A Concise Overview of the Captive Insurance Industry – In the past 20 years, a significant number of smaller businesses have begun purchasing a type of insurance known as “Captive Insurance” to cover their own risks. Small captives, also known as single-parent captives, are insurance companies that are established by the owners of closely held businesses in order to insure risks that are either too expensive or too difficult to insure through the traditional insurance marketplace. These risks can include things like terrorism, natural disasters, and other perils. An authority in the field of captive insurance named Brad Barros explains that “all captives are treated as corporations and must be managed in a method that is consistent with rules established with both the Internal Revenue Service and the appropriate insurance regulator.”
According to Barros, single parent captives are frequently owned by a trust, partnership, or some other structure that has been established by the premium payer or his family. If the plan is well-designed and well-managed, a company may be able to deduct the premium payments that it makes to an insurance provider that is related to the company. Profits from underwriting, if there are any, can be distributed to owners in the form of dividends, and profits from the liquidation of the company can be subject to taxation as capital gains, depending on the circumstances.
Tax benefits are only available to premium payers and their captives if the captive operates in the same manner as a traditional insurance company. Alternately, financial advisors and business owners who use captives as estate planning tools, asset protection vehicles, tax deferral, or for any other benefit that is not directly related to the genuine commercial purpose of an insurance company may be subject to severe regulatory and tax consequences.
Businesses based in the United States frequently establish their captive insurance companies in countries or regions other than the United States. This is due to the fact that legal systems in other countries, particularly those outside of the United States, have greater degrees of adaptability and lower overall costs. As a general rule, businesses located in the United States are permitted to contract with insurance providers based in other countries, provided that the jurisdiction in question satisfies the requirements imposed by the Internal Revenue Service (IRS) regarding insurance regulatory standards (IRS).
There are a number of noteworthy jurisdictions located outside of the United States whose laws regarding insurance are widely acknowledged as being reliable and comprehensive. Bermuda and Saint Lucia are two examples of these. Bermuda is home to many of the largest insurance companies in the world, despite the fact that its prices are higher than those of other jurisdictions. St. Lucia is notable for having statutes that are both progressive and compliant. This makes it an attractive location for smaller captives looking for more affordable options. In addition, St. Lucia has gained praise for its recent passage of “Incorporated Cell” legislation, which was modelled after laws that are already in effect in Washington, DC.
Abuse of Common Captive Insurance Structures While captive insurance continues to provide significant benefits to a great number of companies, certain professionals in the insurance industry have begun to improperly market and misuse captive insurance structures for purposes that are different from those intended by Congress. The following are examples of abusive practises:
1. Improper risk shifting and risk distribution, aka “Bogus Risk Pools”
2. High deductibles in captive-pooling arrangements; re-insurance of captives through private placement variable life insurance schemes
3. Improper marketing
4. Inappropriate life insurance integration
It is recommended that you only attempt to meet the high standards imposed by the Internal Revenue Service and local insurance regulators if you have the assistance of competent and experienced legal counsel. Meeting these standards can be a complex and expensive proposition. The failure to operate as an insurance company carries with it the potential for extremely damaging repercussions, which may include the following penalties:
1. The insurance company will not be entitled to any deductions from the premiums it has received.
2. The elimination of all deductions taken from the person who pays the premium
3. The involuntary distribution or liquidation of the insurance company’s entire asset portfolio, which results in the imposition of additional taxes on dividends and capital gains.
4. The possibility of receiving unfavourable tax treatment because the company is a controlled foreign corporation
5. The possibility of receiving unfavourable tax treatment because the entity is a personal foreign holding company (PFHC)
6. The possibility of incurring regulatory fines from the jurisdiction that provides insurance
7. The possibility of the Internal Revenue Service imposing fines and interest.
In the end, the tax consequences could amount to more than one hundred percent of the premiums that were paid to the captive insurance company. In addition, the Internal Revenue Service (IRS) has the potential to treat attorneys, certified public accountants (CPAs), wealth advisors, and their clients as tax shelter promoters, which could result in fines of at least $100,000 per transaction.
