Evolving Trends in Captive Insurance

By Jean Baxley, J.D., LL.M., and Sheryl Flum, J.D., Washington

Editor: Mary Van Leuven, J.D., LL.M.

Special industries

Recent tax developments relating to captive insurance companies present potential new opportunities for some captive arrangements while raising caution about others. The Tax Court opinion in Securitas Holdings, T.C. Memo. 2014-225, addressed some issues that have been concerning taxpayers and their advisers and provides helpful guidance to corporate taxpayers wishing to set up or maintain tax-viable captives. At the same time, coordinated IRS audits of "micro-captive" promoters are proceeding. In light of the current volume of activity involving captives, it is important to focus on satisfying the insurance fundamentals, which include insurance risk, risk shifting, risk distribution, and insurance in its "commonly accepted sense." This item highlights current, practical considerations regarding qualification of a captive as an insurance company for federal income tax purposes.


In today's global, high-technology business environment, the risks facing enterprises are especially complex. For some risks, required commercial insurance coverage may be difficult to secure in the marketplace or, if available, prohibitively expensive. To meet their risk management and cost management objectives, many companies choose to retain significant risk and use other approaches in addition to, or as an alternative to, procuring commercial insurance. The use of a captive insurance company is one such alternative.

Captives take various forms, but they are typically established and operated to provide insurance coverage to affiliates, e.g., the parent company of the captive, the captive's brother/sister companies, or a particular group. Various types of captive structures may be used, including single-parent captives, group/association captives, risk-retention groups, agency captives, and protected cell companies. A captive can be formed and subject to the insurance regulatory regime in a foreign jurisdiction or domiciled in the United States—possibly in a captive-friendly state such as Vermont, South Carolina, or Utah.

In addition to fulfilling an enterprise's risk management objectives, a captive that qualifies as an insurance company for federal income tax purposes offers tax benefits to its owner or owners and affiliated group. That is, premiums paid for the insurance coverage provided by the captive are deductible to the affiliate, while the captive insurance company may defer recognition of unearned premiums (albeit with a 20% "haircut") and deduct unpaid (discounted) losses.

The Current State of Tax Guidance on Captives

An insurance company is a company "more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies" (Sec. 816(a), cross-referenced for property casualty companies in Sec. 831(c)). This test sounds straightforward in theory—i.e., greater than 50% of an entity's business must be insurance or reinsurance—but in application it is a facts-and-circumstances inquiry because the Internal Revenue Code and accompanying Treasury regulations do not elaborate on this insurance company qualification rule.

In the absence of detailed tests in the Code and regulations, and sometimes in response to what it views as abusive arrangements, the IRS has set forth guidance in formal and informal rulings (see, e.g., Rev. Rul. 2002-90 (captive insuring 12 brother/sister companies) and Rev. Rul. 2002-91 (group captive)). By default, the courts have served as the arbiters of insurance company status under the tax law, and judicial guidance concerning captive insurance has evolved over the last 50-plus years. The courts, however, have never adopted wholesale the IRS's or a taxpayer's views regarding the parameters for what constitutes an insurance company, and guidance is in constant flux. Indeed, the Treasury and IRS Priority Guidance Plan for 2014-2015 includes an item described as "guidance relating to captive insurance companies."

The Four-Prong Test

Over the years, tax litigation has yielded a few guiding principles for qualification as an insurance company for federal tax purposes. These have been articulated in various ways, loosely, as a four-prong test. To qualify as insurance, an arrangement must (1) involve insurance risk, (2) entail risk shifting from the insured party to the insurance company, (3) involve risk distribution, and (4) represent insurance in its "commonly accepted" sense.

Presence of insurance risk: From the IRS's perspective, insurance risk cannot be the risk of loss from past events, must involve "fortuity," and must be different from sheer business or investment-related risks. From a taxpayer perspective, evolving risks (such as heightened cybersecurity and terrorism risk) and continued property, casualty, and liability insurance product innovation support a more fluid view regarding the types of coverage that involve insurance risk.

Pending non-captive litigation in Tax Court, for example, addresses the status of residual value insurance (RVI), which is designed to compensate the owner of a leased asset for the difference between the expected value and the actual value of a leased asset at the termination date of the associated lease (cf. TAM 201149021, concluding that such a contract is not insurance). A captive that provides traditionally accepted lines of coverage such as general liability, workers' compensation, and professional liability, however, still should address whether the amount and pricing of these coverages are appropriate from the perspective of the insured parties; i.e., excessive, inappropriate, or overpriced coverage may not be respected by the IRS. A captive that offers coverage its owners require and that is properly priced from an actuarial and underwriting perspective is generally likely to satisfy the IRS's standard for insurance risk.

