1. What is a captive insurance company?

A captive insurer (or “captive”) is a closely-held insurance company formed primarily to underwrite the risks of its parent or affiliated groups. It is similar to a traditional, commercial insurance company because it:

• is licensed as an insurance company;
• sets insurance-premium rates for the risks it chooses to underwrite;
• writes policies for the risks it insures;
• collects premiums;
• pays out claims made against those policies; and
• proper accounting for reserves and surplus.

The biggest difference between a captive insurer and a commercial insurance company is that a captive cannot sell insurance to the general public. It can only underwrite the risks of its parent organization, related entities, and chosen unrelated parties. Another key difference is that captives are regulated under special captive legislation that is typically less onerous than those regulations governing traditional commercial carriers.

2. What are the benefits of a captive insurance company?

Premium Stability.

The insurance marketplace commonly goes through its “hard and soft” cycles where premium fluctuations have little relation to individual loss experience. By pooling your resources and creating your own captive reinsurance company, these swings can be avoided, making your costs more predictable.

Lower Insurance Costs

A. Retain the profit otherwise earned by a third-party insurer

Commercial market insurance premiums must be adequate to meet the cost of claims, overhead, and profit for the insurance company. By establishing a Captive, the parent/owner seeks to retain the profit within the business family, rather than see it go to an outside party. Specifically, bypassing traditional insurance can often lead to a cost savings through the elimination or reduction of profit loads, broker commissions and administrative costs.

B. Pay premiums that better reflect your loss experience

A Captive may also reduce insurance costs by charging a premium that more accurately reflects the parent’s loss experience. Specifically, premiums are based on your individual loss history, not grouped together with your industry’s
poor performers, as the traditional markets do. You keep unused premiums and earn return from the investment of those dollars.

C. More flexibility in tailoring policies lowers cost

Buying insurance is similar to buying clothing. In a highly simplified analogy, we say buying from a commercial carrier is like buying clothes off the rack and having the choice of small, medium or large; whereas, buying through a Captive is like buying clothes through a tailor who custom makes the clothes for one individual to achieve a perfect fit. A captive simply provides an organization with more risk financing options to create the best fit, thereby lower to total cost of insurance.

D. Access to Reinsurance markets lowers costs

Re-insurers are able to provide coverage at advantageous rates by operating on a lower cost structure than direct insurers. By forming a Captive, the business owner is given access to the reinsurance markets. By using a Captive to access the reinsurance market, the parent/owner can more easily determine its own retention levels and structure its program with greater flexibility, thereby “laying
off” some of its risk to a third-party company and a less expense rate than through traditional insurers.

Increased cash flow / Investment returns

Apart from pure underwriting profit, commercial insurers rely heavily on investment income. Premiums are typically paid in advance, while claims are paid out over a longer period. Until claims become payable, the premium is available for investment. By using a Captive, premiums and investment income are retained by the owner. Additionally, the Captive may be able to offer a more flexible premium payment
plan, thereby offering a direct cash flow advantage to the parent.

Risk retention

A company’s willingness to retain more of its own risk, particularly by increasing deductible or self-insured retention levels, may be frustrated by the inadequate discount offered by insurers to account for the increased deductible/self-insured retention and by the fact that the company is unable to establish reserves to pay future claims. Establishment of a Captive can help address both these problems.

Further, where the commercial market is unable or unwilling to provide coverage for certain risks or where the price quoted is unreasonable, a Captive may provide the insurance desired. Specifically, captives can often provide coverage for:
• unique or specific risk that would not otherwise be transferable in the traditional market;
• lines of business that are either difficult to insure in the conventional market or that provide significant cost savings by retaining the risk.

Reduce Long-term Cost of Risk

As a separate business, the Captive has the potential to be a profit-center for the business owner. As such, mitigating losses are an incentive to creating a Captive. Commercial insurance does not provide such an incentive – if a business’ claims are lower than the industry average, the business is not generally rewarded for the lower claim history. With a captive, low claims continues to directly benefit the overall business owner and consequently encourages the implementation of risk mitigation techniques.

Potential Tax Efficiencies

A. Immediate deductibility for self-insured risks

With traditional self-insurance, companies only receive a an income tax deduction when they make a claims payment (not when a reserve is established). When a Captive is utilized to insure these risks, the company’s premium payments to the Captive are immediately deductible for income tax purposes. Therefore, there is a timing benefit from an income tax perspective from covering self-insured risks through a Captive.