Establishing a captive insurance company is obviously not something that ought to be treated as something that can be done on the fly. In order to avoid the pitfalls that are associated with abusive or poorly designed insurance structures, it is essential for companies that are interested in establishing a captive to collaborate with qualified attorneys and accountants. These professionals should have the necessary knowledge and experience in this area. A legal opinion that addresses the program’s core components should be included with any captive insurance product, as a general rule of thumb. It is common knowledge that the opinion ought to be supplied by an impartial law firm located in either the regional or national level.
Abuse of Risk Shifting and Risk Distribution Two essential components of insurance are the practise of moving risk away from the insured party and onto third parties, known as “risk shifting,” and the subsequent distribution of risk amongst a large number of insured parties, known as “risk distribution” (risk distribution). Following a number of years of litigation, the Internal Revenue Service (IRS) published a Revenue Ruling (2005-40) in 2005, in which it outlined the essential components that must be present in order to satisfy risk shifting and distribution requirements.
Those individuals who are self-insured stand to benefit in two ways from the utilisation of the captive structure that was sanctioned by Revised Ruling 2005-40. To begin, the parent is exempt from any obligation to divide the associated risks with any third parties. The Internal Revenue Service (IRS) announced in Ruling 2005-40 that it is permissible for members of the same economic family to share risks so long as the separate subsidiary companies (a minimum of seven are required) are formed for non-tax business reasons, and the separateness of these subsidiaries also has a business reason. This requirement was placed in place to ensure that the risks can be shared. In addition, “risk distribution” is permitted as long as no insured subsidiary has contributed more than 15 percent or less than 5 percent of the premiums held by the captive. This condition must be met for the allowance of “risk distribution.” Second, the special provisions of insurance law that allow captive insurance companies to take a current deduction for an estimate of future losses and, in certain circumstances, shelter the income earned on the investment of the reserves, reduce the amount of cash flow that is required to fund future claims by approximately 25 to nearly 50 percent. This results in a reduction of the amount of money that is needed to pay for insurance. To put it another way, a well-designed captive insurance company that is compliant with the requirements of 2005-40 may result in a cost savings of at least 25 percent.
While some companies are able to fulfil the requirements of 2005-40 using their own group of related entities, the vast majority of privately held businesses are unable to do so. Because of this, it is common practise for captives to purchase “third party risk” from other insurance companies. The amount of coverage that is required to satisfy the requirements set forth by the IRS typically costs between 4 and 8 percent of the captive’s annual revenue.
One of the most important aspects of the risk that was bought is the fact that there is a good chance of suffering a financial loss. Because of this risk, some promoters have tried to avoid the implications of Revenue Ruling 2005-40 by steering their customers toward so-called “bogus risk pools.” When this occurs, which happens quite frequently, an attorney or some other kind of promoter will have at least ten of the captives that belong to their clients sign a collective risk-sharing agreement. The agreement includes either a written or an unwritten agreement that neither party will make any claims on the pool. This arrangement is popular among the customers because it provides them with all of the tax advantages of owning a captive insurance company without exposing them to the risks that are normally associated with insurance. Unfortunately for these companies, the Internal Revenue Service (IRS) considers arrangements of this kind to be something other than insurance.
It is generally agreed that risk sharing agreements like these have no value and that they should be avoided at all costs. They are nothing more than an account to save money before taxes that is given a fancy name. If it can be demonstrated that a risk pool is bogus, then the protective tax status of the captive can be denied, and the severe tax ramifications described earlier will be enforced. [Case in point]
It is common knowledge that the Internal Revenue Service examines agreements between owners of captives with a great deal of scepticism. Purchasing insurance from a third party provider, also known as third party risk, is considered the industry standard. Anything less than that throws open the door to the possibility of extremely dire outcomes.
Excessively High Deductibles; Some promoters sell captives and then have their captives participate in a large risk pool with a high deductible. This practise is known as abusively high deductibles. The vast majority of losses are subject to the deductible and are therefore borne by the captive rather than the risk pool.
It’s possible that these promoters will tell their customers that there is no real risk of having a third-party claim made against them because the deductible is so high. The problem with this kind of arrangement is that the deductible is so high that the captive is unable to meet the standards that have been established by the Internal Revenue Service (IRS). It is not at all obvious that the captive is an insurance company; rather, it resembles a sophisticated pre-tax savings account.
