Issues and Opportunities for Captive Insurance Companies: Part II

Overview of Captives

As discussed in Part I, captives are bona fide insurance companies that are licensed and regulated in the domiciles where they are registered. These entities write limited risks, generally those of their owner(s) and/or related parties. A captive is a flexible and customized strategic complement to a company's use of third party, commercial insurance companies. The captive enables the company to take advantage of insurance consolidation benefits, to react pro actively and flexibly to changes in the commercial markets and their own business needs, to accumulate cash for future claims tax efficiently, and facilitates direct access to reinsurance markets. And, there are a number of exit strategies available should a company decide to wind down, terminate, or substantially restrict or reduce the scope or use of its captive. In short, a captive is a sophisticated vehicle that is used as an integral part of a company's overall risk management program.

There are several types of captives, such as parent-owned, group, "cell" and rent-a-captives, and risk retention groups. The ownership and operational structure of a captive have, increasingly, a significant impact on the availability of—or at least the confidence in securing—tax benefits and cash flow enhancements. This second article focuses on those tax and economic implications, and some key issues associated with ownership structure, risk distribution, and domicile.

Overview of Tax Treatment of Captives

A variety of tax issues have been presented over the years as to whether or not particular captive insurance company arrangements constitute "insurance" for Federal income tax purposes. Insurance companies generally are taxed under Sub chapter L of the Internal Revenue Code (the "Code"), and captive insurance companies are no different. For Federal tax purposes, "insurance companies" are defined to be "any company more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies."

One of the key benefits of qualifying as an insurance company for Federal tax purposes is the essentially unique authority of those companies to deduct currently their insurance reserves, according to the IRS rules, in advance of the time that the underlying claims are actually paid. This opportunity to accelerate tax deductions, a valuable timing benefit not available to normal corporate taxpayers, provides insurance companies—and, more importantly, their parent companies—the ability to obtain immediate tax benefits, especially if the captive is included in a consolidated tax return with other operating business companies. If the captive arrangement qualifies as "insurance," then the insured companies are also entitled to deduct the premiums paid to the captive for their insurance.

For state tax purposes, however, captives provide their owners with more permanent tax benefits, albeit at lower effective rates. Generally speaking, licensed captive insurance companies are not subject to state income tax where they are domiciled. This means, for example, that the premium income, underwriting profits, investment income, etc., are all state tax free where the captive is licensed. There may be imposed, however, a lower, "in lieu of" state premium tax on the premium amounts received by the captive, though that tax does not apply to amounts contributed as capital or surplus. Some states, like Delaware, even "cap" the amount of premium tax payable, and virtually all states used as captive domiciles provide premium tax schedules for advance review.

Captive insurance companies can also be domiciled outside the United States. Popular foreign domiciles for North American captive owners include Bermuda, Cayman Islands, Barbados, etc. These countries also have insurance company licensing procedures, but generally do not charge premium taxes. However, establishing an owned captive outside the United States involves substantial other Federal tax implications, including the so-called Subpart F rules relating to "controlled foreign corporations," the possible imposition of a sizable Federal excise tax (as much as 4% of gross premiums paid to the offshore insurer) on premium payments to such insurers by their U.S. insureds, and the risk of a 30% gross withholding tax imposed on certain U.S.-source investment income of the captive itself, to name a few. Then, there is the option of having foreign insurers elect to be treated as U.S. corporations for tax purposes. These are all treacherous waters into which one should not wade without competent tax counsel.

Qualification as "Insurance"

The IRS has traditionally resisted the qualification of captive insurance companies generally because of various abuses the IRS believed were occurring within those structures. In a 1977 ruling, the IRS enunciated its view that captives which only insured risks of their parent (or, implicitly, related subsidiaries) did not qualify as insurance arrangements because there was no risk shifting or risk distribution since "the [premium] amounts remained within the economic family and under the practical control" of the parent corporation. This "same economic family" theory was to be the IRS's published position on captives for the next 24 years.

