Why would a family business want to form a captive insurance company (CIC)? The potential benefits include improved risk management, savings on insurance premiums, asset protection, estate and succession planning advantages and retention of key employees.
A CIC, which is an insurance company affiliated with the operating business entity it insures, is typically formed to provide the business with insurance supplementing its commercial coverage. For more than 50 years, large U.S. corporations have used CICs to obtain better rates on reinsurance, allow coverage of risks not available at a reasonable price on the commercial market or replace commercial insurance coverage. Eighty percent of Fortune 500 companies are estimated to operate one or more CICs.1
More recently, family businesses and closely held businesses have been able to enjoy these same benefits of CICs. Previously, it wasn’t cost-effective for a small business to form one. As more U.S. states and foreign jurisdictions enact CIC legislation, however, the forces of competition have resulted in lower costs for CIC formation and operation. In addition, the tax rules governing small CICs have become increasingly clear, thanks to guidance published by the Internal Revenue Service.2 Internal Revenue Code Section 831(b) has included a significant income tax benefit for small insurance companies since 1986. Under this section, eligible companies are taxed only on investment income. IRC Section 806 offers tax subsidies to small life insurers, including CICs formed to provide medical stop-loss insurance.
As a result of these developments, small CICs now can achieve many of the same risk management benefits as the larger ones. In addition, they provide important asset protection benefits, because an insurance company’s assets by statute are exclusively reserved to policyholders and aren’t accessible to creditors of either the business owners or the CIC owners. As an enhancement to asset protection, CIC policies can be written to be completely nonassignable and to provide reimbursement to policyholders only after they’ve paid a covered loss out of other resources. These features discourage creditors from litigating to obtain payment from the CIC.
Estate-planning benefits may also be available if business owners’ family members, or trusts for their benefit, own the CIC. Although the initial capital contribution required to obtain an insurance license, if paid by the business owners, would be a taxable gift to the family members, any increase in the value of the CIC’s shares over time would result from its profitability and wouldn’t be a taxable gift. This benefit is similar to the treatment of appreciation of assets transferred to a properly structured grantor retained annuity trust (GRAT): While a portion of the assets’ value at the transfer date may be a taxable gift, subsequent appreciation is a benefit to the remaindermen not subject to gift or estate taxes.
In the case of a CIC (as well as a GRAT), the subsequent appreciation in stock value may never happen. An insurance company’s assets are subject to claims of policyholders. Importantly, as discussed below in “Risk Shifting and Risk Distribution,” the policyholders of a family business CIC usually include businesses not related to the family. This situation means the family can’t control the amount of claims made against the CIC and its profitability. However, CICs, historically, have had a higher profit margin than commercial insurance companies. This gap exists because overhead, acquisition and marketing costs can be largely eliminated, and more control on claims tends to be exercised.3
In addition to estate-planning uses, key employees may be issued shares in a CIC, to vest over a period of time, as an incentive for them to remain with the business. Children of the first generation of business owners may be given shares of a CIC at its formation, when the shares have a low value, rather than interests in the business. If they work in the business, they’ll have an incentive to improve risk management practices, minimizing claims made by the business against the CIC. They’ll also be motivated to contribute to the business’ long-term success.
The two most common business reasons for the formation of small CICs are the: (1) capturing of profits from low risk exposures, and (2) coverage of uninsured or underinsured losses. An example of a CIC formed to capture the profit of commercial coverage would be a small business that carried Employment Practices Liability and Employee Fidelity insurance for several years without experiencing any claims or losses under the policies. The small business could choose to self-insure these lines of coverage through a CIC, capturing the profit from its own premiums.
A manager should also consider the expectation of occasional large losses, which would weigh against shifting coverage completely to a CIC. To address this situation, a CIC may write policies that supplement, rather than replace, commercial ones. Often, once the CIC is formed, the commercial insurance is renegotiated to include a high deductible limit. The CIC insures risk up to the deductible limit, while the commercial policy covers the excess risk. In this way, businesses using CICs realize savings in the commercial insurance premium payable. Because first-dollar risk coverage is always more expensive than the excess risk layer, the savings achieved by this strategy may be substantial.
The second most common reason for forming small CICs is the insurance of “self-insured,” that is, currently uninsured, risks. The first place to look for these risks is the list of exclusions in the business’ commercial general liability and property policies. The CIC writes policies to cover some or all of these excluded risks. The CIC coverage may also be excess to the commercial coverage, insuring losses above the commercial policies’ limits.
In addition, the CIC can write policies covering completely uninsured business risks. A well-known advantage of CICs is that they’re not bound by coverage terms filed with a state’s insurance department. They can write non-standard coverage for premiums which, although likely to be higher than those charged for narrower commercial policy forms, are equally likely to be below those charged by, for example, Lloyd’s of London, whose premiums would be expected to cover its overhead costs and substantial profits, as well as the actual cost of insurance. For instance, a small business forming a CIC might arrange for insurance against lost business revenues attributable to hazards, such as new competition in the insured’s marketplace, loss of a key employee, loss of a valuable contract or legislative and regulatory changes. In addition, the CIC might write insurance for administrative actions coverage, which would pay the insured its legal expenses, fines and assessments associated with an administrative (non-judicial) proceeding, such as a Medicare audit or Occupational Safety & Health Administration investigation.