A separate worry is that the customers might be led to believe that they can write off the total amount of the premiums they’ve paid into the risk pool. When there are few or no claims made against the risk pool (in comparison to the losses retained by the participating captives using a high deductible), the premiums that are allotted to the risk pool are simply excessive. If there are no claims submitted, then the premiums should be lowered. In this scenario, if the captive is challenged by the IRS regarding the deduction it took for unnecessary premiums that were ceded to the risk pool, the IRS will disallow the deduction. Because the captive did not live up to the requirements described in Revenue Procedure 2005-40 and in earlier rulings on matters related to it, the Internal Revenue Service has the option of classifying it as something other than an insurance company.
Private Placement Variable Life Reinsurance Schemes; Over the years, promoters have attempted to create captive solutions designed to provide abusive tax free benefits or “exit strategies” from captives. These solutions include: Establishing or working with a captive insurance company is one of the more common strategies used today. After doing so, the business then sends a portion of the premium that is commensurate with the portion of the risk that is re-insured to a reinsurance company. This is one of the more popular schemes.
In most cases, the Reinsurance Company is owned in its entirety by a life insurance provider based in another country. A foreign property and casualty insurance company that is not subject to income taxation in the United States is the legal owner of the reinsurance cell in the insurance portfolio. In a practical sense, ownership of the Reinsurance Company can be traced back to the cash value of a life insurance policy that was issued by a foreign life insurance company to the principal owner of the Business, or to a related party, and which insures the principal owner, or a related party. This policy was purchased by the foreign life insurance company.
1. The Internal Revenue Service (IRS) might use the sham-transaction doctrine.
2. The Internal Revenue Service (IRS) may contest the use of a reinsurance agreement on the grounds that it constitutes an improper attempt to transfer income from a taxable entity to a tax-exempt entity, in which case it will reallocate income.
3. Because the life insurance policy that was issued to the Company violates the investor control restrictions, it is possible that the policy will not qualify as life insurance for the purposes of the federal income tax in the United States.
Investor Control; The Internal Revenue Service has stated numerous times in its published revenue rulings, private letter rulings, and other administrative pronouncements that the owner of a life insurance policy will be considered the income tax owner of the assets legally owned by the life insurance policy if the policy owner possesses “incidents of ownership” in those assets. This is the case even if the life insurance policy is not the legal owner of the assets. In general, in order for a life insurance company to be considered the owner of the assets that are held in a separate account, the policy owner cannot have control over individual investment decisions. This is one of the requirements for the life insurance company to be considered the owner of the assets.
The Internal Revenue Service does not permit the owner of the policy or any party related to the policy holder to have any right, either directly or indirectly, to require the insurance company or the separate account to acquire a specific asset using the funds in the separate account. This is because the IRS considers such a right to be a form of coercion. In practise, the owner of the policy does not have the ability to direct the life insurance company regarding the specific assets to be invested in. In addition, the Internal Revenue Service has stated that there cannot be any prearranged plan or oral understanding regarding the specific assets that can be invested in by the separate account. This was announced in a recent press release (commonly referred to as “indirect investor control”). In addition, in an ongoing series of private letter rulings, the Internal Revenue Service (IRS) has demonstrated a consistent application of a look-through strategy when attempting to identify indirect investor control over investments made by separate accounts of life insurance policies. The Internal Revenue Service (IRS) has just recently issued published guidelines on when a violation of the investor control restriction occurs. This guidance establishes safe harbours and levels of investor control that are not allowed, and it does so by discussing what levels of participation by policy owners are reasonable and what levels are unreasonable.
The conclusion that can be drawn from the available evidence is simple. Any court will ask whether there was an understanding, whether it was orally communicated or tacitly understood, that the separate account of the life insurance policy will invest its funds in a reinsurance company that issued reinsurance for a property and casualty policy that insured the risks of a business, where the life insurance policy owner and the person insured under the life insurance policy are related to or are the same person as the owner of the business deducting the premiums from the life insurance policy, and where the life insurance policy
In the event that this question can be answered in the affirmative, the Internal Revenue Service (IRS) should have the ability to successfully convince the Tax Court that the investor control restriction has been violated. Therefore, it follows that the owner of the life insurance policy is subject to taxation on the income that is earned by the life insurance policy as it is earned.
