Captive Insurance Companies: Opportunities and Pitfalls

Paying insurance premiums is a normal cost of doing business. In the case of commercial insurance, companies that manage risk well often find that their high premiums subsidize less-prudent businesses. Other firms find that insurance is simply unobtainable. A “captive” insurance company can solve both problems in an economical and tax-efficient way. However, a captive company that is not respected for tax purposes is neither economical nor tax-efficient.

Benefits

A captive insurance company can allow a business to obtain insurance on risks it could not otherwise insure. It can also provide a lower-cost alternative to commercially available insurance. If a firm has favorable claims experience, the savings will benefit the captive insurance company (rather than a third-party insurer).

The tax benefit of the structure is that the business can deduct insurance premiums paid to the insurance company as if they had been paid to any other third-party insurer. (Note: This discussion applies only to nonlife insurance companies. Different rules apply to life insurance companies.)

The insurance company also receives favorable tax treatment. The most important benefits are provided by Sec. 832(b)(5), which permits them to deduct predicted but unpaid losses (reserves), and Sec. 831(b), which taxes them only on their investment income if premiums received during a tax year do not exceed $1.2 million. (See also Sec. 501(c)(15), which provides a full tax exemption for very small insurance companies.) Because of the exemptions, many captive insurance companies elect under Sec. 953(d) to be taxed as U.S. corporations, even if they are formed outside the U.S.

There can be additional benefits to the entity or its owners. The insurance company may be owned by the business or the business’s owners, but not necessarily; other possible owners include family members or key employees. As long as the owners obtain their interests in arm’s-length transactions, they may be in a position to profit from the company’s success without being treated as having received taxable transfers.

If all goes well, a captive insurance company will normally generate reserves over time. Because amounts set aside for reserves are tax-deductible, the amount of reserves available to invest will not be reduced by taxes.

Mechanics

Before establishing a captive insurance company, it is important to determine the type and extent of risks for which insurance is needed. This requires a good understanding of the business involved, the commercial insurance market and actuarial and economic issues associated with types of risks not addressed by the commercial market. After determining the insurance needed, the insured business contracts with the captive company to insure the relevant risks, in return for paying premiums.

The insurance company must carry on a bona fide insurance business. It must qualify as an insurance company under local law, maintain appropriate capital, establish appropriate reserves, enter into reinsurance treaties when appropriate, investigate claims to determine their validity, reject invalid claims and pay valid ones.

For a captive insurance arrangement to be respected, it must insure diverse risks. That requires insuring risks in addition to those of the primary insured business, which raises the problem of asymmetric information: in many cases, the insured has better information about its risk than does the insurer. Selection of those risks is thus critical to the enterprise’s success. It is vital to deal only with trustworthy and reliable insureds, and it is strongly recommended to work with an adviser who can assist the insurance company in evaluating risks.

Being Respected for Tax Purposes

Under Secs. 831(c) and 816(a), an insurance company is defined as a company more than half of whose business during a tax year is issuing insurance, reinsurance or annuity contracts. (The test is based on business actually done during the tax year; see Regs. Sec. 1.801-3(a)(1).) The IRS will accept the classification of the company’s receipts as insurance premiums if insurance risk is present, that risk is shifted and distributed, and it is shifted and distributed through transactions that are insurance in the commonly accepted sense; see Rev. Rul. 2002-89 and Le Gierse, 312 US 531 (1945).

Without real shifting and spreading of risk, there is no insurance. The mere appearance of shifting and spreading risk is not sufficient; see Steere Tank Lines, Inc., 577 F2d 279 (5th Cir. 1978), cert. den. An element of “fortuitousness” is required (i.e., an arrangement that hedges a simple business or investment risk does not qualify). To be real, insurance must make use of the statistical “law of large numbers” to allow a group of insureds to pool their risk; see Treganowan, 183 F2d 288 (2d Cir. 1950), and Le Gierse.

For some time, the Service attacked captive insurance companies using an “economic family” theory, under which captive insurance subsidiaries were deemed indistinguishable from their parents for purposes of determining whether risk had been shifted. However, the IRS abandoned this argument in Rev. Rul. 2001-31. It now focuses more on the question of risk distribution.

The Service has published some guidance on the risk-shifting and spreading required to achieve insurance. Rev. Rul. 2002-89 held that an arrangement between a parent and a subsidiary would constitute insurance if less than 50% of the premiums received by the subsidiary (on both a gross and net basis) came from the parent. (The ruling did not specify how many additional parties were insured; arithmetically, there would need to be only three insured parties for each to meet the less-than-50% standard.) In Rev. Rul. 2002-90, the Service held that an arrangement—in which an insurance company owned by a parent insured the risks of 12 of the parent’s operating subsidiaries—created adequate spreading of risk. While the 50% and 12-insured thresholds may not be definitive, they are viewed as somewhat akin to a safe harbor; captive insurance arrangements are commonly structured to meet them.

