Captive Insurance
As smaller captive insurance companies proliferate, so do reinsurance pools or exchanges that attempt to deliver sufficient "risk distribution" to satisfy the requirements of the Internal Revenue Service. Without risk distribution, the captive would not be considered an insurance company for tax purposes and would then lose many of its potential tax benefits, including the election for the exclusion of insurance revenues from income under section 831(b) of the Internal Revenue Code.
Previous articles I have written have explored the mechanics of these pools and have questioned whether the majority in fact meet the risk distribution requirements as a matter of law. This article will explore a more basic issue ... are the funds being held by these pools secure?
Many captive managers have formed risk distribution mechanisms whereby the captives under management "swap" risk by ceding a portion of each captive's risk to the other captives and accepting a "retrocession" of risks from those other captives. Frequently, this exchange of risk is accomplished by a transfer of 50% or more of a captive's annual premium income to an entity that is affiliated with the captive manager, either as a "fronting" company to the captives or as a reinsurance company.
In either event, half of the funds paid by the insured to the captive are held for a year or more by this entity. Once losses are settled for the year in question, the balance, if any, is remitted to the captive. In the meantime, of course, if the captive has renewed its insurance policy to the insured, another annual premium has been received by the reinsurance entity and handled in the same manner.
The potential for abuse is immense. Cash is fungible. Whose money was remitted to the captive? The half that was held from last year or half of the latest premium received? This could create a classic case of a "Ponzi" scheme, where the money held from last year is spent and new money is used to cover the obligations from the previous year. The scheme collapses, of course, if there is a net drop in new captive formations for that captive manager.
What if a captive insurance company has virtually no real practical risk except to its own related insured? Is risk distribution really present?
Every captive insurance company must demonstrate, among other things, that it has sufficient "risk distribution" to qualify as an insurance company for tax purposes. This concept was first mentioned by the United States Supreme Court in 1941 with little further definition or guidance. As a result, since that time, many judicial opinions and two Revenue Rulings have attempted to interpret and quantify the "law of large numbers" inherent in the idea of distributing risk.
This article will not analyze all of the case law on the subject, but instead will highlight the typical manner in which captives today attempt to achieve risk distribution and will question whether the attempts will ultimately prove successful.
The Internal Revenue Service issued two Revenue Rulings in 2002 that set their standard for determining whether a captive insurance company has "adequate" risk distribution to be considered an insurance company for tax purposes. This determination is critical since the ability of the taxpayer to deduct premiums paid to a captive is dependent on a finding that the captive qualifies as an insurance company for tax purposes. The standards set forth in the Rulings are arguably tougher than those found in the judicial opinions on the subject, but they remain the basis on which the IRS conducts audits of captive insurance companies.
The two Revenue Rulings represent two different paths to risk distribution. Revenue Ruling 2002-90 examines the number of related companies that must be insured in order to sufficiently distribute risk. If the insured cannot provide a sufficient number of separate insureds, then the captive must rely on Revenue Ruling 2002-89. That Ruling establishes the amount of third party risk that a captive must carry in order to qualify as an insurance company for tax purposes.
A captive insurance company that qualifies for the tax exemption found in section 831(b) of the Internal Revenue Code is a time-tested and useful risk management mechanism that offers the entrepreneur excellent tax and financial planning benefits.
It looks simple — form a small insurance company and pay no more than $1,200,000 in annual premiums to it, which are fully tax-deductible and then later remove the profits of the captive at more favorable dividend (for now) or capital gains rates.
But it is not so simple. There are many pitfalls. Aggressive captive providers have proliferated recently who are ignoring common sense risk management and taxation issues to the potential peril of their clients. And they hide behind actuarial opinions and regulatory acceptance arguing that their plans and pricing are perfectly acceptable.
The problem is that actuarial opinions are only as good as the assumptions that the actuaries are given. And regulators examine different issues than the IRS when they are approving a captive's license. The existence of an actuarial opinion or a license does not assure the client that their captive is truly compliant with the complicated tax issues that are involved.
There are two current "hot buttons" that anyone contemplating forming a captive should consider:
Pricing of Risk: Once the types of risks to be transferred to the captive are identified, the next challenge is to properly calculate the premium for such risk. Underwriting is as much an art as it is a science, with factors such as coverage details, loss history, limits, deductibles, exclusions and the financial strength of the issuing insurance company all coming into play along with sound actuarial practices.
Given these variables, it is easy for different people to offer diverse opinions on what an appropriate premium may be. But common sense must prevail. For tax purposes, the IRS will only allow a deduction for premiums that are reasonable in amount. The starting point for "reasonable" is the market rates for the coverages in question. However, market rates are not the end point for small captives, but they absolutely do create a benchmark. If a taxpayer is considering paying premiums that are vastly beyond that benchmark, they had better have very strong and well documented arguments for doing so.
The recent proliferation of employee benefit group captives has pulled together two sets of people in the insurance industry that have traditionally been in separate silos — "benefits people" and "Property & Casualty people". These two worlds have collided as benefits captives pull from two fairly distinct skill sets. My own experience was largely with Property & Casualty captives until about a half decade ago where it began to lean increasingly towards the benefits side. If you've spent time on 'both sides,' you've probably realized how different the two worlds are — ranging from terminology to coverage types. This article is an attempt to explain the benefits world to someone who understands workers' compensation.
