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CAPTIVE INSURANCE: An Introduction


Hypo: ABC Co. is an American pharmaceutical company that sells products internationally. Recently, one of its controversial drugs has been proved ineffective, causing thousands of angry patients to file suits against the company. ABC Co. has an insurance policy with ForeverGreen Insurance Inc. Due to its massive litigations, ForeverGreen has increased ABC’s premium threefold from the previous policy. Feeling that it has been taken advantage of by ForeverGreen, ABC’s Directors decided to seek an alternative insurance method where it can control its own destiny. 

In the U.S. and internationally, thousands of companies face similar situations to ABC Co.’s. To solve their problems, the insurance market has created Captive Insurance, an alternative to the traditional insurance method where companies can manage their own risks and self-insure themselves. In the following sections, this guide explores the definition of captive insurance; its advantages and disadvantages.

Definition
A captive insurance company (“CIC”) is a corporation created to offer insurance to companies that are related to the CIC. These related companies can be either: (1) the parent company who owns the CIC as a subsidiary (parent-subsidiary relationship); or (2) a company who is owned by the same CIC owner (brother-sister relationship). Because of these close relationships, a CIC is closely held and controlled by its insureds. Unlike the traditional insureds who have no control over the insurance companies’ operations, the CIC’s shareholder-insureds have direct involvement and influence over the CIC’s operations and portfolios management. 

Section 831(b) and the Tax Advantages of Captive Insurance
A major benefit of a CIC is its tax treatment under I.R.C. Section 831(b). Premiums paid to a CIC by its insured shareholder are generally deductible, which is similar to the deductibility of premiums paid on commercial insurance. Specifically, I.R.C. Section 162(a) provides that businesses can deduct certain necessary and ordinary expenses that are incurred in carrying on the business and Treasury Regulation 1.162-1(a) states that business expenses include insurance premiums on policies covering certain business losses.

In addition, I.R.C. Section 831(b) provides that certain electing insurance companies may receive tax-free annual premiums up to $2.2 million, although the CIC would still be taxed for its investment earnings. Thus, the shareholder-insured can deduct the premium payments paid to the CIC, the CIC receives the premium payments tax-free, and will not be taxed on the premiums until the CIC makes a dividend distribution or the CIC stock is sold. In either event, the shareholder-insured will be taxed at long-term capital gains rates (15%) instead of ordinary income rates (35% to 39.60% for most wealthy individuals). 

The Non-Tax Advantages of Captive Insurance
Besides tax advantages, there are four non-tax advantages to owning a captive insurance, which are often referred to as the 4 “C”s: cost, coverage, capacity, and control. 

First, owning a CIC means cost stabilization for an insured that has grown tired of paying increased rates in the commercial insurance market. Avoiding the commercial market can eliminate or reduce brokerage commissions, marketing expenses, and administrative costs. Administrative costs often arise from preventing litigation and controlling the claims review process to reduce insurance fraud incidents as the insured loses the incentive to falsely report incidents to its own insurance companies. Moreover, the premiums paid into a CIC may be invested in the capital market, which may yield profits and increase the surplus CIC funds. 

Second, a CIC can provide coverage for a specific risk that otherwise would not be available in the commercial insurance market. As the CIC essentially covers itself, it will be more willing to broaden the terms of the policy and tailor it to meet the specific needs of its insureds. The insureds also have an incentive to faithfully report their conditions to the CIC in negotiating the insurance coverage, which would lead to an informed decision for both parties in reaching the coverage’s limits.

Third, a CIC gives the insureds the capacity to cover new risks as they arise from the operations of the insureds’ business. It also provides the insureds access to the reinsurance markets and allows them to leverage the premium paid to the CIC to make investments in the capital markets. As a result, a CIC not only broadens the shareholder-insured’s capacity to manage its own risks but also allow them to make additional profits from operating their own insurance companies.

Finally, a CIC gives the shareholder-insureds complete control over their risk management. The insureds can set up their own claim settlement philosophy; decide how much reserve is needed in a CIC; and avoid the volatility of the commercial insurance market. These controls would then lead to a better focus on risk management by the insured companies and enhance the efforts to prevent business losses and damages.

The Disadvantages of Captive Insurance
Like any financial structure, captive insurance has its disadvantages. First, it requires a long-term commitment to see results. A captive requires time, skills, and efforts to manage and is unlikely to yield short-term profits to the owners. Second, as an insurance company, a captive faces the risk of underwriting losses when catastrophes do happen and shareholders face the risk of losing their investments. Finally, captives demand that experts in the commercial insurance market manage the company. This would lead to high cost of operating, the need for collateral with fronting insurers, and compliance issues. 