Risk shifting: The IRS's view regarding risk shifting generally has been that a parent company cannot successfully shift risk to its subsidiary (see, e.g., Rev. Rul. 2005-40). Accordingly, if a captive's only insured is the captive's parent company, the arrangement can be susceptible to IRS challenge. Similarly, if the parent company retains risk of loss that is supposed to be borne by the captive by, for example, providing a guaranty of the captive's performance or financial obligations or indemnifying a third-party fronting insurer or reinsurer, risk shifting to the captive may be challenged.

If a captive is undercapitalized or thinly capitalized, the IRS may assert the captive is not bearing risk because it is not in a financial position to do so; in this regard, the IRS may view letters of credit and "naked" guaranties provided by the captive's parent company with suspicion. Also, if there is no realistic possibility that the captive can experience a loss from bearing the risk that is purportedly shifted (e.g., the annual insurance premium is $1 million and the aggregate loss limit is also $1 million), this may not bode well for a finding of risk shifting. A captive that is adequately capitalized (i.e., has sufficient assets for the magnitude of risks undertaken) and does not rely on a parental guaranty is generally more likely to satisfy the risk-shifting criterion.

Risk distribution: To meet the risk distribution prong of the insurance test, a captive must take on various risks and distribute these risks in a way that takes advantage of the so-called law of large numbers, which allows for increased predictability of aggregate losses for the insurer and spreads the risks over a large group of insureds. The IRS and taxpayers differ significantly in their views regarding whether risk distribution should be measured on a legal-entity basis (e.g., insuring 12 brother corporations passes the test; see Rev. Rul. 2002-90, above) or whether another "unit" of risk being distributed applies (e.g., 5,000 vehicles for automobile coverage spread among three sister corporations may also pass the test).

Two recent Tax Court cases, Rent-A-Center, 142 T.C. 1 (2014), and Securitas Holdings, T.C. Memo. 2014-225, concurred with the generally accepted taxpayer view that the number and distribution of the covered risk units, such as the number of cars, are what count for purposes of the risk distribution analysis. This contradicts the IRS's position that the number of entities transferring risk must reach a sufficient threshold (see Rev. Rul. 2005-40) and the concentration of the risk in one or two entities can undermine risk distribution (see Rev. Rul. 2002-90). The court in Rent-A-Center noted the facts regarding risk distribution but did not pronounce a new test; however, the court implicitly adopted the taxpayer's view on the unit-of-risk issue. The court in Securitas was more straightforward:

The insurer achieves risk distribution when it pools a large enough collection of unrelated risks, those that are not generally affected by the same circumstance or event. . . . During the years in issue [the taxpayer's Swedish parent and subsidiaries] employed over 200,000 people in 20 countries, and the [taxpayer], alone, employed approximately 100,000 people each year and operated over 2,250 vehicles. . . .

Risk distribution is viewed from the insurer's perspective. As a result of the large number of employees, offices, vehicles, and services provided by the U.S. and non-U.S. operating subsidiaries, [the captive] was exposed to a large pool of statistically independent risk exposures. This does not change merely because multiple companies merged into one. The risks associated with those companies did not vanish once they all fell under the same umbrella. As the [taxpayer's] expert . . . explained . . . : "It is the pooling of exposures that brings about the risk distribution—who owns the exposures is not crucial." We agree and find that by insuring the various risks of U.S. and non-U.S. subsidiaries, the captive arrangement achieved risk distribution. [Securitas, slip op. at 25-27]

The Tax Court agreed with the taxpayer's position that assumption by a captive of similar, geographically distributed risks can lead to valid risk distribution regardless of the number of entities whose risks are insured by the captive. It should be noted that the IRS has not appealed either opinion, so it is unclear whether the government still supports the tests laid out in prior guidance.

Insurance in its "commonly accepted sense": The fourth prong of the insurance test is the least well-defined. It involves a fact-intensive inquiry and has the feel of an "I'll know it when I see it" test. If a captive is subject to a state's or foreign jurisdiction's regulation as an insurance company and conducts its insurance business, including processing claims, in an arm's-length, professional manner, the IRS is generally unlikely to challenge its insurance company status based on this criterion. Additionally, the use of a captive manager or a third-party administrator to perform insurance operations generally should not be a problem.

While the lack of clarity on this prong can present tax risk, the IRS typically does not attack a captive on "commonly accepted sense" grounds alone. Rather, unhelpful facts related to this prong of the insurance company test tend to bolster other, better-developed challenges. Problems with state regulators and non-arm's-length activities, such as the insured's forgoing claims or unjustified delays in claims processing, are examples of unhelpful facts.


Tax guidance in the captive area is not Code-based and is not immutable; relevant guidance continues to evolve. Accordingly, it is helpful to revisit a captive's tax status periodically, both to help determine that the captive's operations are consistent with insurance company status and to identify potential opportunities to expand the captive's activities and utility as a risk management vehicle that can legitimately provide tax benefits to its parent and affiliates.


Mary Van Leuven is director, Washington National Tax, at KPMG LLP in Washington.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

This column represents the views of the authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. ©2015 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

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