B. Ordinary deductions vs. capital gains

Consider the fact that the owners of an operating company are in some way related to the owners of the Captive. Further, when a company makes premium payments to a Captive, it earns an ordinary deduction. However, when a Captive earns profits from its insurance activity and distributes such profits to its owner (i.e., a dividend,) such owners pay tax on such dividends at capital gains rates. Therefore when considering the tax position of the owners of the operating company and the Captive, the portion of premium payments that result in Captive profit received an ordinary deduction, but are taxed as income at capital gains rates.

C. I.R.C. 831(b)

Section 831(b) of the Internal Revenue Code states that insurance companies, including captives are exempt from income tax on their insurance-related profits if they collect less than $1.2 million in premiums, annually. Therefore, the profits earned by an 831(b) captive insurer are not taxed at the captive level, but only receive capital gain treatment once distributed to the owners.

Regulatory benefits of captives

• A captive can start writing business much faster than a traditional insurance company due to a simplified process to
   license the captive in a domiciliary state and register it or the Captive in various states.
• There is no requirement for approval from state regulators on rating plans and policy forms.
• There is no requirement to engage licensed agents and brokers to solicit business.
• The reporting requirements to regulators is less demanding than a traditional insurance company.
• With the exception of domicile premium taxes, often there are often no other fee and assessment requirements.

3. Feasibility Study?

Why conduct a Feasibility Study?

A Feasibility Study is undertaken to determine what a Captive can specifically provide for its owners. As Captive’s are often new to companies, this element is very important. Companies will also use the feasibility study to satisfy a statutory requirement.

A major difference between a Captive insurance strategy and other insurance strategies is the capital investment. Unlike in a commercial insurance situation or a self-insured situation, a company that operates a captive must contribute capital (or at least it must tie up collateral to support a letter of credit). That is, when insurance is purchased from a commercial carrier or a company self-insures its risk, there is no requirement to put capital at risk. In the case of the former commercial carrier, premiums are paid to the insurer and become an expense; in the case of the latter self insured, losses are paid as incurred—again, an expense. Any investor who puts capital at risk will want to make sure that capital is put to good use to benefit the business. Understanding how this investment will be utilized is where the Feasibility Study begins.

What is a Feasibility Study?

The focus of the study will depend on the motivating factors for establishing the Captive.

Defining the risk

Once the objectives for conducting the Feasibility Study are clearly stated, an analysis begins. The Feasibility Study will identify the specific risks that will be the focus of the Captive. Understanding the risks that the organization is considering assigning to a Captive is critical because a proper and complete risk-management actuarial report can only be completed once the risks are known and clearly identified.

Measuring the risk

Once the objectives of the study are defined and the potential risks to be included in the analysis are identified, the data analysis can begin. The data and financial analysis is the heart of the feasibility study. In the end, this analysis (that includes a competent actuarial study) will likely play the biggest role in determining whether a Captive is going to be an appropriate alternative risk financial solution. Just keep in mind that it is not the only factor in this decision. A good feasibility study will evaluate the myriad of issues that go beyond the pure financial considerations to get the best picture of whether a Captive is an appropriate investment.

In terms of measuring the pure financial considerations, below are some of the key components:
Retained risk and loss projections- The feasibility study will identify which risks the Captive is willing to retain and at what levels.

Expense budget for the Captive- The Captive Insurance Company is and must be run like a separate, self-sustaining business. Therefore, it must have a clearly defined operating structure with associated expense budget. The Feasibility Study provides the owner the opportunity to fully understand and define this expense structure.

Tax impact- Tax implications should never be the sole or even predominant reason for forming and running a Captive Insurance Company. In fact, if there is no other compelling reason to form a Captive beyond some tax advantage, you can expect the IRS to challenge the Captive’s existence.

The taxes that should be addressed include:

• U.S. (or other country) income tax
• Excise taxes
• Excess and surplus lines taxes
• Domicile premiums taxes
• Local premium taxes
• Other taxes/assessments

Premium strategy- The Captive will need to ensure that it has a clearly established premium rate structure and individual rates for each line of coverage. By presenting these premiums by line-of-coverage, the Captive owner will be able to estimate the total expected premium contribution, which will help determine the overall required capital necessary to support the Captive.

