Captive Insurance Companies

Captive insurance companies, otherwise known simply as captives, are wholly-owned subsidiaries of the insured. A captive insurance company is an insurance company created by the parent company to underwrite insurance for its operating affiliates. The main benefit of captives over self-insurance is that premiums paid to the captive is currently deductible, whereas deductions are only allowed for a self-insurance fund when claims are paid. Captives formed under IRC §831 (b), so-called microcaptives, have an additional tax advantage: within certain limits, they do not have to pay tax on the premium income, only on income earned through investments. Hence, microcaptives are often sold as tax shelters, which the IRS is currently targeting for audits.

A mutual insurance company is also technically owned and controlled by its policyholders, but differs from captives in that the policyholders of a mutual insurance company did not make an equity investment and do not have direct control of the company. Furthermore, policyholders of a mutual insurance company cease to be owners when the policy is canceled.

The primary advantages of forming a captive include:

covering particular risks where insurance is difficult to obtain or is expensive, such as political risks in foreign jurisdictions and terrorist attacks;
lower costs, by avoiding commissions and other marketing expenses, as well as other expenses incurred by insurance companies; the ability to deduct premiums paid to the captive and to earn investment return on the premiums that would otherwise go to commercial insurers;
easier access to reinsurance, since reinsurers only deal with insurance companies, not with insureds.

A captive insurer can also be a source of profits if it can sell insurance to other firms not within the corporate group. Captives also provide several tax advantages, especially small business captives. Indeed, captives have been used as tax shelters by the wealthy for many years. Because of the many benefits of captives, the number of captives used by US businesses has greatly increased from a few hundred in the 1950s to more than 6000 in 2013. Some nonprofit organizations and even some life insurance companies have also formed captives.

Captives are usually formed to retain risk up to a maximum: $250,000 is typical. Excess insurance is purchased to cover losses that exceed the captive limit. Setting a policy limit also makes it easier to calculate the premium based on actuarial tables, which must be done if the captive is expected to pass IRS scrutiny and qualify as a true insurance company. Because captives are organized as insurance companies under state law, it is subject to the domicile states regulatory laws, including reporting, and capital and reserve requirements.

Captive Formation

Captives can only be formed within jurisdictions that have captive enabling laws. The jurisdiction that the captive is formed under is the captive domicile of that company. Captive domiciles can be domestic or foreign. Most offshore captives are located in Bermuda or the Cayman Islands. In the United States, the most prominent captive domicile is Vermont, although at least 27 other states also have captive enabling laws. However, the parent or any other members of the group covered by the captive does not need to be located within the state or country of the captive's domicile.

The 1^st step in forming a captive is deciding on the domicile. The domicile of a captive is a state or offshore jurisdiction under which the captive is incorporated and licensed as an insurer. Although many captives were originally formed in Bermuda or the Cayman Islands, many states in the United States have adopted special laws favoring the formation of captive insurers. Vermont is the domicile of most of the captives domiciled in the United States. In 2013, more than 1000 captives were domiciled in the US.

States and countries compete for the captive insurance business by enacting favorable laws. Nonetheless, the choice of domicile is important, since the captive must satisfy all legal requirements. To maintain solvency, these requirements include a minimum of capital and a minimum surplus-to-premium ratio. Captives are a viable option only if at least $500,000 of premiums is expected to be paid into the captive annually.

Many people with specialized knowledge of captives will also have to be employed, including accountants and auditors, actuaries, attorneys, and managers to run the captive. Most small businesses use a captive manager, a company that specializes in managing captives that provides the know-how in managing the captive, such as drafting policies and keeping the captive in regulatory compliance.

Types of Captives

There are several types of captive insurance companies: pure captives, association or group captives, and cell captives. A pure captive is owned by 1 parent. A pure captive is a created entity for the sole purpose of underwriting risks for the parent and its affiliates, but does not include affiliates whose main purpose is to sell insurance to the public.

An association or group captive is owned by several parents, such as those that belong to a trade or association. An association or group captive is like a pure captive but it underwrites the risks of a group of companies, thus the name. Frequently, these captives were called trade association insurance companies or as risk retention groups. The term risk retention group is a group owned captive organized under the Risk Retention Act.

