Tag Archives: section 831b

How to Prevent IRS Issues for Captives

A regulator of captive insurance is responsible for many aspects of the business of captive insurance companies. He or she must coordinate the application process for obtaining a license, including the financial analysis and financial examination of each captive insurance company. The regulator is also a key marketing person in promoting the domicile as a favorable place to do business, thus fostering economic development for the state.

The captive regulator is not, however, a tax adviser. No statute and regulation in any domestic domicile requires an analysis of the potential tax status of the captives under consideration or under regulation. If the application complies with the stated statutory and regulatory requirements, the regulator must favorably consider the application and allow the new company to be licensed as an insurance company under state law.

That new insurance company may not, however, be considered an insurance company under federal tax law. The Internal Revenue Service recently listed captives as one of their annual “Dirty Dozen” tax scams, citing “esoteric or improbable risks for exorbitant premiums.” And at least seven captive managers (and therefore their clients) have been targeted for “promoter” audits, for allegedly promoting abusive tax transactions.

Yet all of these captives received a license from a regulator, mostly in the U.S. Obviously these regulators did not consider the pricing of the risks to be transferred to the captive, except perhaps at the macro level.

Should the domicile care about the potential tax status of licensed captives? David Provost, Vermont’s Deputy Commissioner of Captive Insurance, has said, “We do not license Section 831(b) captives; we license insurance companies.” While that statement is technically correct, this paper argues that, with respect to small captives, regulators should care about the tax implications of licenses in extreme cases, consistent, of course, with the laws and regulations under which it operates.

Small captives, i.e. those with annual premiums of no more than $1.2 million, can elect under section 831(b) of the Internal Revenue Code to have their insurance income exempt from federal taxation. This provision, combined with certain revenue rulings and case law, creates a strong tax and financial planning incentive to form such a captive insurance company.

This incentive can lead to an “over-pricing” of premiums being paid to the new captive, to maximize the tax benefits on offer. The premiums may be “over-priced” relative to market rates, even after being adjusted for the breadth of policy form, size and age of the insurance company and, in some cases, the uniqueness of the risk being insured by the captive. But “over-priced” in whose eyes?

Insurance regulators are usually more concerned with whether enough premium is being paid to a captive to meet its policy obligations. From that perspective, “too much” premium can never be a bad thing. Indeed, captive statutes and regulations generally use the standard of being “able to meet policy obligations” as the basis of evaluating captive applications or conducting financial reviews. And actuarial studies provided with captive applications generally conclude that “…the level of capitalization plus premiums will provide sufficient funds to cover expected underwriting results.”

These actuarial studies do not usually include a rate analysis, by risk, because none is required by captive statute or regulation.

Small “831(b)” captives, therefore, may easily satisfy the financial requirements set forth in captive statutes and regulations. If, however, the Internal Revenue Service finds on audit that the premiums paid to that captive are “unreasonable,” then the insured and the captive manager may face additional taxes and penalties, and the captive may be dissolved, to the loss of the domicile.

And, as has happened recently, the IRS may believe that a particular captive manager has consistently over-priced the risk being transferred to its captives and may initiate a “promoter” audit, covering all of those captives. Such an action could result in unfavorable publicity to the domiciles that approved those captive applications, regardless of the fact that the regulators were following their own rules and regulations to the letter.

It is that risk of broad bad publicity that should encourage regulators to temper the rush to license as many captives as possible. There should be some level of concern for the “reasonableness” of the premiums being paid to the captives.

One helpful step would be to change captive statutes or regulations to require that actuarial feasibility studies include a detailed rate analysis. Such an analysis would compare proposed premium rates with those of the marketplace and offer specific justifications for any large deviations from market. (Given the competition among jurisdictions for captive business, such a change would only be possible if every domicile acted together, eliminating the fear that a domicile would lose its competitive edge by acting alone.)

Absent such a change, however, regulators still have the power to stop applications that do not pass the “smell test.” Most captive statutes require each applicant to file evidence of the “overall soundness” of its plan of operation, which would logically include its proposed premiums. If the premiums seem unreasonably high for the risks being assumed, the plan of operation may not be “sound,” in that it might face adverse results upon an IRS audit.