Capitalization- The reason for a capital requirement is to ensure that the Captive can support the risk that it is assuming. It only makes sense for the Captive to be adequately funded but not over-funded. Ultimately, capital requirements will be determined by a combination of captive-funding needs and the domicile’s statutory requirements. The quality of the capital estimate will be based on the quality of the information used to arrive at those estimates. That includes the credibility of loss projections, the quality of the rate-setting process, and the claim-management procedures that will be put in place among with the other processes.

Pro forma financial statements- Since the Captive will be an independent operating insurance concern, it will need to show profit and loss projections. A five-year horizon for the pro forma financials is appropriate. These financials should include:

• Income statements and balance sheets
• Five-year pro forma results
• Presentation of tax consequences
• Financial assumptions (interest rates, growth rates, cost of capital, etc.)

Structuring strategy

The structuring section of the feasibility study will address the various captive-program structure options available to the captive owner.

4. What character and types of insurance coverage should be written in a Captive?

A. Character of risks

I. Low frequency/low severity risks- Sometimes it doesn’t make sense to carry traditional insurance for claims that rarely occur and even when they do occur they are always of low-severity. Traditional insurance might not be available or it may be expensive since the carriers may charge a minimum amount for the coverage. In this case, an appropriate Captive policy can balance the need for coverage and the need for appropriate premium pricing based on the individual organization’s risk profile.

II. High-frequency/low severity risks- Some companies experience a high number of low-severity (or low-cost) claims. Purchasing insurance coverage in the
traditional market for this type of claim can be expensive because of the high- frequency nature of the loss history. A Captive can make appropriate adjustments thereby reducing the overall cost of financing the risk.

III. Low-frequency/high severity risks coupled with a stop-loss strategy- When claims related to a particular risk occur very infrequently but the potential loss is severe, companies often find themselves paying very high premiums for events that rarely if ever occur. For those companies who have programs or procedures in place to reduce or eliminate the risk of such claims and who wish to reduce the cost of financing whatever underlying risk actually exists, a Captive is often a good alternative. This works, however, only when there is a sound stop-loss strategy in place to ensure that if a severe claim does occur, there is appropriate excess coverage to handle it.

IV. Risks with large established claims data and existing market of reinsurers- Most Captives rely on reinsurance to handle much of the risk shifting. When there is an existing strong market for the reinsurance sought and there is well-established claims data, there is a good chance that the reinsurance will be very competitively priced and easy to secure. In this case, there is a good chance the overall program to underwrite these risks using a captive will be more financially attractive to the insured than simply buying traditional insurance.

V. Risks where premiums to policy limits are very close- If you are purchasing coverage from a traditional carrier and the premiums you are paying are not too different than your policy limits, you would likely benefit from having the Captive underwrite that risk. First, the Captive coverage will be less expensive even for the same policy, because the Captive’s overhead is much lower than the traditional carrier. Second, you are getting almost no benefit from the traditional insurance if you are paying out about as much as you would hope to get back in the event of a loss. You are much better off paying the premium to yourself (i.e., to your Captive) taking the deduction and then investing the money according to your Captive’s investment policy.

VI. Risks that the company manages better than those in its industry- When your company has figured out a way to manage risk significantly better than others in your industry, writing coverage for that risk through a Captive should be a major consideration.

VII. Currently self-insured risks- There are risks your company is currently self- insuring. Some of these risks are obvious to you; for example, you may decide that for certain risks where you have a history of frequent, small claims, you’d rather pay the claims directly instead of relying on insurance coverage. However, you elect to make sure you are covered in the event one of those small claims becomes a very large claim, you keep traditional coverage but maintain a high deductible. So, effectively, you are self-insuring your claims up to a certain “retention” level. You may even have excess or catastrophic coverage that goes beyond that initial policy limit.

B. Types of risks

I. Generally, business owners do not replace their commercially-purchased insurance with self-insurance except in very limited circumstances where the cost of the commercial insurance is drastically too expensive in comparison to a long, established low claim history by the business. The captive can offer policies which protect against the potential to pay the deductibles on the commercial insurance. This will allow the business to increase its deductibles as high as the commercial insurer will allow – thereby lowering the cost of the commercial insurance.

