Tag Archives: risk distribution

Captives: Congress Shoots, Misses

In late December, Congress put together a last-minute “tax extender” package that, among many other things, made some changes to section 831(b) of the Internal Revenue Code. That section allows “small” captive insurance companies to elect to exempt from income tax all of their insurance income.

These small captives have been widely used in recent years by owners of large, privately held businesses to allegedly add to their existing insurance coverages while enjoying immediate income tax reductions. Further tax benefits could include conversion of ordinary income to capital gains and a potential estate transfer benefit, depending on the ownership of the captive.

Congress has changed those benefits a bit, by eliminating any estate planning benefits, starting in 2017. But Congress failed to address the true levels of abuse that this code section has spawned and, indeed, may have made things worse.

These “enterprise risk” or “micro” captives are primarily used as a form of tax shelter, notwithstanding the pious claims of captive managers that they are meeting legitimate insurance needs. While such needs certainly may exist in some clear cases, the vast majority of entrepreneurs forming these captives care much more about the tax benefits than any increased insurance coverage.

The IRS knows this and has stepped up both audits of individual companies and larger, promoter audits of captive managers in an effort to crack down on captives that are being formed without the intent to form an insurance company. In addition, the IRS is well aware that unscrupulous captive managers create vastly inflated “premiums” payable by the operating company to the captive to maximize the tax benefits of owning such a small captive. These premiums often bear no relation to third-party market costs, nor can they be justified by a reasonable actuarial analysis of the actual risk being insured by the captive.

Another abuse is found in captive managers’ offering the new captive owner what the IRS would call a sham “pooling” arrangement, to comply with certain “risk distribution” requirements of court cases and revenue rulings.

There are many cases pending in the Tax Court that attempt to corral these abuses. Their outcome is, of course, uncertain.

So the Treasury Department went to the Senate Finance Committee in early 2015, hoping to obtain legislation that would gut section 831(b) (and put a lot of captive managers out of business).

Instead, the department got legislation that only stops these captives from being used as estate planning tools.

The legislation also increased the annual allowable premium paid to such captives, from $1.2 million to $2.2 million, indexed for inflation. The reasons for this failure have a lot to do with Sen. Chuck Grassley of Iowa, who has long wanted an increase in premium to benefit certain farm bureau captives in his state. He needed some revenue offset to allow for the increase, and, by closing this “estate planning loophole,” he can claim that tax revenues will increase.

That claim may be doubtful (only about 1% of taxpayers end up being subject to the estate tax), and captive managers now have a new, higher goal of $2.2 million for the “premiums” to be paid to these small captives.

It is also clear that this new legislation will have no effect on the current robust enforcement actions underway by the IRS. The issues of inflated premiums, sham pooling arrangements and lack of substance in the alleged insurance transaction remain in force and subject to serious scrutiny.

It is unlikely that Congress will bother to look at this code section again any time in the near future.

As a result of this new legislation, section 831(b) captives can generally no longer be owned by the entrepreneur’s spouse, children, grandchildren or trusts benefiting them. (Details about how the legislation achieves this change can be found in other sources).

Perhaps as many as half of all existing micro captives were formed with estate planning in mind. These captives will have to change their ownership or dissolve before the end of 2016. Tax professionals should review all captives owned by their clients to ensure that they remain complaint with the changes in the law. Relying on the captive managers may not be sufficient.

Captives: Cutting Through the Obfuscation

If you are not a practicing member of the captive community, either as a professional service provider or a captive owner, and are interested in learning about captives, you will most likely turn to the Internet.  Unfortunately, the vast majority of Internet sources are designed to sell you something, or at the very least, tempt you to contact them with some sort of “teaser.”

Additional sources of captive information are periodic industry-focused magazine articles and occasional pieces that appear in the likes of Forbes and Fortune magazines, along with the odd newspaper article. These are often interesting to read, but they are almost always written from a particular point of view, and because of time and space limitations, rarely present a truly balanced perspective.

You may recall a few years ago, when a financial reporter for the New York Times wrote what was intended to be an expose of captives’ presumed nefarious financial and tax doings.  The piece was ultimately discredited, its author clearly had an agenda. (For good measure, the Times, turned out to own a captive).