Because these schemes generally provide that the Reinsurance Company will be owned by the segregated account of a life insurance policy insuring the life of the owner of the Business or a person related to the owner of the Business, the investor control restriction is violated by the structure described above. In addition, the investor control restriction is violated because the investor control restriction is violated by the structure described above. If one were to draw a circle, it would mean that none of the money paid by the Company as premiums could be made available to unrelated third parties. Because of this, any court that looked at this structure could easily come to the conclusion that each step in the structure had been prearranged, which would mean that the investor control restriction had been broken.
Suffice it to say that the Internal Revenue Service (IRS) announced in Notice 2002-70, 2002-2 C.B. 765, that it would apply both the sham transaction doctrine and 482 or 845 to reallocate income from a non-taxable entity to a taxable entity to situations involving property and casualty reinsurance arrangements similar to the described reinsurance structure. This was done in order to reallocate income from a non-taxable entity to a taxable entity
Even if the property and casualty premiums are reasonable and satisfy the risk sharing and risk distribution requirements so that the payment of these premiums is deductible in full for purposes of U.S. income tax, the ability of the Business to currently deduct its premium payments on its U.S. income tax returns is entirely separate from the question of whether the life insurance policy qualifies as life insurance for purposes of U.S. income tax. This is because the question of whether the premiums are deductible in full for purposes of U
Inappropriate Marketing; One of the ways captives are sold is through aggressive marketing that focuses on benefits other than the company’s actual business purpose. Corporations are referred to as captives. As a result, they have the potential to provide shareholders with advantageous planning opportunities. However, the real business purpose of the insurance company must come first. This means that any potential benefits, such as asset protection, estate planning, investing with tax advantages, and so on, must take a back seat.
A large regional bank in the area has just recently begun providing “business and estate planning captives” to the clients of the trust department of the bank. Once more, a good rule of thumb to follow when dealing with captives is that they need to function just like regular insurance companies. Insurance is what real insurance companies sell; “estate planning” benefits are not part of their offerings. The Internal Revenue Service (IRS) may use deceptive sales promotion materials from a promoter in order to refute a captive’s claims of compliance and subsequent tax deductions. Because of the significant dangers that are associated with improper promotion, your best bet is to only collaborate with captive promoters whose marketing materials centre on ownership of captive insurance companies rather than the benefits of estate, asset, and investment planning. This is the safest way to go about things. Even better would be for a promoter to have a sizable and impartial law firm located in a regional or national jurisdiction review their materials for compliance and provide written confirmation that the materials satisfy the criteria established by the Internal Revenue Service (IRS).
The Internal Revenue Service has the ability to look back several years to find abusive materials. If it has reason to believe that a promoter is selling an abusive tax shelter, it will then start an expensive and potentially devastating investigation into the marketers and the insured.
Abuse of Life Insurance Arrangements; A new source of concern is the practise of combining life insurance policies with small captive insurance companies. There is no statutory authority that allows small captives that are treated under section 831(b) to deduct life premiums. Additionally, if a small captive company uses life insurance as an investment strategy, the cash value of the life policy may be taxable to the captive company, and then it may be taxable once more when it is distributed to the ultimate beneficial owner. This double taxation will have the effect of completely undermining the usefulness of the life insurance policy, and it will also subject any accountant who recommends the plan or even just signs the tax return of the company that pays premiums to the captive to significant new levels of liability.
The Internal Revenue Service is aware that a number of large insurance companies are actively marketing their life insurance policies to be held in small captives as investments. The result is eerily similar to that of the thousands of 419 and 412(I) plans that are currently being reviewed for compliance by the government.
In conclusion, arrangements for captive insurance can, on the whole, be extremely beneficial. There are now clear rules and case histories that define what constitutes a properly designed, marketed, and managed insurance company. In the past, there were no such rules or case histories. Regrettably, in order to sell more captives, some promoters resort to deceptive practises such as abusing, bending, and twisting the rules. Most of the time, the owner of the company that is purchasing a captive is unaware of the enormous risk that he or she faces as a result of the improper actions taken by the promoter. When a person’s insurance provider is judged to be abusive or non-compliant, the insured person and the beneficial owner of the captive are the ones who have to deal with the unpleasant outcomes. The captive insurance industry is comprised of highly trained professionals who deliver compliant services. Instead of going with a slick promoter who is selling something that seems too good to be true, it is in your best interest to use an expert who is backed by a major law firm.