A captive insurance company (commonly referred to in short as a "captive") is an insurance subsidiary that is set up by the parent company to underwrite the insurance needs of the other subsidiaries. For example, British Petroleum wisely set up a captive insurance company (Jupiter Insurance Ltd.) to provide environmental insurance to its operating units, and the moneys from its captive were used to fund in substantial part the Gulf cleanup.
The vast majority of Fortune 500 companies now have captive subsidiaries (and many companies have several captives, including those for employee benefits), and captives are now also routinely used by small companies for the same purpose. Over 30 states now have captive-enabling legislation, most recently North Carolina and Texas, in addition to states such as Delaware, Kentucky, Missouri, Nevada, Utah, and Vermont, which are very active in marketing their states as premier jurisdictions for the formation of captives.
A captive can be a wonderful risk management tool when used correctly; but therein lies the rub, many are not. The difference between a poorly-run captive and a well-run captive is often difficult for novices to discern. So, in reverse order, here are 10 bad practices involving captive insurance companies, followed by 10 good ones.
Dangers of a Bad Captive Arrangement
10. Bogus Risk Pools
A lot of businesses with valid needs for insurance don't have enough subsidiaries to pass what is known as the "multiple insured" test for risk distribution, and so they instead participate in what is known as a "risk pool" to obtain risk-distribution.
In a nutshell, a "risk pool" is an insurance arrangement involving multiple, usually unrelated captive owners who share certain risks through their individual captives. Risk pools are usually set up by captive managers to facilitate the needs of certain of their captive clients. In various guidance, the IRS has validated the concept of the risk pool when run correctly.
The difficulty is with the "when run correctly" part. The problem with most risk pools is that there is in fact very little sharing of risks, and thus, the large premiums being charged by the pool are neither actuarially sound nor bear anything but a coincidental relationship to reality. The IRS refers to these as "notional risk pools" – there is a notion of a risk, but not much beyond the mere notion.
Many of these pools have been operated for years with few or no claims, which calls into serious question whether the large premiums they charge are realistic (the answer is that they are not). Maybe in the first year when the pool has no loss history, it can be aggressive in how it prices the premiums paid. By the fifth year, however, a run of large premiums with few or no losses probably indicates that the premiums were mispriced.
By like token, if there is true risk-sharing in a pool, that means that the participants are subject to actual risk of loss – including the total loss of their premiums paid by their operating businesses into the pool. This is where the wink-wink, nod-nod of "That will never happen; actually you'll never lose anything significant" usually shows up, which is another way of saying the risk pool is just a vehicle to facilitate the appearance of risk-shifting, without actual risk-shifting, i.e., tax fraud.
While the saying around my office is "Pools are for fools!," the truth is that some clients (including some of mine) cannot meet the test for risk distribution in any other way, and therefore make an informed business decision to participate in a risk pool. However, for these clients my advice is usually, “Do whatever reorganization of your business is necessary to get out of the risk pool as quickly as you can.” If a client is still in a risk pool after a few years just because they need the risk-distribution for tax purposes, there has been a serious failure in business planning by someone.
9. Failure to Make Feasibility Study Prior to Formation
Before the decision to form the captive is even made, a feasibility study should be conducted that looks at all aspects of the captive and validates its viability and economics, as well as whether the captive will meet critical tests for risk-shifting and risk-distribution.
If for no other reason, a feasibility study that carefully documents the non-tax purposes of the captive (to distinguish it from a tax shelter masquerading as a captive) should be done, since the IRS on audits of captives routinely asks for such documents as part of its evaluation. A good captive feasibility study will go a long way in showing the IRS that the captive is founded on solid business economics and does not exist merely to try to save some bucks in taxes.
8. Ignoring State Tax Issues
There is a misconception that if the underlying business is doing business in State A, and the captive is formed in State B, then by virtue of that alone, State A cannot tax the captive.
Not true. Actually, whether State A can tax the captive depends on a variety of factors. If business decisions regarding the captive are made in State A, for example (probably the most common way to blow this), then State A can probably tax the captive.