Regulators are not actuaries and often have had little or no underwriting experience. They, therefore, could not and should not “nit-pick” a particular premium or coverage. But some applications may be so egregious on their face that even non-insurance people can legitimately question the efficacy of the captive’s business plan.

Insurance professionals know from both experience and nationally published studies that the cost of risk for most companies is less than 2% of revenue. “Cost of risk” includes losses not covered by traditional third-party insurance, which are generally the type of losses covered by “small” captive insurance companies.

If a captive regulator receives an application in which the “cost” of coverage by that captive is, say, 10% to 12% or more of the revenue of the insured, alarm bells should go off. That captive certainly would have plenty of assets to cover its policy obligations! But in the overall scheme of things, including the real world of taxation, that business plan is not likely “sound.”

At that point, the regulator has a choice of rejecting the applicant, requiring a change in the business plan/premiums or demanding additional support for the proposed plan. We are aware of one case in which the captive regulator required the applicant to provide a rate analysis from an independent actuary when he received an application whose premiums did not appear reasonable.

A rate analysis is not, of course, a guarantee that the IRS will find the premiums acceptable on audit. No one can expect guarantees, but a properly done rate analysis has a better chance of assuring all the parties that the captive has been properly formed as a real insurance company and not simply as a way to reduce the taxable income of the insured and its owners.

Captive insurance regulators have a big job, particularly as the pace of captive formations increases. To protect the domicile from appearing on the front page of the Wall Street Journal, the regulator must consider all aspects of the proposed captive’s business, including, in extreme cases, its vulnerability to adverse federal tax rulings.

831(b) Captives and the IRS: Underwriting and Audit Roulette

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 $1.2 million a year and that 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 sidestepping 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. 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 because of badly overpriced premiums being paid to the captive.

For example, we found a $10 million (revenue) manufacturer that had purchased a $1 million 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 million limit and charged the insured more than $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 because 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 more than $600,000 in premium for $10 million in limits for this type of risk even though 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?”

The simple fact is that the requirements of the captive insurance laws fall far short of the requirements of the IRS. The laws of each captive insurance jurisdiction in the U.S. require that an actuarial opinion accompany each application for an insurance license. But that opinion is limited to determining “the amount and liquidity of its [the captive’s] assets relative to the risks to be assumed [meaning the policy limits].” Thus, a regulator’s primary concern is to ensure the solvency of the captive. Typically, this is achieved through pro-formas showing 3- to 5-year expected and adverse loss scenarios. Note that there is no requirement to examine or opine on individual rates used to price specific exposures being assumed by the captive.

This “gap” between the captive insurance law and the realities of the tax authorities can be immense. One of the first questions asked by the IRS in the audit of a captive is, “How were the premiums (pricing) determined for each risk assumed?” Without an opinion of an actuary regarding these rates, it then comes down to the knowledge of the underwriter used by the captive management company. It is apparent that many captive managers do not have sufficient depth in this area or do not care to go beyond the specific requirements of the captive licensing requirements. (We, however, require that our actuaries examine every rate that we use in our feasibility studies.)

A rule of thumb is that a properly priced portfolio of risk for a captive should equate to total premiums equal to 1% to 2% of the insured’s revenue. The reason revenue is a good guide is because the majority of risks being transferred to section 831(b) captives are casualty risks. And the exposure base for casualty risks is generally revenue. The underwriter cannot change the exposure base, but he can raise the rate that is multiplied times the exposure base to get to a higher premium as desired by the client. But the captive will not survive an audit if rates are raised too high.

That estimate of 1% to 2% of revenue is only a guideline: There are exceptions. But if you see a captive manager suggest that the premiums payable to an 831(b) captive can be 6% to 10% (or more) of revenue, run! That manager is ignoring the important risk management requirements of this captive concept, to the detriment of its clients. And the clients are playing audit roulette, hoping their “number” does not come up.

Authors
James Landis collaborated with Rick Eldridge in writing this article. Eldridge is the president and CEO of Intuitive Insurance and the managing partner of Intuitive Captive Solutions.

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.