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Written By: Sean P. Clancy and Matthew D. Ahlers[1]

Rosenblum Goldenhersh

 St. Louis, MO

Is it time for your client to consider captive insurance?  Captive insurance was once thought of as only a risk management strategy for Fortune 500 companies, however, a growing number of middle market and smaller employers are now turning to self-insurance through captive insurance companies as part of an overall approach to control rising insurance costs.  Several national surveys indicate that there are over 5,000 captives currently being used by employers.[2]  With additional costs to comply with American Protection and Affordable Care Act, many employers are seeking other insurance alternatives.[3]  This article will summarize some reasons to consider forming a captive insurance company, including the types of risks traditionally covered by captives,  tax benefits of captives, types of captives, and special requirements for  micro captive insurance companies, which are also known as  “Section 831(b) captives.”

What is a captive insurance company?

A captive insurance company is an insurance company formed by a business owner to insure the risks of its related or affiliated businesses.  Many captive insurance companies are formed where insurance is not available or is unreasonably priced.[4]   In other instances, a business owner believes that it can simply do a better job than most in controlling costs as is otherwise being actuarially assumed by the insurance company that is writing its premiums, based upon its claims history and risk management.[5]  To the extent that a captive insurance company is successful in keeping claims below actuarial assumptions, the business owner can capture the “underwriting profit” associated with insuring the risk, which is otherwise realized by the general insurance carrier if captive insurance is not utilized.

Why form a captive insurance company?

Companies choose to form a captive insurance company for a variety of reasons.  First, the management of the captive insurance company allows the parent company to actually be directly in control of the management of its claims.  Captive insurance companies have access to the reinsurance market, which is not available otherwise to an everyday business owner.  Reinsurance allows the captive insurance company to take on specific amount of risk but transfer the “catastrophic claim risk” to the reinsurance company.   It allows for a business owner to also mitigate swings in the commercial insurance market.  Finally, the use of a captive allows for potential income tax benefits and estate planning opportunities to be realized by the business owner.[6]

What types of risks can a captive insurance company cover?

Captive insurance companies are commonly used to cover familiar business risks, including directors and officers liability, warranty liability, errors and omissions, environmental liability, and product recall.  In addition, captive insurance can be used to alleviate other less commonly insured risks or items often excluded from insurance policies, such as construction defect insurance, cyber liability, earthquake insurance, punitive damages, unfair competition, HIPPA/billing liability, intellectual property infringement, and deductible reimbursement.

How does a captive insurance company qualify as an insurance company?

In order to qualify as an insurance company, the captive insurance company must have a non-tax business purpose and must underwrite real insurance risks—not speculative or investment risks.  In addition, the captive company must distribute risk to others that is supported by actuarial analysis.  A captive insurance company must act like an insurance company and must be a separate and distinct entity that is not a sham.[7]

Risk distribution refers to the pooling of premiums for risks in a manner that is sufficient to allow the law of averages to operate.  The IRS believes that there must be a number of entities insured in order to have insurance, and a single insured (no matter how large) cannot have insurance if it is the insurance company's only insured.[8]   Captive insurance companies may distribute risk in a number of ways under IRS rulings - by taking on outside business (unrelated third party business)[9], engaging in "brother-sister" insurance where enough related entities are being insured to constitute sufficient distribution of risk[10], or participating in a risk pool.[11]  A risk pool is a contractual arrangement where unrelated companies come together to share risk among one another in a pool and achieve the "law of large numbers."

Types of Captives and Potential Tax Benefits

Captive insurance companies may be formed in either the US or foreign jurisdictions.  In choosing a domicile for a captive, the primary considerations include regulatory environment, the infrastructure of the country selected (if not in the US), the cost to implement and maintain the captive in the domicile, and tax consequences.[12]  Although many offshore countries offer premium tax and income tax advantages that are not available to US domiciles, selection of an offshore domicile will often create US excise taxes, which can be significant.[13]   Various domiciles differ in the amount of capital required to establish a captive insurance company.[14]  Generally, US domiciles will require higher capitalization requirements and have additional regulatory requirements in comparison to foreign domiciles.[15]  Many business owners that choose to form a foreign domiciled captive make a federal tax election to have their captive insurance company treated as a US taxpayer to avoid additional federal excise taxes that are levied on foreign insurers.[16]   States vary greatly in the manner in which they tax captive insurance companies, and sometimes the choice of whether to use a foreign or domestic insurance company will depend upon the particular state where the business owner operates or insurable risks exist.[17]

US domiciled captive insurance companies and foreign insurance companies electing to be treated as US taxpayers are able to take advantage of special income tax advantages under Section 831(b) of the Internal Revenue Code.[18]  In part due to tax reasons, Section 831(b) captives are experiencing a large amount of growth.[19]  Normally, when a business owner operates multiple affiliates, a payment by one affiliate to another affiliate for goods or services may be an expense to the payor but income to the payee.  In other words, the payment between affiliates is tax neutral to the business owners because the income and expenses offset one another.  Under the Section 831(b) of the Internal Revenue Code, an insurance company with no greater than $1,200,000 of annual written premium pays no income taxes on insurance underwriting profits.  Section 831(b) captive insurance companies are treated as a separate taxpaying entity; however, Section 831(b) captives are taxed only on the investment income realized by the company.  When profits from the insurance company are realized and distributed as dividends, shareholders must pay income taxes on dividends.[20]

There are several potential abuse areas for Section 831(b) captives that are a concern for the IRS:  inadequate pricing of premiums (i.e., inflated insurance premiums), insufficient liquidity and reserves being maintained by the insurance company, lack of sound investment standards, loans back to affiliates, and failure to pay claims.[21]  Failure to take precautions that an ordinary insurance company undertakes could ultimately lead to the IRS treating the captive insurance company as a “sham” and disallowance of the tax benefits.  It is important to employ the right professionals, including a competent captive management company, to navigate these concerns.