A substantial number of cases were litigated in the intervening years, and taxpayers succeeded in several to convince the courts that their particular arrangements in fact did qualify as "insurance" for tax purposes. Nevertheless, since IRS agents are bound by published IRS positions, such as the 1977 ruling, when they conduct their audits of taxpayers, the IRS battle with taxpayers and tax planners continued unchanged until 2001. In a ruling published that year, however, the IRS formally acknowledged that its stance with respect to this "same economic family" argument needed to be changed because "no court, in addressing a captive insurance transaction, has fully accepted the economic family theory" established in the 1977 ruling.

At the end of 2002, the IRS published three rulings that established certain basic principles the IRS would follow henceforth in this area, even as the IRS conceded that certain captive insurance companies could qualify as "insurance companies" for Federal income tax purposes. The three rulings addressed differing fact patterns. The first ruling involved a parent-subsidiary captive, where, in one part of the ruling, only the parent's risks were insured by the captive and, in the second part, an unrelated party insured "more than" 50 percent of the captive's total risks (inclusive of the parent's). The second ruling involved "12" brother/sister subsidiaries that insured their professional liability risks with a commonly-owned captive, though the parent did not insure any risks with the captive. The third ruling involved a "small group" of unrelated companies in the same industry that established their own "group" captive and insured certain common risks with it.

To generally synthesize the principles identified by the IRS in these three rulings for captive insurance company arrangements to qualify as "insurance" for Federal tax purposes, the IRS requires:

• All premiums and assets of the captive must be "pooled" and available to pay all claims of all insureds
• The captive cannot loan funds to its parent or to its affiliated insureds
• The parent or insureds cannot guarantee the performance of the captive
• There must be adequate risk shifting and risk distribution present
• The arrangements must be consistent with commonly accepted notions of insurance
• When a parent company is insuring its risks with its subsidiary captive, "more than half" of the captive's risks must be "third party" risks
• The captive must also meet normal inter-company transaction requirements, such as arms length pricing, proper documentation, business purpose, etc.

Recently, in 2005, the IRS published another ruling in the captive area, a ruling dealing primarily with "single" policyholder/insured issues under various fact patterns. The interesting nuance here was that the insurance company to which the premiums were paid was "unrelated." In the 2002 trilogy of rulings, however, the captives were all related to the insureds. The IRS concluded in various fact patterns considered in this 2005 ruling that a single insured did not constitute adequate risk shifting or risk distribution, hence the arrangements failed to qualify as insurance for tax purposes.

Also in 2005, the IRS sought comments from the tax bar on four specific, captive-related matters: "cell" captives, loan-back of premiums, homogeneity of risk, and "finite" risk transactions. The comment period closed in October of 2005, and the IRS is now considering the issuance of formal guidance in these areas.

Implications of IRS Qualification Requirements

So, as Michael Caine said in the movie Alfie, "what's it all about"? What do the foregoing rulings and positions of the IRS mean to taxpayers and their counsel?

When virtual certainly is required as to the predictive outcome tax-wise of a captive insurance structure, it would be advisable to stick strictly to the IRS positions stated in the rulings, even to the point in a brother/sister captive structure of having at least "12" insured subsidiaries, each with no more than 15% and no less than 5% of the risks insured by the captive. (Those are the actual facts in the brother/sister ruling in 2002.) But, does anyone think that it is an immutable principle of insurance that you need to have no fewer than "12" insureds before you can have valid "insurance"?

The courts certainly do not think so. While there are a number of decisions in this area, this article will focus on only a few of them to identify the evolution and impact of the issues that still foster contention between taxpayers and the IRS, the issues of risk shifting and, more significantly, risk distribution.

Risk Shifting and Risk Distribution

The seminal case in the insurance area, and in particular in the captive insurance area, predates all the rulings. In a 1941 U.S. Supreme Court case, Helvering v. LeGierse, the Supreme Court said: "Historically and commonly insurance involves risk shifting and risk distributing . . . ." To this day, virtually every court that deals with deductibility of insurance premiums and/or the tax qualification of an entity as an "insurance company" for Federal income tax purposes confronts the issue of whether there is adequate risk shifting and risk distribution present under the facts in issue. So, too, does the IRS. The differences are in the interpretation of what constitutes "adequate."