II. For instance, most business owners would not transfer all risk property insurance coverage, including fire risk, to a Captive where a catastrophic fire loss could destroy the business and perhaps the Captive. However, it might be wise to transfer the first $500,000 of property loss risk to a Captive and purchase commercial insurance for the coverage above $500,000.

III. Captives can offer practically all types of insurance with the exceptions of life insurance and workers compensation insurance.

IV. Casualty Program

  • Transmission & Distribution
  • Patent Infringement
  • Handset Insurance
  • OCIP
  • Personal Lines
  • Supplemental Employee Life
  • Global risk aggregator

V. Others

1. Typical commercial policies:
• Antitrust & Unfair Competition
• Advertising Liability
• Commercial Vehicle Insurance
• Errors & Omissions
• Construction and Design Defect
• Malpractice
• Copyright Infringement
• Performance Claims
• Deceptive Trade Practices
• Structural Defects
• Directors & Officers Liability
• Title Insurance
• Employment Practices
• Trademark Infringement
• Environmental
• Libel & Slander

2. Softer Policies:
• Administrative Action
• Administrative Delay
• Advertising & Marketing
• Antitrust and Unfair Comp.
• Business Credit Cover
• Business Dirty Tricks
• Business Document Forgery
• Business Extortion
• Business Interruption
• Business Reputation
• Cargo Consequential Loss
• Cash In Transit
• Commercial Crime
• Communication Breakdown
• Computers: Dissemination
• Computers: Loss of Data
• Computers: Software
• Computers: Virus Loss
• Confiscation
• Contract Frustration
• Copyright Infringement
• Crime.
• Currency Risks
• Cyber Risk.
• Delay Start-Up, including construction-related
• Distributor Liability
• Eminent Domain
• Employment Practices Liability.
• Environmental/Pollution.
• Financial Crime
• Force Majeure
• Foreign Operations
• Insurance Failure
• Knock-Off Lost Profit
• Labor Costs
• Lawsuit Interruption
• Legal Expenses
• Lender Failure
• Loss of Key Customer
• Loss of Talent
• Machinery Breakdown
• Market Flooding
• Market Risks
• Patent & Trademark Infringement
• Political Risk
• Product Launches
• Product Liability
• Product Recall.
• Product Tampering
• Production Benchmarks
• Professional Liability.
• Property Damage
• Property Risk (including wind and quake).
• Strike and Labor Unrest
• Supply Chain Risk.
• Terrorism
• Theft
• Trade Credit
• Trade Good Will
• Trade Secrets
• Transit Risk
• Unfair Calling of Guarantees
• Weather Risks

5. What are the key components of Captive management?

At its highest level, Captive management focuses on four key areas:

A. Underwriting – It is the process of reviewing and evaluating risk for potential coverage, setting premium rates, reviewing coverage applications and writing policies. The initial critical step of the underwriting process is defining the insured. The underwriting process also requires the establishment of underwriting
policy. A clear underwriting policy is necessary to ensure that the captive is indeed operating as an insurance company.

B. Claims management – Deciding what risk to underwrite is an important first step of the captive operations process. Equally important is having a mechanism in place to handle the claims that result from the policies written. In fact, this step should be carefully considered before any risk is underwritten given that the claim management system must be capable of handling the volume and type of claim
that could result from the underwritten risk.

C. Financial management – While nothing about managing a captive insurance company is unimportant, it can be safely said that financial management is among the most important functions. After all, the captive is a financial management
tool. Management of this function will likely involve more of the captive owner’s internal resources than any other operations management function. The Captive will influence risk financing decisions, tax decisions, capitalization decisions, cash management decisions, capital investment decisions, etc.

D. Compliance/reporting -The reporting and compliance issues for a Captive insurance company are not as onerous as those for a traditional insurance company. This is because the Captive insurance companies are not offering insurance to the public. Each domicile has specific reporting requirements. The domicile’s Captive regulations will identify the type of reports it requires and the frequency of those filings. You will find that these filings and their frequency are similar among the domiciles.