Estate planning opportunities exist with Section 831(b) captives.  Many business owners establish trusts, which are outside their gross estate for purposes of the estate and gift tax, to own the captive insurance company.  To the extent that underwriting profit can be achieved consistently and investments grow in value outside the business owner’s estate, the heirs of the business owner may realize substantial estate tax savings later.

For companies interested in the concept of self-insurance, but not interested in establishing their own captive insurance company due to cost or other concerns, other opportunities may still exist in “group captives,” whereby several businesses join together as owners of the captive.  Normally, participant owners have good claims history and a common interest in insuring a particular class of risk.  Workman’s compensation and general liability insurance are popular types of insurance insured in group captives.  Recently, a number of group captives have begun forming to cover health insurance[22], and new types of group insurance are continuing to develop as well.

Cell Captives are another option designed to allow businesses to self-insure risks at a lower cost.  Cell captives usually consist of a core entity and have several cell entities that are legally treated as separate from one another.[23]  Each cell has assets and liabilities that are attributed to it, and the assets of each cell cannot be utilized to meet the liabilities of any other cell.   The core cell portion of the company is permitted to have assets that may be used to pay liabilities that cannot be attributed to another cell.   A core cell company may also have non-core assets, which may be made available to meet liabilities that cannot be attributed to another single cell.  There are several types of cell captive structures.  A cell captive sometimes has a common board of directors.  In other structures, each cell can have its own board of directors.

Conclusion

The area of captive insurance is a fast growing industry, and current trends in the insurance market make captive insurance an exciting alternative tool to complement or replace traditional insurance.  However, clients can only design better plans for risk management if they have the right insurance professionals and attorneys to guide them through the regulatory requirements.    IRS guidance needs to be carefully observed too to ensure the captive insurance company operates as a “real insurance company.”

For more information about our St. Louis Primerus member law firm, Rosenblum Goldenhersh, please visit the International Society of Primerus Law Firms.

[1] Sean P. Clancy is shareholder at Rosenblum Goldenhersh in St. Louis, Missouri and Chair of his Firm’s Tax and Estate Planning practice group.  His practice is focused primarily on representing closely-held businesses and their individual business owners, and he specializes in tax issues, including the area of captive insurance. He speaks regularly on tax and estate planning at various trade association and bar association seminars for both practitioners and clients.

Matt Ahlers is an associate at Rosenbum Goldenhersh.  His practice focuses primarily on transactional and corporate matters, including HUD/FHA Financing and Tax Credit Transactions.

[2]  Business Insurance News: Captives 2008.  See also Wikepedia on Captive Insurance at http://en.wikipedia.org/wiki/Captive_insurance#Micro_Captives.

[3] See "Why Companies Are Opting for Captive Insurance Arrangements," Christine Harris, Forbes (January 28, 2013).

[4] See “A Guide to Captive Insurance Companies,” by William P. Elliott, Journal of International Taxation (WG&L) (April 2005).

[5] Id.

[6] Id.

[7] Elliott at 3.  See also, Chrishold v. Commissioner, 79 F.2d 14 (1935), for further information about the sham transaction doctrine.

[8] IRS Revenue Ruling 2005-40 (risk distribution requirement met where 12 or more insured(s)).  See also Humana Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989).

[9] Harper Group and Includable Subsidiaries v. Commissioner, 96 T.C. 45 (1991)(captive insurance company with at least 30% unrelated third party risk constituted insurance).

[10] IRS Revenue Ruling 2005-40.

[11] IRS Revenue Ruling 2002-89.

[12] Elliott at 3.

[13] I.R.C. §4371.  A 1% excise tax is imposed on gross reinsurance and life insurance premiums.  A 4% excise tax is imposed on direct property and casualty premiums paid to foreign insurers.

[14] Elliot at 3.

[15] Elliot at 3.

[16] See I.R.C.§ 953(d).

[17] See “White Paper Discussing the Nonadmitted and Reinsurance Reform Act of 2010 and Its Potential Application to Captive Insurance,” James McIntyre, Adam D. Maarec, McIntyre & Lemon (October 6, 2011).

[18] I.R.C. §831(b).

[19] Business, at 1.

[20] I.R.C. §1, §316.

[21] See “Tax & Regulatory Issues for 831(b) Captives,” Charles J. Lavelle, Ernie Achtien, Jeffrey Simpson, Self-Insurance Institute of America Conference Materials (October 21-23, 2013), Chicago, IL

[22] See “Using Group Captives for Health Insurance,” Jeff Fitzgerald, Risk Management, p.48-49 (July/August 2009).

[23] See IRS Revenue Ruling 2008-8.