Why Form A Captive?
Captive Property & Casualty Insurance Companies
Your company may also benefit from creating, owning and fully funding a Captive Property & Casualty Insurance Company (henceforth called a Captive) that operates under the Internal Revenue Code (IRC) Section 831(b) that addresses a specific type of Captive.
There are numerous potential advantages to forming a captive insurance company. Captive insurance companies are formed primarily for risk management purposes. For example, by forming a captive insurance company, a business can dramatically lower insurance costs in comparison to premiums paid to a conventional property and casualty insurance company. By establishing one’s own insurance vehicle, costs for overhead, marketing, agent commissions, advertising, etc., may result in significant savings in the form of underwriting profits, which can be retained by the owner of the captive company.
Additionally, a captive insurance company can provide protection against risks which prove to be too costly in commercial markets or may be generally unavailable. The inability to obtain specialized types of coverage from commercial third-party insurers is another reason why clients may choose to establish a captive insurance company. With a captive insurance company, a business owner can address their self-insured risks by paying tax deductible premium payments to their captive insurance company. To the extent the captive generates profits, those dollars belong to the owner of the captive.
In most cases, to the extent existing P&C coverage is reasonably priced, business owners will continue to maintain existing policies for their traditional coverage and supplement existing coverage by addressing their self-insured risks with their own captive insurance company. Policy features, coverage and limits can be drafted to meet specific enterprise exposures. This allows for many risk-management advantages, including:
- Greater Control over Claims
- Increased Coverage
- Increased Capacity
- Underwriting Flexibility
- Access Reinsurance Market
- Incentive for Loss Control
- Reduced Insurance Costs
- Capture Underwriting Profit
- Pricing Stability
- Improved Claims Review and Processing
Our feasibility analyst team works closely with Oxford Risk Management Group to determine the best balance between coverage retained from commercial carriers and your captive insurance carrier.
We rely on Oxford Risk Management Group to coordinate the services of a captive manager, risk manager and actuary to determine an appropriate amount of premium to be paid for the coverage being provided. Premium payments made by the operating company to the captive insurance company for property and casualty insurance coverage should be tax-deductible as an ordinary and necessary business expense, just as they would be treated had they been made to a traditional insurance company.
Internal Revenue Code Section 831(b) provides that captive insurance companies are taxed only on their investment income, and do not pay income taxes on the premiums they collect, providing premiums to the captive do not exceed $2.2m per year based on legislation that was signed into law on December 18, 2015 which increased the premium limitation from $1.2m to $2.2m per year for taxable years beginning after December 31, 2016. This new limit is indexed for inflation annually and has been increased to $2.3m annually for tax year 2018.
Further, the captive may retain surplus from underwriting profits within reserve accounts, free from income tax. It can also generate profits by controlling or eliminating costs for overhead, marketing, advertising, agent commissions, profits, etc., items normally built into the premiums charged by traditional insurance companies. After adjustment for expenses and claim payments, net underwriting profits are retained within the captive insurance company. Over the years, profits and surplus may accumulate to sizeable amounts, and may be distributed to the owner(s) of the captive company as either dividends or long-term capital gains under current tax law.
Amounts set aside as reserves for potential claims payments, plus capital surplus, should be maintained in safe, liquid asset classes so that the captive has adequate solvency to pay claims when called upon. The formation of your Captive Insurance Company and eventual issuance of a certificate of authority to do business, are subject to approval by the insurance regulators in the jurisdiction where the insurance captive is formed. The insurance regulators will also oversee the organization and ongoing operation of the captive insurance company to assure ongoing compliance with the rules for that jurisdiction.
The new 2015 tax legislation adds diversification requirements to the 831(b) eligibility rules. A company can meet these rules in one of two ways – allowing for continued enjoyment of captive benefits and section 831(b) eligibility. Ownership options for your captive remain very flexible but requires the assistance of competent advisors and an efficient captive structure to assure compliance with the new eligibility rules.
A properly designed Captive Insurance Company arrangement can provide many advantages for the insured enterprise and the owner(s) of the captive. Our Professionals working closely with Oxford Risk Management Group will work with your legal and tax advisors, your risk management department and coordinate the activities of Oxford’s Best-in-Class professional advisors, to help ensure that your captive arrangement is compliant and meets all requirements for successful implementation.