6. What considerations are important to deciding where to domicile?

In considering in which jurisdiction to form a Captive, there are several factors to consider, namely:

  • What is the premium tax, if any?
  • What assets can be considered for reserve purposes – i.e., “permitted assets”?
  • How long has the jurisdiction been issuing Captive licenses?
  • Will the insured need a “Certificate of Insurance” for any of the policies issued by the Captive?
  • What are the annual meeting requirements of the jurisdiction?
  • What are the restrictions, if any, on the types of permitted investments?
  • What are the fees for the initial application to obtain the insurance license?
  • What are the capitalization requirements?
  • What reporting is required by the Captive?
  • Do the principals have to meet with the Insurance Commissioner in the jurisdiction before obtaining a license?

7. What types of Captive structures exist?

Single parent (Pure)

  • The Captive is formed to insure the risks of its parent and parent-affiliated companies.
  • At its most basic level a “pure” Captive works like this: A corporation with one or more subsidiaries establishes a Captive insurance company as a wholly owned subsidiary. The Captive is capitalized and domiciled in a jurisdiction with Captive-enabling legislation which allows the Captive to operate as a licensed insurer. The parent identifies the risks of its subsidiaries that it wants the Captive to underwrite. The captive evaluates the risks, writes policies, sets premium levels and accepts premium payments. The subsidiaries then pay the Captive tax-deductible premium payments and the Captive, like any insurer, invests the premium payments for future claim payouts.
  • The capital required to form and operate a single-parent Captive is provided by the parent.
  • The parent, as owner of the Captive, maintains in complete control over underwriting terms, policy language, Reinsurance decisions and investment policy

Series Limited Liability Captives in which assets and liabilities of each Series (or cell) are segregated from each other as well as its overall Limited Liability Company.

Association Captives owned by a trade, industry, or service group for the benefit of its members.

Group Captives created to provide an option to meet a common insurance need for multiple companies.

Agency Captives whose purpose is to re-insure a portion of an insurance company’s clients’ risks.

Rent-a-Captives that provides “Captive” facilities to others for a fee.

8. What is risk shift or transfer?

In its purest form, risk transfer is a transaction by which a risk is passed from one party who does not wish to have this risk (the insured) to a party who is willing to take on the risk for a fee, or premium (the insurer). However, for Captive insurers, risk transfer is not necessarily achieved by the Captive buying risks from related businesses, because of the related-party nature of the Captive and the businesses.
If the Captive is insuring the risks of a parent and the parent’s subsidiaries (a pure Captive), then risk transfer is achieved as it relates to risks that the Captive acquires from the subsidiaries, because the subsidiaries are considered unrelated to the Captive for insurance purposes.

For a Captive that is insuring the parent’s risk, then for risk transfer to be achieved, the Captive must re-insure the risks. Risk reinsurance for a Captive is achieved by ceding (or selling) an adequate portion of its risks to either a:

I. third-party re-insurer
II. a pool that contains an adequate amount of other insurers’ risks, whereby the Captive then acquires an adequate portion of such pool’s risks (i.e., trading its risks for a portion of the pool’s risks)

9. What is risk distribution?

Risk distribution is achieved with the Law of Large Numbers. The Law of Large Numbers is considered when determining risk distribution, which means that there is an adequate amount of different, diversified risks acquired by an insurer such that there is a reasonable probability that the actual loss experience will equal the expected loss experience. For Captives, risk distribution occurs when it insures multiple risks that are diverse risks of related (but separate) entities (i.e., a parent and its subsidiaries), or risks of multiple unrelated entities (through a Risk Pool purchase).

10. What is a Risk Pool?

A risk distribution pool combines the investments of many Captives into a single account that is held as a reinsurance pool. Risk is transferred from each individual Captive through a quota share reinsurance agreement whereby the re-insurer accepts a stated percentage of each and every risk within a defined category of business on a pro rata basis. This quota share agreement provides a fixed and certain risk for all Captives that bought coverage from the reinsurance pool. A contract is issued between the reinsurance pool and each Captive for the reinsurance pool to retain funds in its trust account for a certain period. A number of pools can be invested in, and access to them can usually be gained through a captive management company.

11. What is Reinsurance and how is it utilized by a Captive?

“Reinsurance” can be thought of as a means by which an insurer transfers some or all of the risk under a policy of insurance to another insurer or insurers. For example, a Captive may want to be exposed to only $500,000 per general liability claim. As a way to limit its exposure, it could purchase reinsurance to pay 50% or all of a claim exceeding $500,000.

