Captive Insurance Companies: A 2020 Year-End Update

Insurance is a contract whereby an individual or entity (the “insured”) pays a fee to a second party in return for financial protection against losses. An insurance company issues multiple contracts to multiple insureds with the goal of making a profit from a net gain between claims paid for losses and cumulative premiums received along with earnings from investment of those premiums. A captive insurance company (“captive”) is an insurance company owned and controlled by the insureds.

In the U.S., a small “captive” has tax benefits as outlined by Internal Revenue Code Section 831(b), which allows small captive insurers to pay federal taxes only on investment income, not on underwriting income. The maximum allowable premium for an 831(b) captive is $2.2 million annually.

During the early 2010s, the IRS started investigating captives for abusive transactions. In 2016, the IRS published Notice 2016-66 in which the agency advised that micro-captive insurance transactions have the potential for tax avoidance or evasion. The IRS filed suit against companies paying premiums to captives and won three major lawsuits starting in 2017. The Tax Court articulated four factors that indicate an arrangement constituting insurance:

• Insurance risk,
• Risk shifting to the insurer,
• Risk distribution, and
• Commonly accepted notions of insurance.

In these three cases, the Tax Court concluded that contracts between the captives and defendant companies had not passed the risk. In 2019, the IRS offered settlements to companies paying premiums to captives, which the IRS reported were accepted by 80% of the companies receiving such notice.

TYPES OF CAPTIVE COMPANIES

• Related Captives – The type of captive that was the focus of the IRS investigations and lawsuits. The lawsuits were not because of the relationship between the captive and the operating company. The lawsuits were based on the failure of the captives to meet the four factors above.
• Group Captives – Owned by a number of different companies generally in the same industry. The goal is for the operating company owners to have a lower cost of insurance. Premiums on a commercial insurance policy need to cover losses from well-run companies with less insurable incidents as well as losses from companies with greater insurable incidents. Generally, owners of the group captive are better risks than the general population because the owners make the decision to admit better risk companies as owners and insureds. Group captives are generally managed by an insurance professional who also places reinsurance policies for excess losses.
• Association Captives – Similar to a group captive except that it is affiliated with an association, members of which have a shared focus. Generally, all members of the association can be members of the captive.
• Industry Captives – Similar to an association captive except that its members are from the same industry. Often it is established to solve a specific insurance problem such as the unavailability of a specific type of insurance.

WHEN IS A CAPTIVE APPROPRIATE?

A captive can be a viable solution for insurance cost savings when the following requirements are met:

• The captive has a real risk of loss from claims.
• There is a shift of risk from the company to the related captive.
• The risk is distributed among all members of a group, association or industry captive.
• The captive behaves like an insurance company.

A properly formed and managed captive insurance company can provide a client company with significant cost savings and benefits. Risks of a defective captive occur when premiums are significantly larger than they would be if the coverage were purchased from an unrelated commercial insurance company; the premiums are not paid consistently; or when there is no actuarial analysis in setting premiums. The management of the captive can come into question should the captive not conform with the laws of the jurisdiction in which it is incorporated, or if there is not sufficient capital to assume the risk of claims. The captive’s assets should not include any type of illiquid assets not normally held by an insurance company. Also, there should be no “transactions of interest” with the owners of the captive. Typical transactions of interest include financing by or loans to an owner, as the captive can’t be treated as the company or owner’s “piggy bank.”

SUMMARY

In establishing a captive, to avoid these issues, owners should engage a consultant with expertise in insurance and actuarial operations. In many cases, a company interested in starting a captive can achieve significant cost savings by instead joining an industry or association captive that is already formed.

If a captive is set up and managed correctly, it is possible for a company to lower its insurance premiums. Eventually, upon the dissolution of the business, the owners can reclaim any funds remaining after paying claims. The related captive has a difficult, but not impossible task, meeting the above requirements. However, with the right counsel and planning, the related captive can provide insurance to its related company and end the year with a non-taxable profit.