Although captive insurance is an effective and efficient alternative to the commercial insurance market, there are times when companies should not form a captive. First, when there is a lack of executive buy-in in the parent or related company. Second, when tax is the primary driver for the decision to open a captive, especially now due to Section 831(b) scrutiny. Third, when there is an attempt from the parent or related company to compete with the professionals insurance companies. Fourth, when there is insufficient premium flow-through to cover fixed expenses for the captive. Last, when the captive would provide no strategic value to the core business. When more than one factor mentioned above exists, a company should seriously reconsider its decision to open a captive because its value might not be worth the “headache.”

Section 831(b) Election: The Requirements
In order to achieve the tax benefits of Section 831(b), a CIC must be considered an “insurance company” and the arrangement must be considered an “insurance contract.” To meet the “insurance” requirements, each CIC with U.S. shareholders must use I.R.S. safe harbors or otherwise show: (i) that it has properly shifted the risk of economic loss (“risk shifting”) from the insured to the insurer; and (ii) that the insurer has adequately distributed the risk among several insurance companies so that no particular insurance company has all the risk for an economic loss. A CIC that fails to meet any of these requirements will not be granted the favorable tax treatment allowed for insurance companies and may incur C-Corporation double taxation on all of its income.

I.R.S. Safe Harbor: Operating as an Insurance Company
In order to be considered an insurance company, a CIC must operate in a manner consistent with being primarily in the business of insurance. Treasury Regulation 1.801-3(a) provides that an insurance company is “a company whose primary and predominant business activity…is the issuing of insurance or annuity contracts, or the reinsuring of risks underwritten by insurance companies.” 

A CIC will not be considered a bona fide insurance company if it charges commercially unreasonable or non-arms-length premiums, or if there are no underwriting or management fees payable to the CIC. However, reasonable premiums and the existence of separate management and underwriting fees are not dispositive. The CIC must be operated as an insurance company in other aspects. For example, it should employ licensed professionals to handle management, underwriting, accounting, and audit roles. It must also meet local licensing and capital requirements for insurance companies, which vary by jurisdictions.

In addition, the CIC must issue “insurance” through “insurance contracts.” Although there is no formal definition of “insurance” or “insurance contract,” the U.S. Supreme Court has held, in Helvering v. LeGierse, that in order for an arrangement to constitute insurance for federal income tax purposes, both risk shifting and risk distribution must be present.

Risk Shifting
Risk shifting occurs when a party facing the risk of a large economic loss transfers some (or all) of the financial consequences of such potential loss to the insurance company. Risk shifting generally requires: enforceable written insurance contracts; premiums negotiated and actually paid at arms-length; and the insurance company to be a separate entity capable for meeting its obligations and formed under the laws of the applicable jurisdiction. The test for risk shifting is whether the insured has truly transferred risk of loss.

Risk Distribution
Risk distribution involves the pooling of insurance premiums for separate entities so that the insured is not paying for a significant part of its own risks. A risk distribution analysis is broader than a risk shifting analysis. A risk distribution analysis focuses on whether the risk insured against can be distributed over a larger group, rather than the relationship between the insurer and any single insured. Unfortunately, there are little authorities in determining whether a risk distribution occurs.

However, in Humana, Inc. v. Commissioner, the 6th Circuit found that an arrangement constitutes valid risk distribution because the premiums paid by each insured may be used to offset the CIC losses as a whole. The courts have never established a floor for sufficient unrelated business to constitute risk distribution, but the courts have ruled that 2% is insufficient and 30% is sufficient. 

Recent Developments: PATH Act and Notice 2016-66
Concerned about the potential abuse of Section 831(b), in December 2015, Congress passed the “Protecting America from Tax Hikes” (“PATH”) Act which will apply to tax years after December 31, 2016. The Act increased the maximum premium from $1.2 million to $2.2 million with adjusted for inflation. It also provides restrictions related to estate planning. Captives now must meet one of two diversification tests: 

Test 1: No more than 20% premium from one policyholder (related insureds treated as one policyholder).

Test 2: Limits spouse or lineal descendant ownership in the captive to no more than ownership in operating company (with 2% de minimis tolerance).
Thus, these new requirements make it harder for taxpayers to abuse Section 831(b) preferred treatments and ensure that captive insurance companies actually provide insurance services to their related entities instead of being a vehicle for estate planning. 

In addition, in November 2016, the I.R.S. issued Notice 2016-66, which lays out the factors that the I.R.S. will look at in determining whether a CIC is not a bona fide insurance company. These factors include:
  • Premiums & Coverage
    • No actuarial analysis or market pricing
    • Coverage for “esoteric, implausible risks for exorbitant premiums”
    • Coverage for “ordinary business risks while maintaining their economical commercial coverage with traditional insurers”
    • Not paid according to policy terms
    • Not properly allocated among insured affiliates
  • Captive does not follow regulatory requirements or standard industry procedures
  • Capital is inadequate
  • Investments are illiquid, speculative or include loan backs
  • Pooling agreements
While this list is not intended to be an exhaustive list, it is a great resource for CIC’s managers to look at to ensure that the entity complies with I.R.S. requirements. 


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