The IRS takes a rather formalistic approach to risk-shifting and spreading. For example, in Rev. Rul. 2005-40, a corporation’s insuring the risks of 12 different operating single-member limited liability companies that were disregarded entities for tax purposes did not qualify. However, if the entities are incorporated, they qualify as separate insureds, apparently even if they are members of a consolidated group; see Kidde Industries, Inc., 40 Fed. Cl. 42 (1997) (insurance existed when 100 operating subsidiaries were insured by a parent’s captive insurance company).

Pitfalls

As with any arrangement that can yield a tax benefit, there may be temptations to plan aggressively. Meanwhile, the law on captive insurance arrangements is developing rapidly. In planning, tax advisers should consider both current and developing doctrines.

To be respected, a captive insurance arrangement must have business substance; see Ocean Drilling & Exploration Co., 988 F2d 1135 (Fed. Cir. 1993) (insurance arrangement respected; factors discussed included whether (1) true commercial hazards existed, (2) commercial rates were charged, (3) claims were properly investigated, (4) claims were actually paid, (5) the insurance company was regulated as such and (6) assets of an insurance subsidiary were commingled); and Malone & Hyde, Inc., 62 F3d 835 (6th Cir. 1995) (thinly capitalized subsidiary that reinsured risks of an operating business using a third-party primary insurer by prearrangement, under which owners of the operating business agreed to hold the primary insurer harmless in case of default by the subsidiary, was not real insurance).

There may be situations in which an adequate number of insureds is created by splitting an existing business into several companies. The form-over-substance approach of Rev. Rul. 2005-40 makes this an appealing alternative. However, unless there are other business reasons for the split, it may not be respected. Also, unless the new companies represent different risks, the mere existence of several companies does not mean that risk is being spread; see Letter Ruling 200644047, in which an insurance policy purportedly for the benefit of the named insured and several parties related thereto did not qualify, because all claims would fundamentally be against the named insured.

Call for comments: In Notice 2005-49, the IRS noted that various issues remain unsettled and requested comments in four areas:

1. Cell captives: These are generally arrangements in which a company insures enough separate risks to qualify as an insurance company, but segregates them to an extent that calls into question whether the risks are really being pooled.
2. Loan-back arrangements: Some insurance companies invest portions of their reserves by lending them back to their operating companies. In such situations, the genuineness of the arrangement may be called into question.
3. Homogeneity of risk: In some cases, the risks being insured, while nominally independent, may all be affected by the same events. For example, insuring several properties in the same region against storm damage would create homogeneity of risk, while insuring properties in many locations against such damage would not. Thus, captive insurance companies should attempt to insure non-homogeneous risks.
4. Finite risk: In some cases, captive insurance companies may insure relatively narrow “bands” or “tranches” of risk—e.g., ensuring against a particular loss only to the extent the damage exceeds $100,000, but does not exceed $500,000. Such limits exist in virtually all insurance policies; however, if they fall outside market norms, they may be viewed as reducing the arrangement’s insurance value.

Taxpayers should expect guidance on each of these issues. That guidance most likely will impose some restrictions on the use of the techniques described in the notice. Because the notice has been issued to warn taxpayers, it may be inferred that any transition rules provided under it will not be generous.

Not all payments made to an insurance company necessarily constitute insurance. While a company may qualify under Sec. 831(c), unless a particular policy meets the requirements to qualify as insurance, its premiums will not be deductible as insurance premiums.

Over time, an insurance company’s reserve can become a considerable source of pretax dollars available for investment. However, the company must choose investments that are appropriate for an insurance reserve: low-risk, diversified and liquid. Investing reserves in less stable or liquid investments (especially if those investments are related to activities of the company’s owners) could actually be viewed as a taxable removal of those amounts from the reserve.

Conclusion

Captive insurance companies can create substantial benefits; the IRS guidance issued in 2005 seems to indicate that it intends to respect properly structured arrangements. That guidance also shows that the Service does not intend to allow any pattern of abuse to develop. It is important to plan carefully, to ensure that the companies engaging in a captive insurance arrangement are actually complying with the plan, and to be alert for new legal developments.

From Paul Shanbrom, CPA, Detroit, MI, and Michael Kerekes, J.D., Los Angeles, CA