Given the general lack of information about captives, let’s begin with some basics.  Regardless of what you may have read, a captive is first and foremost, an insurance company.  The term “captive” denotes insurance company status.  Insurance company status means that the captive employs insurance accounting.  If the structure cannot qualify for insurance accounting, it must use deposit accounting, which renders it something other than a captive insurance company.

Insurance accounting allows the captive to deduct its loss reserves from its federal income taxes; taxes are paid on earnings, and earnings are recognized once losses for a particular period (usually a year) are no longer expected to occur or become reported.

Moreover, the captive’s contracts (insurance policies) must conform to Financial Accounting Standard (FAS) 113.  FAS 113 requires that the insurance contract provide coverage for a reasonable chance of a significant loss.

Contrary to what you may read, a captive is not a tax shelter, nor is it a bank.  It can be used, however, as an estate-planning tool (more on this later).  To qualify to use insurance accounting every captive must:

  • Establish and document non-tax business objectives and purpose
  • Experience insurance losses
  • No parental guarantees to bail out the captive
  • Have adequate capitalization
  • Avoid substantial loan-backs
  • Engage professional captive management
  • Comply with local insurance regulations and formalities
  • Follow conventional investment strategies
  • Use risk-transferring insurance contracts per FAS 113
  • Make sure risk sharing is sufficient based on IRS safe harbors
  • Transact business at “arms length” using actuarial-based pricing
  • Maintain the business, books, and records separate from the parent company and comparable to other insurers
  • Not have premiums match the maximum limit of liability

The majority of the companies selling captives – not feasibility studies, just captives – sell what is known as the 831(b) captive.  Caompnies will also assist in the creation of standard captives, but their primary stock-in-trade is the 831(b).

This captive’s name is derived from the section of the Internal Revenue Code that enables their use.  Many of these 831(b) companies make little pretense of providing objective risk management advice; their advice centers on estate planning, which is the primary purpose of the 831(b) captive.  The primary benefits of the 831(B) captive are that (1) only investment income is subject to U.S. federal income taxation (income from premiums is tax-free)  and that (2) 831(b) captives are off-balance sheet.

Unfortunately, many firms have a less-than-comprehensive grasp on the rules to which all captives must adhere, to be considered bona fide insures.  Others conflate certain aspects of the 831(b) captive with captives in general, which of course causes confusion and adds to the amount of misinformation available to prospective captive owners.

Because there is so much blatant misinformation on the Internet, it was hard to pick out the best examples for this article, but I think you’ll find the following examples entertaining, if not disconcerting.

Example 1

An article appearing in a respected technical journal on taxation and accounting lists the following as three benefits of captives:

  • “Asset protection from the claims of business and personal creditors” 
  • “Opportunity to accumulate wealth in a tax-favored vehicle”
  • “Distributions to captive owners at favorable income tax rates”

The problem is that none of the three so-called benefits apply to the vast majority of captive insurers.  They apply ONLY to the 831(b) captive, which, as noted above, is used as an estate-planning vehicle.

The vast majority of captives (non-831 (b) captives) are on-balance-sheet, risk-financing vehicles.  Their tax filings are consolidated with their parents’ filings, so they provide no asset protection from creditors.  Likewise, the vast majority of captives are not “tax-favored,” thanks to the 1986 tax law changes.

The fact that the article is actually devoted to only 831(b) captives is never revealed; the term 831(b) is not even mentioned until page three of the six-page article.

Example 2

A promoter advertises itself as offering a “new service” to help clients “take advantage of Captive structures and domiciles to meet their individual risk management needs.”

It is clear that this company has almost no institutional knowledge of captives.  Its litany of captive benefits is a recitation of the generic, non-specific “benefits” cited hundreds of times across the Internet and elsewhere.  It is obvious that this firm is, like many others, describing the 831(b) captive, but it doesn't even use the term.

This firm’s captive “sin” is tax-related.  This is ironic as according to the firm’s marketing literature, it is the leading tax services firm in North America!  Its sales material on captives states that annual insurance premiums (paid to a captive from its parent) are tax-deductible as ordinary and reasonable expenses pursuant to IRC Section 162(a).  This statement is untrue on its face.

IRC Section 162(a) does indeed provide guidance as to tax-deductible business expenses.  However, given the specialized rules (for captives) promulgated by the IRS over the last couple of decades, this firm’s lack of understanding of captives is not only annoying; it’s potentially dangerous.  The IRS has issued a raft of revenue rulings that address the tax status of captives and their parents, in a wide variety of circumstances.