Captive owners must be very careful to not let the captive "touch" State A in any way, unless of course the captive is formed in State A (and then it doesn't matter, which is often the easiest and most sensible approach). This is usually accomplished by using a captive management firm ("captive manager") to perform all the functions of the captive in State B; but just having a captive manager in State B isn't enough – diligence is required not to blow this.
7. Single-Line Myopia
Too often, captives are formed to underwrite one single risk of the organization, without looking at the myriad other risks of the enterprise. This happens the most when the captive is promoted by an insurance broker who is only focusing on helping the client with that one line of business, usually workers compensation, and it misses a lot of benefits for the client.
In a sense, a captive is a lot like a casino – the more games in a casino, the better the risk distribution of the casino. The same is true with a captive having different types of policies; there is more risk distribution. Also, since the costs of a captive are often fixed or not dependent on how much insurance the captive underwrites, the more insurance that it underwrites, the better the economics of the captive. Which is to say that captives are usually the most efficient when they are underwriting all possible lines of coverage for the organization, not just a single line.
Often, when a captive is being evaluated solely for a single line, the conclusion is reached that the captive will not be economical as to that single line only, when it might be very economical if it takes on other risks. It is difficult to understand why those involved with captives would not look to all the possible coverages the captive might underwrite for a particular client, but such myopia occurs very frequently. Frankly, there is a lot of "If I don't sell it, I'm not going to worry about it" going on with the insurance brokers, but that attitude doesn't serve their clients well. Good insurance brokers who assist their clients with captives will look at the entirety of the clients' books of insurance business, as well as where the clients have chosen not to purchase third-party insurance because it is too costly.
Take caution, however, that the IRS now apparently tests for "line-item homogeneity," meaning it takes the position that each line of coverage must meet the tests for risk distribution separately, i.e., without regard to other lines of coverage being underwritten by the captive. Many captive tax professionals believe the IRS is flat wrong on that point and will lose a challenge on appeal to a U.S. Court of Appeals, but who wants to pay for that fight?
6. Poorly-Drafted Policies
The policies underwritten by a captive should not be substantially different in their form than policies underwritten by any other insurance company. A good captive manager will use modified standard industry forms to draft policies. By contrast, bad captive managers will draft simplistic policies that often omit key insurance contract terms or else unnecessarily expose the captive to lawsuits by third-party claimants.
There is a reason why there is so much boilerplate in typical insurance contracts – it works. But also, one of the biggest benefits to a client is the ability to custom-tailor coverage to more closely fit their needs by modifying the standard industry forms. Too many captive managers just slap out some basic policies and call it a day; what a shame for their clients to lose a wonderful opportunity.
5. Bogus Insurance Contracts
I've actually sat in on meetings where some other adviser has told their prospective client something to the effect that, "You'll pay premiums, but you don't have to make claims!" (wink-wink, nod-nod). Then, I've had to inform the client that, "If you don't make and pay valid claims under the policies, then you don't have a captive, but instead, you just have a tax fraud."
The U.S. Supreme Court has defined "insurance" as including an "insurance contract." If there is no valid, binding contract, which is fully honored between the captive and the operating subsidiaries, then there is no insurance. What you have then is simply a sham.
4. Inadequate Capital
About once a month, somebody will call me to inquire about a captive, and say that they have already decided to put the captive in X jurisdiction. When I ask why, they say that it is because X jurisdiction only requires $25,000 in capital or some other small number.
The problem here is that while a small amount of capital may be all that is required by local regulatory law, the minimum capital requirements of a captive for tax purposes is usually much higher, and must be set by an actuary. It is very rare that a captive will take in more than five times the amount of its capital in the first year, and more than three times the amount of capital in succeeding years.
The idea is that the captive needs to have some "skin in the game" other than the premiums that it receives from insureds. In fact, the more capital that a captive has, the safer the arrangement will be from a tax standpoint.