Purchasing reinsurance stabilizes loss experience, increases capacity for undertaking risks and limits liability on specific risks. While the cost of reinsurance is lower than standard commercial insurance, it is almost always more expensive than the actuarial cost of the risk being transferred. Therefore, the cost vs. benefit must be carefully analyzed.

With reinsurance, an insurer, the Captive in this instance, transfers premiums
collected from customers to a re-insurer. In return, the re-insurer accepts part of the risk assumed by the insurer. In calculating the price of the risk transferred, the re-insurer takes into account the loss experience during the previous three to five years and the estimated future losses according to the types of risks insured and the loss experience using actuarial analysis. Interestingly, this is the same analysis that a commercial insurance company undertakes in analyzing and pricing commercial insurance policies.

The benefit to a Captive, and therefore to its owner, is that it can insure risks and then spread the risk of losses through reinsurance at a cost much lower than commercial insurance. Direct access to the reinsurance market is a significant benefit that a Captive provides, which typically would not be available to a business owner. Over time, as a company gains comfort with its Captive, it can shift risks that it has covered through the commercial insurance market to its Captive and protect its capital by re-insuring those risks to minimize its loss exposure to those risks.

12. Why is it advisable not to acquire life insurance from a captive?

Since Captives must be taxed as C corporations, investment vehicles that are not subject to current income tax are attractive assets. In that respect, permanent life insurance policies would seem an ideal asset for a Captive to consider owning because increases in cash value are not subject to current income taxation.

On the other hand, I.R.C. Section 264 states that life insurance premiums cannot be deducted either directly or indirectly for income tax purposes. Therefore, when a Captive owns life insurance, the IRS could conceivably attempt to collapse the business’ payment of premiums to the Captive and the Captive’s payment of premiums to the life insurance company, deeming them to be a single payment of premiums from the business directly to the life insurance company.

Such classification would result in a determination that any income tax deductions taken by the business for premiums paid to the Captive were improper. Because there is no authority on this issue, prudence and common sense are advisable to reduce any IRS risk. For instance, if life insurance is being contemplated as an investment for a Captive, the business should apply for it only after the Captive has been formed.
Also, its purchase should be for a significant non-taxable purpose. When life insurance is not a primary asset of a Captive, but a minority portion of a diversified investment portfolio, the likelihood of a successful challenge by the Service under Section 264 should be significantly reduced.

13. What is a Series Limited Liability Company (“Series LLC”)?
A Series LLC is a form of entity that allows a single LLC to establish one or more series of members, managers, membership interests, or assets, each of which has separate rights, powers, or duties related to specified property or obligations of the LLC. Each series may have a separate business purpose or investment objective.

A Series LLC is expected to provide limited liability protection to the members of each series and eliminate the expense of forming multiple entities for members that want to segregate assets and liabilities of different activities.

14. What are the benefits of using a Series LLC for Captive insurance?

Consider the example of a condominium when thinking about a cell captive structure. Just as each condo apartment resident has separate ownership of a piece of the entire building, cell members are kept separate from other cells under a single captive cell umbrella, which retains the captive license. Just as there would be a condo developer, here there is a sponsor of the core cell captive. That sponsor forms the cell captive with initial funding before selling off different units—the “cells”—that are used for various types of insurance business.

Unit A might be providing property insurance for a real estate organization, whereas Unit B could be providing professional liability insurance for midwives. Unit C could provide cyber-risk liability insurance for an ISP provider. Through the legal structure of the cells, the series LLC owner creates firewalls between these ‘condo’ units, so if Unit A suffers a catastrophic loss, it is contained in that unit or cell without the other cells being impacted.

The Series LLC legislation has furthered this effort. Before Series LLCs were permitted, a separate LLC had to be formed for each and every cell. Now, protected cell Captive sponsors can create just one LLC and have the ability to issue a unique series of preferred ownership interests to individual cells.

The minimum premium tax in a domicile usually applies to business written by all the cells, instead of each one individually.

15. How are “Insurance” and “Insurance Company” defined for federal income tax purposes?

A. Insurance
Neither the Internal Revenue Code nor the Treasury regulations define “insurance.” Instead, “Insurance” is defined by judicial precedent. The Tax Court in 1991 summarized prior judicial precedent and created a three-prong framework to be adopted when addressing a question regarding the existence of insurance for federal tax purposes: 1. presence of insurance risk, 2. risk shifting/risk distribution, and 3. commonly accepted notions of insurance.