Businesses that are too small to form captives of their own may be able to use a sponsored captive, which is a captive created by an unrelated 3^rd party. The sponsored captive provides a cell captive to each of its members, where the capital invested by the business is only used to cover the losses of that business; a cell captive is not exposed to the losses of the other cell captives. Some sponsored captives may only charge a fee for a cell captive, often called a rental captive. A business using a cell captive may eventually be able to form its own captive if it accumulates sufficient reserves. A sponsored captive is owned by its members and each member has a voting privilege over the control of the sponsored captive.

Benefits and Drawbacks of Captives

There are several benefits and drawbacks to captives. Benefits include:

The captive can be used as a source of cash in trying times.
Even when commercial insurance is available to cover certain risks, it will probably be much more expensive than what a captive can provide, because captives do not have to pay for marketing or advertising expenses and executive compensation will probably be less, since there will be fewer executives and the parent company has more control over their compensation.
The captive may become a major insurance business that can sell policies to the public, simply by changing its license and fulfilling other state requirements.
Because the business pays for its own risks, moral hazard is minimized, since the business will manage its risk carefully to avoid paying for its own losses.
The captive has more control over its policies, and claims management, and can choose its own attorneys.
Specific risks that cannot be covered by commercial insurance can be covered by a captive.
Captives also have access to the reinsurance market, which is only available to insurance companies, not to the insured.
A major tax advantage is that the parent company can deduct premiums paid to the captive, but the loss reserves can be accumulated by the captive tax-free until they are paid out as earnings.
Captives can also be used to lower premiums for risks for which a particular business has a lower loss experience than similar businesses in the industry, since commercial insurance companies generally base the premium on the overall loss history of the industry.

The drawbacks of captives include the following:

Because funds held by the captive must be available to pay for losses, investment choices are generally limited to investment-grade securities, which may incur an opportunity cost.
The captive management is often inexperienced, often relying on employees of the parent and outside consultants as a means of saving money rather than outsourcing the management to insurance professionals.
Expenses are often excessive, especially when the captive is part of a group, since expenses associated with the group are often determined by the promoters and management of the group.
If the captive qualifies as an insurance company, then the captive can use insurance accounting, which allows premiums paid to the captive to be deducted by the insured business. However, if insufficient risk, both underwriting and timing risk, are transferred to the captive, then it will not be treated as an insurance company, so it must use deposit accounting, where the premiums paid are treated as deposits rather than as income, so the loss reserves will be treated as a nondeductible liability of the captive, much like a bank deposit is an asset to the customer but a liability of the bank.
A captive may decrease the parent company's short-term cash flow. If the parent company simply retained the risk, then it can hold on to the cash until it must pay for the loss. On the other hand, premiums must regularly be paid to the captive, reducing the parent's liquidity.
Because captives are frequently used to shelter gratuitous transfers from taxes, governments and tax authorities are often changing the laws and regulations to rein in abuses, which is a significant legal risk of captives.
A major disadvantage of group captives is that each individual captive does not have direct control over loss prevention or claims management for the group, thus leading to uncertain expenses.

Taxation of Captives

As insurance companies, captives are generally subject to state premium taxes and taxes on excess and surplus lines; captives domiciled outside the United States may have to pay a federal excise tax. Otherwise, the tax rules that apply to most insurance companies also apply to captives. However, microcaptives have additional tax advantages.

Premiums paid to a single parent captive cannot be deducted because there is no risk shifting or risk distribution. The IRS may allow premium deductions if the pure captive provides significant coverage for affiliates of the corporation, covering so-called brother-sister risks. Case law also allows premiums to be deducted if at least 30% of net premiums are derived from unrelated loss exposures.

Microcaptives as Tax Shelters

Originally, captives were formed so that the parent company could deduct premiums paid to the captives, so that they would not be considered nondeductible contributions to a self-insurance reserve. However, the IRS has contended that there is no shifting of risk or distribution of risk through pooling of premiums for single-parent captives, since the premiums remained within the economic family.

Some captive insurance companies are being sold and used as tax shelters, especially captives that have elected to be taxed as a small insurance company under IRC §831(b), otherwise known as microcaptives. These so-called tax-shelter captives attempt to save on taxes by paying excessive premiums and covering nonexistent risks. But they often fail to satisfy other legal requirements, such as having adequate capital and basing premiums on a sound actuarial basis.