The Coverage
A workers' compensation policy covers all the payments (medical and indemnity) associated with accidents that occur during the policy period. These claim payments can stretch out over five to ten or more years. If a worker slips and falls and injures their back, the policy in force at the time of the accident covers all future payments related to the injury.
A benefits policy covers the costs for the medical and pharmacy claims that occur during the policy period. A "paid" contract requires that the claim is also actually paid within the policy period and an "occurrence" policy provides an extended period for claims to be paid (which is often three to six months). Since it is nearly impossible to tie an illness back to a particular date or occurrence, a benefits policy is written to cover all claims within the policy period, regardless of when an illness manifested itself.
Think about how a severe back claim is treated differently by the two policies. Assume the back injury is the result of an accident in Year One. Further assume that there will be a surgery and physical therapy in Year One, and an additional surgery, more physical therapy, and pain medication in Year Two. With the workers' compensation policy, both surgeries and all other costs are covered by the single Year One policy. With the benefits policy, Year One policy pays for the first surgery and Year Two policy pays for the second surgery.
This is the third and final installment in a three-part series of articles on the ten questions all prospective captive owners should ask themselves (or, that their financial representatives should ask them) to help in the captive formation decision making process. Part 1 in the series can be found here, and Part 2 can be found here.
Forming a captive insurance company is an incredibly big decision. To help decide if you should form a captive, please answer the 10 questions, the last three of which are presented below.
Am I comfortable placing money into a business enterprise for an extended period of time?
When forming the captive insurance company, the insured — the person forming the captive — must place money into the captive so that from day one, the captive can pay claims. While some people use jurisdictions that have a low initial capital requirement, the Internal Revenue Service will look at the captive's ability to pay the actual claims underwritten, making a low initial statutory capital requirement moot.
In addition, the captive can't do anything to jeopardize its financial position regarding the risks it has underwritten, so removing money via dividends or loans can't be considered until the captive has developed adequate reserves and surplus (usually 3-5 years minimum). So, after placing capital into the captive, you have to leave it there. Are you financially able and willing to do this?
Am I committed to lowering the cost of my risk?
Captives should be used in conjunction with an overall plan to lower the cost of insurance coverage. As such, are you ready to undertake risk minimization strategies?
For example, if your captive underwrites a cyber-risk policy, are you willing to purchase anti-hacking services from third-party vendors? If you underwrite an employment practices policy, are you willing to hire a third party human resources company to help with your internal HR policies?
This is the second installment in a three-part series of articles on the ten questions all prospective captive owners should ask themselves (or, that their financial representatives should ask them) to help in the captive formation decision making process. Part 1 in the series can be found here, and Part 3 can be found here.
Forming a captive insurance company is an incredibly big decision. To help decide if you should form a captive, please answer the 10 questions, the second three of which are presented below.
Have I seen my insurance prices increase?
Sometimes, simply being in a certain line of business can mean you see insurance costs increase despite your individual loss experience. For example, OB/GYNs have incredibly high insurance costs, simply because of the nature of their work.
And some individuals — depending on their geographic location and despite having an excellent loss history — have seen sharp increases in their premiums for certain types of coverage. For example, after Hurricane Ike in Houston, property owners saw their property premiums increase.
For people in this situation, a captive makes tremendous financial sense. Remember that most large insurance companies spend between 20 percent and 30 percent of their gross revenue on selling, general and administration expenses. Captives, in contrast, are much leaner and have far lower overhead, thereby lowering the overall cost of insurance.
As a corollary to the above point, captives can also provide stable pricing. When the public's premium for a particular line of insurance increases, a captive's may not, depending on the experience of the parent company.
Captives focus on a smaller number of insureds. Therefore, if the insureds also control their risk, they can work to prevent premiums from increasing, thereby creating a more stable pricing environment.
This is the first in a three-part series of articles on the ten questions all prospective captive owners should ask themselves (or, that their financial representatives should ask them) to help in the captive formation decision making process. Part 2 can be found here, and Part 3 can be found here.
Forming a captive insurance company is an incredibly big decision. To help decide if you should form a captive, please answer the 10 questions, the first three of which are presented below.
Has there been a problem with one of my existing property and casualty insurance plans?
For example, have I had a difficult time getting a claim paid, have I have a hard time reaching my agent, or have I found the service to be lacking?
Two personal stories should help to illustrate this point. I have several friends who are corporate counsel, meaning they are attorneys whose client is a corporation rather than an individual. When asked what their biggest problems are, dealing with insurance companies tops the list.
Or, consider another story from my personal experience. I had a real estate development corporation client that had a claim related to Hurricane Ike. It took the company two years and the actual filing of a lawsuit to receive payment on their claim. During those two years, the property could not be rented, negatively impacting the company (which eventually dissolved).
Most professionals in business for a number of years typically have at least one insurance company horror story to tell. This is a prime reason to form a captive: to take control of the captive in order to prevent an insurance company horror story from happening to you.