The central theme of many is the notion of what constitutes risk distribution (risk sharing).  These rules are applicable to every captive, including the 831(b) variety.  Briefly, a single-parent captive (such as an 831(b) captive), must have at least 50% unrelated business to qualify as a bona fide insurer.  This means that only about half of the captive’s total annual premiums can come from the captive parent.

To add insult to injury, in the same marketing piece, this firm says that safe harbor revenue rulings provide the tax benefits.  They do indeed, but only if the prospective captive owner can qualify under them!  This firm’s message is that any company that pays taxes is automatically qualified to form a captive.  Bait and switch?

This firm’s marketing literature also says that a captive’s funds can be immediately invested in just about anything the owner wants – real estate, stocks, bonds, mutual funds, etc.  Nothing could be further from the truth.  Some captive domiciles, such as Bermuda, have specific investment guidelines designed to require the captive to hold primarily liquid investments.  In Bermuda, 75% of investments must be considered “relevant,” another way to say liquid.

Some onshore domiciles such as Vermont have no specific investment guidelines for single-parent captives, but I guarantee that the regulator (and your actuaries) will seriously discourage illiquid investments such as real estate and equities.  Bonds are the preferred captive investments.

Example 3

Another firm proclaiming captive expertise provides an exhibit that ostensibly shows captive tax benefits over ten years.  If you’ll recall, the first principle – Establish and document non-tax business objectives and purpose  doesn’t appear to be a priority with this firm.  The exhibit compares after-tax income with and without an 831(b) captive.

On its face, the exhibit shows that with a captive, if the parent company pays about $10 million into its little captive over 10 years, it earns about $5 million over the no-captive scenario.  Unfortunately, the exhibit fails to include a rather important element – captive losses.  Without losses, captives are nothing more than tax-advantaged pools of funds, upon which the IRS frowns.  This omission effectively renders the exhibit worthless.

Conclusion

Unfortunately the snake oil trade is alive and well on the Internet.  How does one guard against such shenanigans?  The only effective way to do so is to talk to qualified professionals (consultants, attorneys, etc.) who have nothing to sell but advice.  My next article will include a few more egregious examples of professional malpractice or prevarication, along with a detailed, unbiased, discussion of the 831(b) captive and its uses.  Stay tuned.

Section 831(b) Captive Insurance Companies And The Tax Preparer Penalty

An Actual Scenario: A CPA was preparing the tax return of a longtime client who had purchased three captive insurance companies from a well-known provider of such entities, and had paid $3.3 million in insurance premiums to these companies. The client wished to show that payment as a tax deductible item. The client had $28 million in revenue and paid $92,000 annually for their usual third-party insurance program. The insurance premiums paid to these new captives were for “coverages” that supplemented their existing insurance. What could the CPA do with this request?

Background: Owners of profitable businesses are attracted to the tax and financial planning benefits of forming and owning a captive insurance company that qualifies for the tax benefits of section 831(b) of the Internal Revenue Code (the “Code”).

The Code section provides that if an insurance company has no more than $1.2 million in annual premium income, it can elect to exempt that income from taxation. And under a series of judicial decisions and Revenue Rulings, the insured company may be able to fully deduct the premium paid, even if the same person (or persons) owns both the insured and the insurance company.

This concept can be financially powerful, resulting in an immediate reduction in the owner's tax bill, yet virtually all of the funds remain tax free inside a related company. The profits of that company can either be accessed later at capital gains rates or passed to heirs outside of the estate tax regime.

The Problem: The deductibility of the premium is not automatic. The hurdles for properly deducting premiums paid to one's own insurance company are both numerous and, to some extent, subjective. The new insurance company must demonstrate sufficient “risk distribution,” the amounts charged by the insurance company as premium for the coverages offered must be “reasonable,” and the client must demonstrate an adequate “business purpose” for entering into the transaction, to name just a few of the important hurdles involved. These are each very important requirements that a tax preparer is unlikely to be able to judge with any degree of comfort.

Tax preparers who face the request to sign a return that reflects the deduction of such premiums must be careful not to run afoul of the Return Preparer Penalties of section 6694 of the Code. In addition, the client could face an accuracy-related penalty under section 6662 of the Code equal to 20 percent of the underpaid tax should the deduction ultimately be disallowed.