Because captives have been used as tax shelters for many years, the IRS scrutinizes captives to ensure that there is a real transfer or pooling of risk; otherwise, there would be no real economic benefit for a company to pay premiums to itself. For years, the IRS has restricted the tax advantages of captives because they were considered part of the economic family of the parent corporation. Nowadays, the IRS allows the deductions of premiums paid to captives if its rules are followed.

Microcaptives were used as tax shelters because the §831(b) regulations allowed up to $1.2 million to be paid annually to a captive that was entirely deductible by the parent corporation but that was not taxed as income to the captive; only the captive's investment income was taxed. Thus, microcaptives became an effective way to transfer wealth across generations, such as when the business owner of the parent company pays premiums to a captive owned by his children, or to purchase life insurance with tax-free funds. However, the IRS has attacked these microcaptives as the tax shelters that many of them were, especially since the law governing microcaptives was not clear. Consequently, even legitimate businesses were uncertain whether they were complying with the law when using a captive. The IRS had set a stringent requirement that a captive will be treated as an insurance company if it insured at least 31 unrelated companies.

However, in 2002, the IRS enacted Revenue Ruling 2002-89 providing a safe harbor for deducting premiums paid to a captive if the premiums paid by the parent do not account for more than 50% of the captive's annual income. Revenue Ruling 2002-90 stipulates that a captive will be treated as an insurance company if it conducts itself as one, including engaging at arm's-length transactions with subsidiaries of the parent, such as when setting premiums, and not lending money to either its parent or its brother-sister subsidiaries.

For group captives, Revenue Ruling 2002-91 stipulates that a group captive will be treated as an insurance company for federal tax purposes if no member owns more than 15% of the captive nor has more than 15% of the voting power over the governance of the captive. The corporate group must be structured as a holding company, so that the parent and each subsidiary is independent of the others in such a way that the failure of one will not affect the others.

Some captive sponsors sold captives as a tax shelter by using risk pools to satisfy the 50% safe harbor. For instance, the captive manager may have 20 participants in the risk pool, where each contributes 5%, $250,000, into the pool. At the same time, each captive would issue a reinsurance policy to the risk pool for the same premium paid by the parent to the risk pool, thus receiving the $250,000 that the parent paid to the risk pool. So the captive ends up with the $500,000 paid by the parent, which the parent deducts, rationalizing that it has satisfied the diversification requirement by participating in the risk pool, since 50% of the premium earned by the captive came from the reinsurance premium paid by the risk pool.

Many of these tax shelters were advertised by guaranteeing that there would be no losses in the risk pool because they would be insuring events that were highly unlikely, or deductibles were high enough to cover actual losses, or because each participant signed an agreement that they will reimburse the pool if the participant files claims of a significant amount. Obviously, this scheme is not real insurance and will not pass muster with the IRS. Indeed, the IRS has a strong motivation to audit risk pools, for if the risk is not truly pooled, then the deductions that were claimed by each participant of the pool will be invalid. Hence, by auditing the captive manager, the IRS can collect back taxes from every participant in the pool.

However, starting in 2017, the Protecting Americans from Tax Hikes Act of 2015 increased the premium limits by $1 million, to $2.2 million, but made the diversity requirement harder to pass. The diversity requirement could be satisfied with 1 of 2 tests. The 1^st test requires that no more than 20% of the premium paid to a captive can come from any single policyholder, defined as any business owned by the owner of the captive or of the parent corporation or any of its subsidiaries, including any of the above that are owned by the owner's spouse or other heirs, or any business that is part of the same control group. The 2^nd test is that the ownership percentage of the captive held by the spouse or heirs of the business owner cannot exceed 2% + the percentage of ownership held in the business being insured. For instance, if the daughter of the business owner owns 35% of the business being insured, then she cannot own more than 37% of the captive. Likewise, if the business owner owns 100% of the business, then the daughter can only own 2% of the captive. Any captive that is not in compliance with the new regulations will have until December 31, 2016 to comply.

Nonetheless, the main test will be whether the microcaptive is an actual insurance company: whether there is a true distribution or transfer of risk; whether the insurance was for a real risk, one for which claims are paid periodically; whether there are any contract provisions that would negate the transfer or distribution of risk, such as high deductibles or reimbursement provisions; and whether the transactions were at arm's length.