Although we think that the first important legal battle for captive insurance occurred during the economic substance cases that started in the 1970s, the reality is two cases from the 1950s (US. v. Weber and Consumers Oil Corp v. US) have all the hallmarks of modern-day captive insurance programs. Most importantly, at their conclusion, these cases offered the IRS the opportunity to clearly outline specific rules and regulations related to captives. However, the IRS declined to do so, instead issuing a Revenue Ruling stating they would not follow the conclusion of the cases and instead continue to litigate captive insurance cases.
First, let's set the stage by explaining what caused the need to create one of these captives in the first place: the Trenton Flood of 1955
- The worst natural catastrophe to befall Trenton was the flood of 1955.
- City streets were turned into rivers and hundreds of families were evacuated as the normally placid Delaware River surged over its banks.
- Flood damage totaled $100 million in New Jersey, mostly in property damage, with $500,000 coming from the destruction of Mercer County roads.
- In the weeks leading up to the flood, the area had been scorched with temperatures hitting the 90s nearly every day in July and early August.
- Worse yet, there had been little rain to ease the record-setting temperatures, as most towns considered water rationing measures.
- The earth became parched, reservoirs dried up, and sewers backed up due to a loss of water pressure.
- Area residents, especially Burlington County farmers who had suffered severe crop damage due to the heat, were probably praying for rain, ignoring the adage, "Be careful what you wish for."
- After the drought came the deluge, as Mother Nature flashed her fickle side.
- The drought broke on August 7, when 2.9 inches of rain fell on Trenton.
Starting in the mid-1970s, and continuing through the UPS case, the IRS fought captives tooth and nail. Over the course of these cases, they advanced three different legal arguments against captive insurance: the economic family argument, the nexus of contracts and the assignment of income doctrine.
However, it's important to ask this question regarding the IRS' legal battle: "what was it about captives that the IRS didn't like?" To answer that question, we need to go back to a series of cases from the early 20th century called the reserve cases. In all of these cases, a taxpayer foresaw a particular adverse event and started to place money into a reserve fund in anticipation of future payment. In all of these cases, the taxpayer attempted to deduct the amount paid into the fund as a legitimate, section 162 deduction. The Bureau of Tax Appeals (B.T.A.) heard all of these cases and struck down the deduction. They advanced several reasons for these denials.
- The tax code allowed a deduction for business expenses, but not for amounts paid into an internally held reserve. This is supported by a strict reading of the statute.
- Moving funds internally — from cash to a reserve or from one corporate "pocket" to another — does not shift the risk as required by insurance.
- Preventing the manipulation of gross income through the use of "reserves" and "contingency funds" as outlined in the case Spring Canyon Coal.
- Both accrual and cash accounting methods require the taxpayer to deduct specific "realized" amounts. A taxpayer cannot deduct a speculative amount.
Much has been written about the financial and tax power of forming and operating a captive insurance company that qualifies for the tax benefits of section 831(b) of the Internal Revenue Code. But all too often, promoters of this concept forget that each captive must be first and foremost a risk management tool with legitimate risks and properly priced premiums.
An "831(b)" captive is an insurance company whose premiums do not exceed $1,200,000 per year and which elects to have those premiums exempted from taxation. If the captive has proper "risk distribution" (a topic for another article), then the insured company can deduct the premium being paid to the captive, while the captive pays no income taxes on that premium. After the payment of losses and expenses, any profits in that captive can be distributed at a favorable dividend rate or can be distributed in a full liquidation of the captive, and the shareholders will receive those accumulated profits at capital gains rates. And if the captive is owned by trusts or adult children, the entrepreneur can also enhance the benefits in his or her estate plan by side stepping the estate tax.
But these benefits are only possible if you first get the underwriting right. Over the years we have conducted audits on existing 831(b) captives formed by some of our competitors. After reviewing the underwriting done for these captives, we have been amazed by what people are charging for risks, many of which can be insured in the traditional insurance market at much lower rates. We call it "underwriting by the blind." The IRS is well aware of the pricing abuses in our industry. As we understand it, the majority of negative audits recently have not been because of faulty "risk distribution" mechanisms, but due to badly over-priced premiums being paid to the captive.
For example, we found a $10,000,000 (revenues) manufacturer who had purchased a $1,000,000 general liability policy, including products liability, in the insurance market for an estimated $25,000 annual premium. The new captive issued a "differences in condition" policy with a $1,000,000 limit and charged the insured over $200,000 in annual premium. This type of policy covers things like exclusions in the underlying policy. It does not take an insurance expert to realize that such a premium is unreasonable and bears no relation to either market rates or the real risk that is being assumed (particularly since the insured was manufacturing a non-hazardous consumer product).
Another example of egregious pricing is in the area of terrorism risk. One provider is promoting captives with over $600,000 in premium for $10 million in limits for this type of risk despite the fact that the client could purchase that same coverage in the standard insurance market for less than $5,000. How can such a payment be "ordinary and necessary" and therefore be deductible?
Knowing that these captives were approved by a regulator, we keep asking ourselves "where are the actuaries and the regulators and why do they not concern themselves with the relationship between the risk assumed and the premiums charged?"
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