Malley, Stephen : Captive Insurance Companies

I. INTRODUCTION Captive insurance companies (‘Captives’) offer a significant planning tool for U.S. companies. A Captive typically insures its owner-parent and/or related companies, and its assets are owned and controlled by its owner. Industry publications estimate that there are in excess of four thousand offshore Captives, and the use of State domiciled Captives is steadily increasing. Captives might be owned by a single company or group of companies, by an association of companies in a particular industry, or by a Trade Association. Captives are used by local governments, hospitals, and non-profit organizations.Captives may be owned by their insureds, and some insurance agencies, brokers and insurance administrators maintain Captives for use by unrelated insureds, which are sometimes referred to as ‘Rent-A-Captive’ arrangements; in addition to insurance, these may serve to meet legal requirements and to avoid the maintenance and capital requirements of an owned Captive. While not discussed in this article, the Special Purpose Vehicle (SPV), is a form of reinsurance company designed to securitize risks by issuing bonds to the capital markets, and the Risk Retention Group, authorized by the Federal Liability Retention Act of 1986, generally allows industry specific companies to insure members in several States. A Captive may serve a number of purposes, for example, to reduce premiums by increased retentions, to provide insurance at predicted costs to avoid otherwise unpredictable and fluctuating premium levels, to control the claims process, and to access reinsurance markets directly. A Captive can in addition provide insurance coverage not otherwise available. The tax benefits of a Captive are discussed below.
II. TAX DEDUCTABLITY OF PROPERTY AND CASUALTY INSURANCE PREMIUMS Captives may provide significant tax benefits because premiums paid for casualty insurance can be deducted as a business expense under IRC section 162, provided the premium is reasonable and there is a legitimate business purpose for the insurance. The Court of Appeals in one well known insurance case states, “A ‘business purpose’ does not mean a reason for a transaction that is free of tax considerations. Rather, a transaction has a business purpose (if it) figures in a bona fide profit seeking business”. While a company can self-insure by creating a bookkeeping reserve for claims, no tax deduction is allowed regardless of whether the reserve is based on claims or premiums history. The IRC does not define insurance, and IRC section 162(a) simply states that ‘ordinary and necessary’ business expenses are deductible. IRC Regulations define business expenses to include premiums for insurance against fire, storms, theft, accident or ‘other similar losses in the case of a business’. In general, any reasonable risk of a particular business can be insured against. However, the courts have sought to define what is an ‘ordinary and necessary business expense’ and in fact this issue has been frequently litigated. The general rule is that a business expense need not be absolutely necessary, but only reasonably ‘appropriate and helpful’. The term ‘ordinary’ does not necessarily mean continuing or repeating.

III. INSURANCE DEFINED The definition of ‘insurance’ has been left to the courts. An analysis of the extensive case law history is beyond the scope of this article, but the authoritative 1991 case of Harper Group v Commissioner established a three- part test to determine the existence of ‘insurance': (1.) there must be a real insurance risk, i.e. a risk which the particular business has; (2.) there must be ‘risk shifting’ and ‘risk distribution’, discussed below, and (3.) the arrangement must provide for insurance in its ‘commonly accepted sense'; this last requirement essentially means that premiums are paid to an ‘insurance company’, which can be a licensed Captive, that the premium is reasonable for the coverage provided, that the polices are legal, binding contracts, and finally that the insurance company is ‘adequately capitalized’. Once a company determines that a Captive is an attractive alternative, its analysis must then focus on a number of issues, including the deductibility of the premiums to be paid, and the Company might be wise to insist on qualified actuarial support for the premium. Next, the company will want to ensure that its Captive or Rent-A-Captive accomplishes ‘risk shifting’ and ‘risk transfer’, concepts which have a long tax court history. Risk shifting may be best understood by an example of a situation which fails this test: a single purpose captive insuring its parent company does not shift the risk of loss from the company to the captive, because a claim paid by the captive directly affects the balance sheet of the parent company. However, a Captive might insure a parent company and number of subsidiaries, provided the parent company actually shifts the risk of loss among the subsidiaries, on an arms-length basis. A 2005 Revenue Ruling, provided the example of a company conducting business through 12 Limited Liability Companies, all insured through a single purpose captive. The Ruling finds the risk shifting occurs if the 12 LLCs elect to be classified as Associations for Federal tax purposes, i.e., are not pass-through entities for tax purposes. While this Ruling does not provide a specific safe harbor (how many subsidiaries less than 12 would be sufficient?) it does confirm that the insured must transfer some of the economic risk of loss to other entities.