A Captive must possess a legitimate business reason to avoid being characterized as a sham by the IRS (i.e., characterized as not being an insurance company). Some legitimate business reasons are as follows:

(1) To obtain coverage where insurers are unwilling to do so
(2) To reduce premium payments
(3) To control risk
(4) To increase cash-flow
(5) To gain access to the reinsurance market
(6) To create diversification
(7) To balance coverage

Each legitimate business reason for forming a Captive should be fully analyzed and documented from the planning stage through the formation of the entity. Any evidence that could be produced on audit to show the business purposes of formation may be extremely useful in combating sham characterization by the IRS.

B. Insurance Company

The Internal Revenue Code defines an “insurance company” as a company where more than half of the business during the tax year is derived from issuing insurance, annuity contracts or re-insuring risks underwritten by insurance companies.

16. How are insurance companies taxed for federal income tax purposes?

Section 7701 and its accompanying Regulations determine the classification for business entities recognized for tax purposes based on the entity’s ownership. Under those rules, an insurance company is treated as a “per se” corporation and, thus, is ineligible to elect any other classification than a C corporation for U.S. income tax purposes. To be clear, an insurance company must be taxed as a C corporation and not as a partnership or S corporation.

17. What types of risks does the IRS consider as not being insurance risk?

Only premiums paid for insurance risks qualify for deductibility by the operating company. Insurance risk is generally a risk that can have bad or neutral results. In contrast, speculative, business, or investment risk can generally have good, bad, or neutral results, and are therefore not considered legitimate insurable risks. Investment risk, services risk, and pure warranty risk are examples of risk that are not treated as insurance risks.

There is a difference between insurance risk and business risk. There is no definition in the Internal Revenue Code or Treasury Regulations regarding this, however. The IRS basically makes it up as they go along, generally preferring whatever position it better from an IRS perspective. There are some hotly debated types of coverage as to whether it is business risk or insurance risk. For instance, what is supply chain coverage? What is credit default coverage? There are no clear answers on some of these coverage’s.

To mitigate this risk, there needs to be as much fortuity in the contract so that there are more insurance qualities than mere business-type risks when the coverage is something that is outside of the traditional marketplace.

18. What does the IRS consider when evaluating whether a captive is a true insurance company?

Insurance considerations

A. Sufficient Risk transfer
B. Sufficient risk distribution among separate policyholders
C. Reasonable premiums as compared to risk
D. Claims payments
E. Standard policy forms
F. Use of risk-transferring insurance contracts
G. Reasonable reserves

Operational considerations
A. Maintain corporate formalities and comply with required insurance regulations
B. Licensed in all jurisdictions where the risks are located
C. Engage professional captive managerial expertise to operate the captive

Investment activity
A. Appropriate investment profile
B. Follow conventional investment strategies

Separation from insured’s operations
A. Reasonable/adequate capitalization; no parent guarantees
B. Transact business at arm’s length using actuarially determined pricing
C. No commingling of assets with the insureds
D. No loans with captive
E. Separate from insured’s operations
F. Separate letterhead, etc.

A. Non-tax business purpose
B. Implement loss prevention programs, including safety and quality control programs

Other factors considered when the IRS considered whether a captive insurance company has a legitimate business purpose include:

I. Was a feasibility study performed showing business benefits? The IRS is more likely to “find an adjustment” with a taxpayer that does not follow good business practice.
II. Assess whether the assuming company has the capacity to assume the risk. Look at the premium to surplus ratio. Are there any parental guarantees? What is the maximum single risk exposure compared to surplus?
III. Consider whether the risks are garden-variety insurance risks or unique risks that require further investigation into whether the risks are insurance risks.
IV. Consider whether the insured is in substantial part paying for its own losses, by comparing the relationship of the largest insured as measured by premiums to total premiums.
V. Consider whether there are sufficient exposure units for risk to be reasonably predictable (law of large numbers).
VI. Assess whether the Captive is operating as an independent entity and whether there is insurance in its generally accepted sense. Part of this is the question is could the Captive still function if its largest investment failed?
VII. Is there a loss portfolio transfer and is there a significant chance of a significant loss as required for GAAP under FASB 113?
VIII. If parent premiums are deducted, determine whether there is a sufficient amount of unrelated risk assumed by the Captive.
IX. Are Captive assets used as security or as a compensating balance for the liabilities of another entity?