The standard for avoiding the Return Preparer Penalty is that the preparer held a reasonable belief that the position (the deductibility of the insurance premium) would have a greater than 50 percent likelihood of being sustained on its merits.

One of the factors included in the Regulations covering Section 6662 to determine whether a tax return has been negligently prepared is “failure to reasonably ascertain the correctness of an item that to a reasonably prudent person would appear 'too good to be true' under the circumstances.”

In this case, it appeared that a sudden increase in insurance expense from $92,000 to over $3 million might make the deduction of that expense “too good to be true.” But how could the preparer “reasonably ascertain” the likelihood of this deduction being upheld in audit?

The third party that the client relied on for advice in this transaction was the captive insurance company provider that sold them the program in the first place. But that party obviously believed that their program was fully compliant and therefore could not deliver a truly objective response to the CPA's concerns.

The client's attorney was not versed in captive insurance companies and could not be helpful without an expensive journey up the learning curve.

Turning to another captive insurance provider for an analysis of the client's situation was an obvious option. But each provider has their own competing program and clearly has an incentive to undermine the competition and encourage the client to switch providers. Certainly this may not always be the case, but it is wise to question the objectivity of the person doing the analysis if that person is a competitor.

The Solution: In this case, the CPA needed two sources of help. First, she needed to find an expert in captive insurance who did not also offer his own competing program. Second, she had to find an independent actuary who was familiar with captive insurance programs and who would be willing to opine as to the “reasonableness” of the premiums being charged by the captives.

Finding these independent advisors required networking with other CPA firms, searching the web for relevant articles and identifying their authors, and locating captive insurance sites and blogs.

The Result: The independent advisor created a report that the CPA could rely on, stating that while the structure of the captive insurance program would likely be compliant, the amounts of the premiums being charged did not appear reasonable, given both the nature of the client's business and relevant premium rates in the third-party market. The CPA then advised the client to hire an independent actuary to perform a rate review. The actuary ultimately opined that the client could reasonably support premiums of about half of the amount originally considered.

The client got a large tax deduction and the preparer had in file objective third-party support for the position ultimately taken on the tax return. While this support does not guarantee a favorable result in the event of audit, it should be very valuable evidence in any such audit and should satisfy the requirements for avoiding the Return Preparer Penalty.

Captive Insurance Reinsurance Pools – Where's My Money?

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.

These fronting companies or reinsurance companies are often domiciled offshore where annual audited statements may not be required and where litigation over mishandled funds would be difficult for the captive owner. Not all risk distribution mechanisms involve the retention of client funds; unfortunately, however, most of them do.

This article does not suggest that any captive manager has in fact mishandled client funds as described. But it is important to recognize the temptation and ask what, if anything, is being done to be sure that the temptation is never tested. A captive manager with 100 captives under management — each with $1,000,000 in annual premium — will have $50,000,000 or more of “float” to tempt him.

At a minimum, captive owners should require an accounting of retained funds by an independent CPA firm. Ideally, the captive owner should require that retained funds be held in a separate trust account by an independent trustee. But neither of these practices appears common in the captive insurance industry. In some cases, captive mangers have returned the “withheld” funds early, easing the fear of loss of the funds, but potentially making a mockery of the risk distribution mechanism itself.

What is the role, if any, of the captive insurance regulator? Captive legislation is not consistent when it comes to reinsurance pools. A review of the legislation of 14 of the most active captive domiciles reveals that 8 of them have no provision in their statutes to monitor or limit the activities of reinsurance pools (other than actual reinsurance companies licensed in their own domicile). The other 6 have specific language as follows:

The Commissioner may require any other documents, financial information, or other evidence that the pool, exchange or association will be able to provide adequate security for its financial obligations. The Commissioner may deny authorization or impose any limitations on the activities of a reinsurance pool, exchange, or association that, in the Commissioner's judgment, is necessary and proper to provide adequate security for the ceding captive insurer or segregated account and for the protection and consequent benefit of the public at large.

The domiciles break down as follows:

Specific language: Vermont, Missouri, District of Columbia, Kentucky, Montana and Tennessee.

No language: Delaware, Utah, South Carolina, Nevada, Arizona, Hawaii, Alabama and New Jersey.