In general, "risk shifting" is said to exist when one party, facing liability for economic risk of loss, transfers that financial risk to another party, i.e., the insurer. Once the risk has been shifted to the insurer, then a loss suffered by the insured party is recompensed by the insurance proceeds from the party who has accepted that risk of loss, the insurer, from the pool of premiums and capital the insurer has fully at its disposal. "Risk distribution" generally involves application of the statistical concept of the "law of large numbers." Under this statistical theory of probability, the insurer reduces the potential for a single claim to exceed the total amount received as premium by insuring (accepting) numerous independent risks that could occur randomly over time and whose statistical outcome approaches the probable if the number of occurrences is infinite.

An important case in this area, one referred to by the IRS in its 2001 ruling where it renounced its "same economic family" theory, was Clougherty Packing Co. v. Commissioner. In Clougherty, the Ninth Circuit rejected the IRS view on the "economic family" theory by looking to a balance sheet analysis with respect to the particular companies involved as insureds. The court concluded that the parent/subsidiary captive arrangement was not "insurance" because the parent owned an economic stake in the subsidiary captive that was to pay the loss, i.e., there was no net change on the parent's balance sheet when the loss was paid or reimbursed to it by its owned subsidiary/ captive. But, this balance sheet test did not disqualify brother/sister captive arrangements as insurance, unlike the IRS's general position, because the brother/sister insureds in such cases did suffer a reduction in net worth on their respective balance sheets due to a loss. Not only was the captive in such cases not owned by—and did not own—the brother/sister insureds, but also a venerated Supreme Court precedent requires a corporation with valid business purposes to be treated as a "separate taxable entity." In the brother/sister situation in Clougherty, the number of brother/sister insureds was not critical to the decision as to whether risk shifting or risk distribution occurred.

In another key case in this area, a case also cited by the IRS in its 2001 ruling, the Sixth Circuit in Humana, Inc. v. Commissioner held that a valid insurance arrangement could exist between the captive and its brother/sister subsidiary affiliates if there was adequate risk shifting and risk distribution, a pro-taxpayer result. The court said: "Risk distribution [could occur] where the captive insures several separate corporations within an affiliated group . . . ." The holding on this issue was one part of a decision that concluded on another issue that premiums paid by a parent company to its wholly-owned captive subsidiary were not considered to be deductible insurance, a pro-IRS result. The Human a court concluded in the latter case that such payments were to be considered as capital contributions to a loss reserve and therefore not deductible until claims were actually paid by or on behalf of the parent/insured.

A number of courts have weighed in on the issues of risk shifting and risk distribution, though usually it is the latter issue that is normally in express contention. In Gulf Oil, the Tax Court, went so far as to say: "…a single insured can have sufficient unrelated risks to achieve adequate risk distribution." And, the Tax Court reemphasized its view that no "specific number of subsidiaries or risk events are required," holding in Malone & Hyde that the eight subsidiary insureds there were adequate to achieve risk distribution. The IRS, on the other hand, has published its key ruling saying, essentially, there needs to be twelve brother/sister insureds from its regulatory perspective and, in another ruling, that a single insured is not adequate to constitute risk distribution regardless of the nature of the underlying coverages.

Summary

Thus, the lines are clearly drawn between taxpayers and the IRS. As stated initially in this article, if clients wish certainty in their tax structures and can demonstrate adherence to all the specific structural and risk concentration issues in the published rulings, then a private letter ruling should be sought from the IRS. If clients do not wish on this basis to pursue a private ruling, with the attendant costs and delays, they should seek competent counsel to evaluate their facts—and, potentially, alternatives—in order to achieve adequate comfort regarding the tax consequences of their captive structures and their uses.