A captive insurance company that qualifies for the tax exemption found in section 831(b) of the Internal Revenue Code is a time-tested and useful risk management mechanism that offers the entrepreneur excellent tax and financial planning benefits.
It looks simple — form a small insurance company and pay no more than $1,200,000 in annual premiums to it, which are fully tax-deductible and then later remove the profits of the captive at more favorable dividend (for now) or capital gains rates.
But it is not so simple. There are many pitfalls. Aggressive captive providers have proliferated recently who are ignoring common sense risk management and taxation issues to the potential peril of their clients. And they hide behind actuarial opinions and regulatory acceptance arguing that their plans and pricing are perfectly acceptable.
The problem is that actuarial opinions are only as good as the assumptions that the actuaries are given. And regulators examine different issues than the IRS when they are approving a captive's license. The existence of an actuarial opinion or a license does not assure the client that their captive is truly compliant with the complicated tax issues that are involved.
There are two current "hot buttons" that anyone contemplating forming a captive should consider:
Pricing of Risk: Once the types of risks to be transferred to the captive are identified, the next challenge is to properly calculate the premium for such risk. Underwriting is as much an art as it is a science, with factors such as coverage details, loss history, limits, deductibles, exclusions and the financial strength of the issuing insurance company all coming into play along with sound actuarial practices.
Given these variables, it is easy for different people to offer diverse opinions on what an appropriate premium may be. But common sense must prevail. For tax purposes, the IRS will only allow a deduction for premiums that are reasonable in amount. The starting point for "reasonable" is the market rates for the coverages in question. However, market rates are not the end point for small captives, but they absolutely do create a benchmark. If a taxpayer is considering paying premiums that are vastly beyond that benchmark, they had better have very strong and well documented arguments for doing so.
Let's take an actual case in point. A captive provider suggested that a client's captive issue a $3,000,000 excess policy for Employment Practices Liability for a premium of over $250,000. Yet the client already had a $3,000,000 primary layer for this type of coverage for which he had paid less than $12,000.
Given that the primary layer would have to pay out full limits of $3,000,000 in order to trigger a loss on the excess layer, insurance companies would normally charge less than the premium paid for the primary layer of the same size. And when we compared what actual clients paid for this type of excess coverage, we found a rate of about $3.00 per employee. The suggested premium for the captive, however, equated to $808.50 per employee. A review of the actual excess policy language did not reveal any special provisions that could possibly justify such a high premium.
While it is true that a small insurance company may need to charge more than market rates because it has a very low capital base, common sense (and the IRS) would never accept a premium that is 269 times the market rate as in any way "reasonable." [When presented with this argument, the captive provider in question simply stated that they felt that they could defend the premium in the event of an audit. The client was not comforted.]
Terrorism insurance is another area of controversy in the small captive market. It is a coverage that can legitimately be placed in a captive insurance company, but pricing is a serious issue. Given the fact that TRIA does not cover loss of income from a terrorist attack and that such coverage is not easily available in the domestic market, some captive providers have suggested that small captives can charge $500,000 to $600,000 for a $5,000,000 limit of such coverage.
In fact, such a policy is available from Lloyds of London at rates significantly lower than those used by these captive providers. For example, one of our clients, a $100 million (revenues) company in Dallas, Texas was recently quoted a price of $10,000 for $5,000,000 of terrorism coverage that includes loss of income as a result of a terrorist attack anywhere in the United States, not just in Dallas. Lloyds obviously has the financial strength to price risks lower than the average captive, but the disparity between the real market price and the pricing quoted by captive providers with little or no insurance experience once again defies common sense.
One of the basic tenets of risk management is that if the risk of loss is severe, and coverage can be purchased at a low price from the third-party market, it is not a sound business decision to self-insure that exposure. If a client is truly concerned about a terrorism related loss, it therefore would make more sense to buy the coverage from Lloyds rather than self-insure it in their own captive. Except, of course, for the tax benefits of doing so. Thus, the decision to form and fund such a captive clearly indicates a lack of economic substance and is motivated primarily by tax considerations. Such a captive would most likely fail an audit by the IRS.
Of course, even Lloyds might not have the ability to pay a claim in the event of an enormous terrorist event, which could be a reason to self-insure this risk in a captive. But pricing the premium at a "worst case plus" rate is not sensible and would likely not survive an IRS audit.
Finally, terrorism quotes in the captive market rarely take into account individual risk characteristics. If the client is located in a "target rich" area, such as near a nuclear facility, some higher rates certainly can be justified, but common sense says that such a rate is not applicable to everyone, particularly in lower exposure areas.
What about an actuarial opinion? Certainly an opinion that is specific to the actual policy coverages in question and to the client's unique risk characteristics can go a long way to justifying the given premium. But clients must be careful that a proffered opinion truly relates specifically to them and not just to the type of coverage in general. When it comes to terrorism insurance, however, we submit that there can be no such "coverage in general" that makes economic or common sense.
Life Insurance: Whole life insurance can be an acceptable part of a captive's investment portfolio. But that statement has opened the door to abuses — abuses that the IRS is well aware of and is determined to quash. A captive must be formed first and foremost for risk management purposes. The tax benefits that follow are wonderful, but must be secondary, and the investment portfolio then ranks third.
Some life insurance agents (who likely know nothing about property & casualty risk management) are touting the formation of a captive for (effectively) the benefit of purchasing life insurance with the premiums received by the captive. This, in effect, allows life insurance to be purchased with pre-tax dollars. Not only does this approach likely violate section 264 of the Internal Revenue Code (that disallows the deduction, directly or indirectly, of premiums paid for life insurance), it violates the economic substance doctrine.
Again, common sense would show that if the primary purpose of forming a captive insurance company is to buy life insurance with pre-tax dollars, that would not constitute a valid reason to become involved with what is, first and foremost, a risk management vehicle.
It is our understanding that the Internal Revenue Service has a specific internal mandate to find and close captives that are marketed in this manner.
To avoid this issue, we suggest the following: (a) do not purchase a captive from anyone promoting it as a vehicle for the purchase of life insurance, particularly an immediate purchase; (b) make any life insurance decisions a part of an overall investment strategy; (c) do not use any unearned premium to purchase life insurance (which means no purchases in the first year); and, (d) do not use more than 50% of the captive's premiums in such an investment.
These issues of pricing and the use of life insurance are particularly important to the CPAs who are being asked to sign the client's tax return showing deductions to a captive. CPAs now have a higher financial and professional risk when signing a tax return and must be acutely aware of these potential issues with respect to their clients' captives.
Historically, many good business ideas that have tax benefits have been abused and distorted by greedy promoters and unsuspecting taxpayers. The end result is often a complete closure of the benefit by Congress or the IRS. We hope that the few "bad actors" in the 831(b) space do not cause the same result with this excellent risk management and financial planning tool.
Authors
James Landis collaborated with Rick Eldridge in writing this article. Rick Eldridge is the President & CEO of Intuitive Insurance Corporation and, along with James Landis, a Managing Partner of Intuitive Captive Solutions, LLC.