It is interesting that the majority of small captives that use these reinsurance pools are domiciled in the 8 states that give the regulator no direct statutory authority to address the security of retained client funds. Of course, the regulators do have broad authority to question the overall efficacy of a captive's business plan. This review arguably could address concerns about the security of the captive's funds in the hands of third parties, particularly in the early years of a captive's life. But do they?

This author polled a number (but not all) of the regulators in these 14 states and got few responses from the 8 states without the specific language referenced above. Those few responses indicated that their view is that the relationship between the captive and the fronting company or reinsurer was a matter of private contract not subject to their regulation (other than determining that the reinsurance itself was real and met industry standards).

As the number of captives, captive managers and risk distribution pools continues to grow rapidly, the opportunity for a scandal in the captive industry also grows. The industry would not fare well if such a scandal made the front page of the Wall Street Journal. Captive owners should be aware of this risk and take action accordingly. And captive regulators should become more alert to possible abuses in this area and take action consistent with the powers available to them under their respective statutes.

Risk Distribution – Where Is The Risk?

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.

Revenue Ruling 2002-90 requires that the captive insure at least 12 separate companies (single member LLCs do not count), with no one company representing more than 15% of the total premium paid to the captive. [In practice, the IRS seems to accept as few as 6 separate insureds with none paying more than 45% of the total premium, but it is difficult to rely too heavily on such practice as it may change without notice.]

Most closely-held companies cannot meet the standard of Revenue Ruling 2002-90. While the entrepreneur may own separate companies for real estate, distribution, etc., usually there is one main operating company that carries the bulk of the exposures.

Captives insuring those companies must therefore rely on Revenue Ruling 2002-89 for guidance as to risk distribution. That Ruling states that the captive must show that “more than 50%” of its risk comes from unrelated third parties. (“Risk” in this case is typically measured by premium). [For captives located in the Western United States, a Ninth Circuit Court of Appeals case reduces that percentage to 30%, but the opinion is not binding on the IRS outside of that jurisdiction.]

The typical way for small captives (such as those qualified under section 831(b) of the Code) to accept risk from unrelated parties is through a pooling mechanism where a number of unrelated captives “swap risk.” This risk sharing is accomplished a number of ways, with two common forms:

  • First, the captive may pay all of its premium to a single “fronting captive” (usually owned by the captive manager) who then will cede 50% back to the captive as reinsurance premium and retain 50% for a year or more to potentially pay losses of the other captives who are also using this fronting mechanism.
  • The second common method is a direct ceding/retrocession agreement among unrelated captives under which each promises to pay for 50% or more of the losses of the other captives who have signed the agreement.

In theory, either one of these approaches to third-party risk should qualify under Revenue Ruling 2002-89. But in actual practice, questions arise.

Many risk sharing programs exempt the first $250,000 of any loss of any single captive from the pooling arrangement. In other words, if the captive pays its insured less than $250,000 on any single claim, that captive will have no right to receive reinsurance from the other captives in the pool. Indeed, it is possible that the captive could pay multiple claims — each less than $250,000 — and still not have any reinsurance. On the other hand, any client considering such a pool might feel comfortable that his captive would not be at much risk to pay reinsurance out to other captives, absent a large loss.

These pools are constructed so that in a catastrophic loss, at least 50% is paid by the other captives. They therefore argue that the pool still qualifies under 2002-89. But few captive pools ever suffer such losses — particularly pools that share risk among 831(b) captives. The types of risks generally insured by these types of small captives rarely generate large losses. Indeed, one captive manager boasts that in 12 years, no captive in his pool has ever suffered a loss above that first “no reinsurance” layer.

So, is this really risk distribution?

Large group captives typically use a similar A/B loss structure, but the nature of the risks insured by group captives (auto, general liability and workers’ compensation) commonly result in losses above the A layer, so risk distribution is not an issue.

The judicial opinions on the subject of third-party risk have never addressed the question of layers within a risk sharing pool. Perhaps that is why these types of pools apparently continue to pass muster when one of their captives faces an IRS audit.

Several years ago at a national captive insurance conference, an IRS representative stated that if he found that actual captive losses always fell within an exempted layer, he would deny the existence of sufficient risk distribution. But he has now retired and there is no current indication that the IRS is thinking that way.

Logic would dictate that the lack of actual shared losses would also indicate the lack of risk distribution. The IRS may soon test this question in the Tax Court. If logic prevails, then many risk sharing pools will be in trouble.