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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.