19. How does the IRS treat a Series LLC cell that is a Captive insurance company?

When determining whether a transaction is insurance and if the insured receives a tax deduction, insurance is tested on a cell-by-cell basis. This means that the cell has to have risk distribution and transfer (enough insured’s and/or enough outside business) within its own walls and it cannot rely on the mere fact that cell owners are unrelated, unless it shares in other cells’ risks.
For the taxation of the cell and the entire cell company, the IRS:

1) proposed a set of rules, but did not finalize them; and
2) said they would not be effective for at least a year after they are finalized

As currently proposed, each cell:

• Is its own insurance company (if it sells insurance)
• Makes its own elections (for example, 953(d) and 831(b))
• Gets its own Federal ID number

20. What are the consequences if the IRS determines premiums paid to a captive to be excessive?

If the IRS, or upon the taxpayer’s appeal, a court determines that the insurance premiums being charged by the Captive are excessive, undesirable consequences follow. First, the premium-paying company loses the income tax deduction and, most likely, also has to pay interest and penalties. Second, the Captive may have taxable income. There also could be gift tax issues with the transfer for Captive business structures where the Captive is owned by the business owner’s descendants or trusts.

If the taxpayer-owner did not file a gift tax return, the taxpayer may be subjected to failure to file penalties, as well as other penalties. For this reason, the client may consider filing a gift tax return every year a premium is paid to a Captive. By filing the Form 709 and making proper disclosure, the gift tax statute of limitations will begin to run, and, thus, the transfer tax risk should be reduced

21. IRS Published Ruling and Guidance related to Captives

A. Rev. Rul. 77-316

Premiums paid to the captive were not deductible because there was no transfer of risk outside the “economic family”. It was made obsolete by Rev. Rul. 2001-31,

B. Rev. Rul. 78-277

Federal excise tax is not applicable to payments made to captive if they are not made pursuant to an insurance transaction. Had the captive assumed outside risks, however, the outcome could change. It was made obsolete by Rev. Rul. 2001-31.

C. Rev. Rul. 78-338

Premiums paid to association captives are deductible if there is a true sharing of risk between participants in, or owners of, an association Captive. Facts indicated 31 unrelated participants, no one of which accounted for over 5% of aggregate premiums. It was modified by Rev. Rul. 2001-31, then further modified by Rev. Rul. 2002-91.

D. Rev. Rul. 79-138

The computation of federal excise tax is based on gross premiums. Applies to portion of risk assumed by foreign re-insurers.

E. Rev. Rul. 80-191

The IRS will not follow the Crescent Wharf and Warehouse Company decision, which hold that an employer’s liability for workmen’s compensation is deductible in the year of an employee’s death or injury even if the amount of the liability is contingent upon the occurrence of future events. The IRS continues to disallow deductions for expenses not based on a fixed liability.

F. Rev. Rul. 80-222

Federal excise tax is payable on insurance premiums paid to alien insurers. Such payments should not, however, be subject to withholding tax of 30%.

G. Rev. Rul. 80-225

Alien insurer is doing business in U. S. and is therefore subject to U. S. income tax if it has an agent in the state.

H. Rev. Rul. 92-93

Parent corporation may deduct the premiums paid to its wholly-owned captive subsidiary with respect to group-term life insurance of its employees. It was modified by Rev. Rul. 2001-31.

I. Rev. Rul. 2001-31

IRS abandoned its 24-year old “economic family” argument for denying “insurance” status (and therefore premium/loss reserve deductions) for single parent and brother-sister captive insurance arrangements.

J. Notice 2002-70

IRS identified transactions involving so-called “producer owned reinsurance companies” (“PORCs”) as listed transactions, thereby subjecting such transactions to the disclosure requirements of IRC § 6011, the tax. In a typical PORC transaction, a service provider sells its customers a product or service and offers insurance on the product. The insurance contracts are issued by an unrelated commercial insurer, but are then reinsured with an offshore reinsurer owned by the service provider. The PORC elects domestic tax treatment under IRC § 953(d) and takes advantage of benefits provided by IRC § 501(c)(15) (tax exemption if annual premiums of $350,000 or less) or IRC § 831(b) (tax investment income only if annual premiums are between $350,000 and $1.2 million).