Risks for Starting a Captive
A company seeking to self-insure through a captive must consider all scenarios. An ill-timed adverse event may place both the captive and its parent company in dire circumstances. A new captive will not start out with ample capital on hand to deal with one or more serious casualties; in fact, it may take many years for a captive to build up such capital.
Taxation Issues
Any insurance company, from the perspective of the Internal Revenue Service (IRS), basically collects premiums on one day and holds them for an indeterminate time until they are paid as a claim; used toward overhead; or, in most circumstances, held as taxable income.
The IRS has for more than a decade highlighted potential risks of unlawful tax evasion through the use of captives. A poorly designed captive and one not carefully monitored can bring down significant tax penalties for both itself and its parent.
Certain captive insurance companies, electing a provision under I.R.C. § 831(b) as long as their premiums don’t exceed $2.65 million in 2023, will not pay any tax on any underwriting income but also will not gain any deduction if there is an underwriting loss. The problem with this “micro-captive insurance company” arrangement, from the IRS’s perspective, is that if the insurer-owned insurance company could all but guarantee that no claims would be filed, the taxpayer could defer its tax obligations indefinitely. Aggressive captive insurance promoters can entice business owners with the prospect of substantial indefinite tax deferral utilizing an 831(b) election. Businesses can then fall into the difficult circumstances outlined in Avrahami v. Commissioner, 149 T.C. 144 (2017), where the U.S. Tax Court found that the taxpayer’s wholly owned captive was not bona fide insurance, disallowing deductions for premiums paid into the captive and imposing substantial penalties.
Properly designed captives avoid forcing captive owners to take aggressive tax positions. However, the IRS has been less than clear in providing guidelines to aid business owners who legitimately desire to efficiently use a captive for risk management and risk financing purposes. It is essential for corporate attorneys to temper the enthusiasm of business owners for taking overly aggressive tax positions that may end up doing long-term harm. Corporate attorneys should further encourage business owners to make reasoned decisions about a captive insurance program after receiving quality, independent tax, legal, and accounting advice.
Solutions for Problematic Situations
A captive insurance company can provide a unique solution to what would otherwise be an intractable problem. For example, a corporate acquisition may be at an impasse over the status of a preexisting lawsuit against the target company. A captive insurance company may be able to write a specialty line of insurance, ride out the issue at hand, and help facilitate the transaction.
Public companies also can look to a captive to help facilitate a self-insurance strategy. Businesses that value steady and predictable earnings and expenses sometimes shy away from self-insurance solutions where large, expected losses incurred at inconvenient times can wreck an otherwise attractive balance sheet. By transferring those risks to a captive insurance company, the business can appropriately and steadily account for the costs associated with that risk.
Captive insurance can be an effective risk management and risk financing tool. Companies can use a captive to reap the benefit of better-than-peer risk mitigation efforts. Captives can help smooth out the peaks and valleys of a company’s balance sheet. As captive insurance becomes more regularly utilized by businesses large and small, corporate attorneys are increasingly likely to be called upon to opine on the merits of a captive insurance program. Helping a company form a captive for the right reasons and utilizing best business practices can provide a real long-term benefit.