Captive insurance planning involves sophisticated insurance and risk management issues, regulatory and corporate legal issues, federal, state and, in the case of an offshore captive, usually international tax issues, and a wide range of accounting and financial issues. This planning is circumstance-specific. It is not appropriate to apply the general information described herein to any singular situation. The formation of a captive is a small part of a client’s implementation of alternative risk planning; a captive’s mere formation is dwarfed in complexity by its ongoing operations. As a result, this planning should not be undertaken without a competent team of professionals who have extensive experience in captive insurance and alternative risk planning and are prepared to operate the planning on a going forward basis.
Case Law History
Helvering v. LeGierse (1941)
Established the principle that both risk shifting, and risk distribution are requirements for a contract to be treated as insurance.
Crawford Fitting Co. v. U.S. (1985)
Insurance premiums paid to a Captive by a group of separate corporations that were owned and controlled by a group of related individuals were deductible. The shareholders of the captive were not so economically related that their transactions had to be aggregated and treated as the transactions of a single taxpayer.
Humana, Inc. v. Com’r (1989)
Held that the brother-sister captive arrangement constituted insurance and premium payments of the captive’s brother-sister entities (but not its parent) were deductible.
Ocean Drilling & Exploration Company (1991)
Deduction allowed for premiums paid to a Captive that was a wholly owned subsidiary based on the following facts: 1) The insured faced recognized hazards. 2) Insurance contracts were written, and premiums paid. 3) Unrelated parties purchased insurance. 4) Premiums charged were based on the commercial rates 5) The company’s capitalization was adequate.
Kidde Industries, Inc. v. U.S. (1997)
The Court held that premium payments made by brother-sister entities to the captive were currently deductible. Payments made by divisions of the parent corporation did not constitute insurance premiums deductible under IRC §162.
The Harper Group v. Com’r (1992)
Risk shifting, and risk distribution were present where the captive received 29 to 32 percent of its premiums from unrelated parties. The captive arrangement was found to constitute insurance and payments made to the captive were deductible.
Sears, Roebuck and Co. and Affiliated Corporations v. Commissioner (1992)
The Court recognized the premiums were determined at “arm’s length”. 99.75% of premiums paid to Allstate came from unrelated insureds. The IRS’s “economic family” argument was rejected.
United Parcel Service vs. Com’r (2001)
The Tax Court sides with UPS based on the economic-substance doctrine.
Rent-A-Center, Inc. v. Com’r (2014)
On January 14, 2014 the Tax Court upheld deductions for insurance premiums paid by the parent company’s wholly owned subsidiaries to another wholly owned captive insurance subsidiary. The Tax Court found the captive to be a bona-fide insurance company, adequately capitalized and regulated, organized and operated as an insurance company, issued valid and binding policies, charged and received actuarially determined premiums and paid claims. (Rent-A-Center, Inc., 142 T.C. No.1 (2014)).
Securitas Holdings, Inc. vs. Com’r (2014)
Ruling in the Securitas vs. Commissioner captive insurance case was issued on October 29, 2014 by the United States Tax Court. The Court found the captive insurance arrangement was valid. It was somewhat similar to Rent-A-Center – a “brother-sister” case with a guaranty and a large percentage of the premium paid by one subsidiary. It distinguished a guaranty from adverse cases, and looked more to the exposure units, than the concentration of risk in determining adequate risk distribution.
Benjamin and Orna Avrahami vs. Com’r (2017) Holdings, Inc. vs. Com’r (2014)
This United States Tax Court decision was issued on August 21, 2017. It denied deductions for premiums paid to off-shore insurance companies, and determined, among other things, that elections under IRC Section 831(b) were invalid, as the amounts paid did not qualify as insurance premiums for federal income tax purposes.
The fact pattern for this case is not indicative of how compliant captive insurance companies are currently structured or managed. The Tax Court found that the captive’s direct insurance arrangement fell short on risk distribution, as it failed to meet the minimum requirements for a valid structure. The Court also concluded that the terrorism coverage utilized in the policy was drafted in a manner that made claims highly unlikely. For this, and other reasons, the Court also found the risk pool was not a bona fide insurance company.
The Court also determined that the arrangement did not constitute insurance in the commonly accepted sense. In reaching this conclusion, the Court found that the pricing was not realistic, claims were not made until after an audit was initiated, claims were not addressed in an orderly fashion, and the insurance policies were internally inconsistent.
This Tax Court decision is great news for the captive industry as it brings clarity to the use of 831(b) arrangements and helps highlight features of non-compliant programs. It provides a clear picture of what “not to do” when structuring and managing a micro-captive arrangement, and also provides additional clarity and reaffirmation of many of the best practices employed by Oxford Risk Management Group. (Avrahami, 149 T.C. No. 7 (2017)).