One result of the Patient Protection and Affordable Care Act is an increase in medical stop-loss CICs formed by small businesses, particularly those with favorable demographics or claims experience. These CICs (sometimes formed as group CICs) enable the businesses to self-insure employees’ health care risks at potentially significant savings, compared with plans offered through insurance exchanges. These arrangements are subject to regulation under state law.
Recently, the IRS increased its scrutiny of small CICs. Audits appear to focus on issues of economic substance and business purpose, raising the issue of the motivation of the business owner in forming a CIC. If the motivation was purely to obtain a tax deduction for an insurance expense, the CIC wouldn’t be respected as a valid insurance company for tax purposes, and the deduction for premiums would be disallowed. Under the judicial doctrine of economic substance, a structure can be disregarded for tax purposes when it has “no economic effects other than the creation of tax benefits.”4 Some courts have held that even if a transaction has economic effects, it may be disregarded if it has no business purpose and its only motive is tax avoidance.5
A recent Advisory Memorandum from the IRS Chief Counsel’s Office may signal that insurance companies formed offshore will be increasingly targeted.6
Despite IRS attacks, there’s solid legal authority for the proposition that a business may legitimately decide to form a CIC without having the government question its business judgment in doing so. In the leading case of United Parcel Service of America, Inc. v. Commissioner,7 the U.S. Court of Appeals for the Eleventh Circuit reversed a Tax Court decision finding that UPS had engaged in a sham transaction involving the formation and operation of a CIC issuing shipping insurance. The court rejected the application of the business purpose test to a captive insurance transaction. The court’s decision, in effect, attributed to the CIC the legitimacy of the business operation that it was formed to serve. The opinion stated that “. . . a transaction has a ‘business purpose,’ when we are talking about a going concern like UPS, as long as it figures in a bona-fide profit seeking business.”8
In the recent Rent-A-Center, Inc. and Affiliated Subsidiaries v. Comm’r case,9 the Tax Court held that a Bermuda insurance company formed as a CIC to several related businesses operating rent-to-own stores throughout the United States was a valid insurance company, and premium payments made to it by the businesses were deductible as insurance expenses. The IRS had claimed that the CIC was a sham entity created primarily to generate income tax savings. The IRS pointed out that the CIC’s assets consisted in part of deferred tax accounts, guaranties of the parent company and Treasury shares of the parent company and argued that the economic substance of the arrangement was merely an accounting device and not an independent insurance company.10 The court declined to apply a “vague and broad ‘economic reality’ test” and held that the legal tests of validity are risk shifting and risk distribution (discussed below), unless sham factors are present.11
Courts analyzing captive insurance transactions, including the Tax Court in Rent-A-Center, rely, in part, on a list of factors indicating sham transactions to determine whether to respect the CIC for tax purposes. These factors, briefly summarized, are: (1) the CIC is thinly capitalized; (2) its parent or affiliated business supports it by means of guaranties or letters of credit; (3) the CIC is loosely regulated in the jurisdiction where it’s licensed; (4) the businesses insured by the CIC don’t truly face the risks insured; (5) the premiums charged by the CIC aren’t based in part on commercial rates; (6) the validity of claims isn’t established before payment is made; (7) there’s a circular flow of funds; and (8) the CIC’s business operations and assets aren’t kept separate from those of the affiliated business.
Risk Shifting and Risk Distribution
Absent factors indicating a sham transaction, the courts acknowledge the deductibility of insurance payments to a CIC as long as risk shifting and risk distribution are present. These are terms of art that have been defined by a long line of cases and addressed in many IRS rulings. Risk shifting and risk distribution are the two litmus tests applied to CICs since the U.S. Supreme Court case, Helvering v. LeGierse.12 In any proposed CIC situation, these tests need to be carefully complied with.
Risk shifting occurs when the risk of loss passes from the insured to the insurer. Risk shifting can’t occur when the insured entity is the direct parent of a CIC.13 In a parent-subsidiary structure, the financial consequences of a loss remain on the parent’s balance sheet. Outside of a parent-subsidiary structure, however, risk shifting isn’t difficult to achieve and hasn’t often been raised in recent cases or rulings. However, recent Chief Counsel Advisories from the IRS suggest that arrangements in which an insured is given partial refunds of its premiums if it doesn’t make claims, or is surcharged if it does make claims, may undermine risk shifting.14
More difficult to achieve is risk distribution, which requires an insurance company to spread the risk of loss among a large number of insureds. By assuming numerous relatively small, independent risks that occur randomly over time, the insurer smoothes out losses to match more closely its receipt of premiums.15 The IRS established a safe harbor of 12 insureds, each accounting for approximately equal premium payments to an insurance company, for risk distribution to be sufficient.16 Most small business structures don’t involve this number of affiliates. Accordingly, small business CICs generally join risk pools to accomplish the required risk distribution.