Note that this is primarily a first-year problem, since after the first-year's policies expire, the reserves that back those policies then go into surplus and are available as capital for future underwriting. However, the problem can materialize in later years if there are excessive claims or the captive's owners distribute too much of profits to themselves, leaving the captive's capital cupboard bare.
3. Highly Questionable Risks
A big problem with captives that are just disguised tax shelters is that their policies reflect the underwriting of longshot risks. Like, a really big longshot, as in a “10,000,000,000 to 1, an-asteroid-is-likely-to-hit-the-Earth-first” longshot. Think, hurricane insurance for a business whose operations are in Lincoln, Nebraska, or terrorism insurance for a business in Little Rock, Arkansas.
Maybe it is possible that a really huge hurricane could make its way to Lincoln, or Al Qaeda someday decides to take out a firm in Little Rock, but what is the real risk of that happening? And even if one could say with a straight fact that it might happen, what is the correct amount of premiums for such a policy? $1 per $100,000,000 in coverage? It is sure not $500,000 for $2,000,000 in coverage, which is how the promoters of sham captives will often write it.
Where a captive is formed as a tax shelter, sometimes the risks that are underwritten are already covered by insurance; such as where a doctor sets up a captive for tax reasons and tries to underwrite his or her malpractice liability risks, but then keeps an existing malpractice policy in place so that there is in actuality nothing being covered by the policy (since he or she doesn't want the captive to actually have to pay a claim!).
2. Premiums Not Bearing Any Relationship to Reality
There is an old joke in the captive insurance world, which is that "You don't go to the bathroom without first getting an actuary to sign off on it." That is not too far from the truth. Premiums must be set by a qualified actuary, or else they are probably not defensible in tax court. Unfortunately, what happens too often is that a tax attorney and the insurance manager meet with the client and ask, "How much do you want to save in taxes?" They then pull some premium numbers out of the sky to get the client to the desired target.
Sorry, but it doesn't work that way. The premiums of a captive have to be determined like any other insurance company; setting the premiums as would be done in an arm's length transaction, which is by, among many other things, assessing the true risks of the operating subsidiaries, their needs for the particular insurance, and the minimum and maximum coverage required.
Going back to the hurricane insurance for the business in Lincoln or the terrorism insurance for the company in Little Rock: what is the correct amount of premiums? It is going to be really low, as in dig-the-loose-change-out-of-your-couch low. It is not going to be $500,000 or even $100,000, yet such goofy premium calculations are common with captives that are merely a facade for a tax shelter.
Note that having an actuary sign off on premium calculations is not always going to save you, as those premiums have to be reasonable too. Just like there are real estate appraisers whose first question is "What number do you want?," there are corrupt actuaries who will give you either a $1 or $10,000,000 premium number for the exact same policy and risk. But remember: if the premium calculation is not reasonable, it will not survive a challenge no matter how lengthy the actuary's credentials.
1. Captive Insurance Companies Sold as Tax Shelters
The primary use of a captive must be for bona fide risk management purposes, and not to save taxes. Unfortunately, many of the same promoters of tax shelters who a few years ago were selling Son of Boss, CARDS, BLIPS, and other flavor-of-the-day tax shelters, are now selling captives as a way to save taxes, with only the barest lip-service being paid to the risk management function.
Hale Stewart, an author of a book on captive insurance company taxation, told me recently, "Captives sold as a tax mitigation tool and not as a bona fide risk reduction, are not really captives at all. But I keep running into them." So do I, mostly (but not all) so-called 831(b) captive insurance companies, i.e., captives that have made an election to be taxed as a small insurance company under IRS Code Section 831(b). While the vast majority of 831(b) captives are quite legitimate, there is still probably much more abuse going on with these companies than with non-831(b) companies.
These "tax shelter captives" usually suffer from significant flaws, including inadequate capital, grossly overpriced premiums, insuring non-existent risks, lack of true risk distribution, or as a scheme to buy life insurance with pre-tax dollars. It is probably only a matter of time before these companies, and their owners, come to grief on any number of theories the IRS could assert.