business Lines.

Captives not only cover traditional insurance risks, but for more inventive/creative purposes.
 
Workers’ compensation has predictable claim rates. So companies use captives to cover that insurance line.

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.

Jurisdictions.

Companies often base their captives outside the United States (i.e., “offshore). Many jurisdictions license captives, which are then regulated by local authorities. Captives must have enough money to play claims, as well as maintaismallimum surplus. Typical bases abroad include Gibraltar, Bermuda, Cayman Islands, Bahamas, Dubai, and others.  Captive insurers are then regulated by local insurance authority agencies. These agencies require the captives to have enough money to pay claims as well as maintain a minimum surplus.
 
Bermuda is the world’s leading offshore captive domicile. In the 1960s, the regulatory burden and costs to operate a U.S. captive was prohibitory. Reiss sought another jurisdiction where his captive concept could flourish. He opted for Bermuda (a British territory). The reason was that it was close to the U.S., had a good reputation. It also avoided many risks of other politically unstable countries. Large U.S. corporations predominantly own Bermuda captives.
 
U.S. states are updating their laws to be more “captive friendly”. Examples include Vermont, Montana, Delaware, and Oregon.

Licensing.

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:

  1. forming and managing the captive insurer, and
  2. 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.

1986 was a critical year for the captive insurance industry. Congress enacted §831(b) of the Internal Revenue Code (IRC). This permits 100% deductibility of allowed insurance premiums. Yet at the same time it exempts from taxable income a large part of the premiums received. In 2019, that was approximately $2.4 Million.
 
Why did Congress weigh in? To encourage smaller companies to create necessary insurance coverage to protect themselves. Insurance costs frequently limit the growth of smaller businesses. IRC §831(b) allowed mid-sized businesses to grow their balance sheets more quickly to support the risk of their owners. That resulted in rapid growth of captive insurance companies among mid-sized businesses.

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:

YearCiteComments
1941Helvering 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.
1977IRS Revenue Ruling 77-316IRS 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.
1978IRS Revenue Ruling 78-338Defined 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.”
1991Harper Group v. Commissioner (96 T.C. 45, 47The 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.
2001Revenue Ruling 2001-31The 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.
2014Rent-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)
2016IRS Notice 2016-66IRS 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.
2017Benjamin 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

Key Takeaways:

This history offers a clear picture of what not to do when structuring and managing an IRC-compliant captive arrangement. It also encourages a “best practices” approach for businesses.
 
A captive program can provide a viable risk management solution by adhering to five things. It must adhere to proper risk-shifting. It must have proper risk-distribution. The insurance pricing must be appropriate. Claims processing must be proper. And it must follow state and federal laws.

IRS Warns of Abuses, Fraud and Scams.

Tax laws allow businesses to create “captive” insurance companies to protect against certain risks. Traditional captive insurance allows a taxpayer to reduce insurance costs. The insured business claims deductions for premiums paid for insurance policies. Under §831(b) of the tax code, captive insurers that qualify as small insurance companies can elect to exclude limited amounts of annual net premiums from income. In that way, the captive pays tax only on its investment income.
 
Yet, in abusive “micro-captive” structures, promoters, accountants or wealth planners persuade owners of closely-held businesses to take part in ‘schemes’ which lack many features of genuine insurance. For example, captives may not insure improbable risks. They can’t fail to serve legitimate business needs. They also can’t duplicate the company’s existing coverages. The premiums must be proportionate to the underwriting and actuarial need. Premiums must have a relation to the relative risk of loss. Companies may not design a program with a specific deduction amount in mind.

On its website, the IRS publishes a stark warning about using captive insurers as an abusive tax shelter scam.

Costs.

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.

Summary.

Integrating commercial and captive insurance can cover a business for its indemnification liabilities. Insurance premium payments from the business to its captive are income tax deductible. Yet, the captive can exclude a significant amount of premiums received from the captive’s income. Thus, the captive insurance industry has developed into an option for many businesses.
 
A company must structure its captive to follow IRC §831(b). The captive must also have attributes of genuine insurance. Otherwise, the IRS will scrutinize it for possible abuses. Yet, an IRS §831(b) captive-compliant under current law can work.
 
A captive insurance program offers significant tax benefits. They may provide highly-specialized insurance programs unique to the business’s requirements. All insurance coverages must be assessed for gaps. And each company must determine whether benefits outweigh the risks and costs.

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Own a Small- or Medium-Sized Business?  Struggling with Skyrocketing Insurance Premiums? Seeking to Reduce Your Tax Liability, and Protect Your Hard-Earned Wealth and Assets? Contact a Seasoned Professional in Maricopa County, Arizona for Help

If you want to know more, contact us right away. We are seasoned asset protection, estate planning and tax counselors. Captive insurance programs and tax law are complicated. Trust Paul Deloughery, Esq. and the experienced, caring professionals at Magellan Law, PLC, in Scottsdale, Arizona. Call us right away (602-443-4888), or contact us confidentially. Our experienced team will make you our priority and put your mind at ease. We will answer your questions, evaluate your circumstances, and discuss your options.