Risk pools are structured in various ways, sometimes involving primary insurance and sometimes involving reinsurance. Multiple lines of coverage may be involved in a pool. The thought of joining a risk pool with other, unaffiliated businesses can be alarming to a small business owner. It’s important to find an actuarially stable risk pool providing a level of risk that’s both acceptable to the business owner and substantial enough to qualify as real economic risk. As noted above, there should be no side agreements shifting risk back to pool members that make claims. In 2012, the IRS published three private letter rulings illustrating different risk pools that it determined were bona fide.17
While CICs can legitimately be formed for a variety of business reasons, they shouldn’t be used improperly. A CIC that’s formed to create a fund of pre-tax monies for investment in property available for the personal use of the business owners or employees wouldn’t be considered valid by insurance regulators or tax authorities. Similarly, CICs that are formed to purchase life insurance on the lives of the business owners and spouses will be closely scrutinized. Life insurance, as a captive investment, isn’t illegal and, in many ways, is well-suited as an investment of a small CIC. Nevertheless, CICs that are formed simultaneously with an application for life insurance or which pay most of their annual income in life insurance premiums will be viewed as merely a means to finance life insurance investments and, in many cases, disregarded.
Other mistakes made by CIC owners and businesses forming CICs include the commingling of funds and assets. A CIC’s assets must be maintained separate and apart from those of the operating business and its owners. Often, the latter want to borrow funds from the CIC. While this transaction isn’t improper, particularly if the loans carry commercial interest and are adequately collateralized, it’s a situation the IRS has said it will study.18 Co-investments between a CIC and the insured business or affiliate don’t seem to be in the same category. However, these agreements also should be structured carefully so that each party to the transaction is allocated profits and losses commensurate with its capital contribution.
Another problem that can arise is the failure of a CIC’s business plan to address actual hazards of the operating business. Some CIC programs attempt to apply a package of coverage to all participating businesses, without verifying whether each business is actually subject to the risks covered. A CIC’s business plan should be based on the particular risk profile of a business and its commercial insurance coverage.
Finally, in many IRS audits, the presence or absence of claims made under a CIC’s policies is an important factor. While there’s no regulatory or tax requirement that any particular number of claims be made in any particular period, a failure of an insured business to make any claims against a CIC for several years raises the issue of whether the CIC is covering real risks of the business.
1. David N. Kotkowski, “A Process and a Plan for the Road to Recovery—A Fortune 500 Business Tool for Any Business,” http://uscpa.org/uploads/A_Fortune_500_ Business_ Tool_for_Any_Business.pdf.
2. See, e.g., Revenue Ruling 2002–89; Rev. Rul. 2002–90; Rev. Rul. 2002–91; Rev. Rul. 2005–40.
3. International Association of Insurance Supervisors, “Issues Paper on the Regulation and Supervision of Captive Insurance Companies” (October 2006), www.iaisweb.org.
4. See, e.g., Kirchman v. Commissioner, 862 F.2d 1486, 1492 (11th Cir. 1989).
5. See, e.g., Neely v. United States, 775 F.2d 1092, 1094 (9th Cir. 1995). Under Internal Revenue Code Section 7701(o), economic substance requires both a meaningful change in economic position and a substantial purpose other than income tax effects.
6. AM 2014-002, relating to invalid elections under IRC Section 953(d).
7. United Parcel Service of America, Inc. v. Comm’r, 254 F.3d 1014 (11th Cir. 2001).
8. Ibid., at p. 1019.
9. Rent-A-Center, Inc. and Affiliated Subsidiaries v. Comm’r, 142 T.C. No. 1 (2014).
10. Ibid., at p. 18.
11. Ibid., at pp. 17, 30.
12. Helvering v. LeGierse, 312 U.S. 531 (1941).
13. See, e.g., Beech Aircraft Corp. v. U.S., 797 F.2d 920, 922 (10th Cir. 1986); Clougherty Packing Co. v. Comm’r, 811 F.2d 1297 (9th Cir. 1987).
14. Chief Counsel Advice IRS Legal Memoranda 201350008-10, 201350031., et al.
15. Rev. Rul. 2002-90; Humana, Inc. v. Comm’r, 881 F.2d 247 (6th Cir. 1989).
16. Rev. Rul. 2005-40.
17. Private Letter Rulings 201219009 (Feb. 3, 2012), 201219010 (Feb. 3, 2012) and 201219011 (Feb. 3, 2012). A brief summary of the law on risk shifting and risk distribution can be found in the IRS Excise Tax—Foreign Insurance Audit Techniques Guide, Revised April 2008, Chapter 6 (applying to captive insurance companies generally).
18. See IRS Notice 2005-49.