The process for companies to accurately determine the value of establishing a captive insurance platform involves an extensive examination of the responsibilities and benefits in order to access how the organization will be impacted. Throughout our captive insurance article series, we have highlighted many of the key components involved with launching a captive and we have discussed the importance of operating a captive as part of a long-term, integrated risk management and asset protection strategy. As we have previously noted, the feasibility study will provide the particulars of whether or not a captive insurance program will be cost effective for a particular company or organization. However, many captive candidates never reach the feasibility study stage. Captive formation can encounter a number of road blocks in the early stages of development, including capital requirements, gaining approval from state regulators and achieving risk distribution and risk transfer to name a few.
Initial & Ongoing Funding Requirements
It should not be surprising that the capital requirements for establishing and operating a captive on an annual basis is the first and the most commonly cited deal breaker for launching a captive. The annual business insurance premiums currently paid by the company and the level of predictable annual cash flows available to properly fund the captive are the key financial metrics for most companies in considering the feasibility of a captive platform. Though some variances depending on industry and types of risks do exist, a viable candidate for a captive insurance platform is a group or company with at least $10 million in annual revenue that typically pays in the neighborhood of $300,000 in premiums per year for its current commercial coverage.
As an example of what is required to properly initiate a captive, consider the start-up funding needed to establish a captive in the state of Tennessee. A captive insurance program in Tennessee is generally going to necessitate an initial capital commitment of $250,000. Additionally, it will likely take $80,000-plus to facilitate the setup with a feasibility study and the other organizational legal work. Beyond that, the group or company utilizing a captive must be prepared to cover claims’ administration fees, actuary fees, captive manager fees, audit fees and taxes.
Even if a business meets the benchmarks to warrant a feasibility study, historical experience rates for the risks to be written in the captive may be problematic. If the required premiums for these risks are higher or relatively comparable to the current premiums being insured, it will likely be cost prohibitive to develop and maintain a captive arrangement.
Taking the First Steps & Satisfying State Regulators
Selecting a captive manager and conducting a feasibility study, as discussed in the previous articles in this series, are the first steps that must be taken to establish a captive insurance platform. At this stage, all possible costs, the management resources required and the potential outcomes from establishing a captive will be considered.
A captive program determined to be feasible will then be subject to the review and approval of insurance regulators in the state in which the captive will be domiciled. A good captive manager will typically have a strong working relationship with state regulators, and they will have a good sense of what will (and will not) pass muster. Without state approval of the proposed insurance program, a captive will not be allowed to operate as an insurance entity in that state.
Though tax benefits should never be the primary reason for establishing a captive, companies implementing captive programs generally want to be positioned to realize some income tax efficiencies. In order for the insured to deduct premiums paid to a captive for income taxes, the insurance program must meet certain criteria to gain recognition as a bona fide insurance company by the Internal Revenue Service, and must be able to document the non-tax reasons for forming a captive.
Critical Issues for Regulators and the Internal Revenue Service
Risk transfer and risk distribution are the two most critical components that must be incorporated within the structure of a captive program in order to qualify as a bona fide insurance company. Without achieving these criteria, the arrangement is merely self-insurance for which premiums paid are not deductible.
The IRS is well aware that, while most captive platforms are legitimate, some businesses establish captives solely for tax shelter purposes. The basis of legitimate insurance is dependent upon the certainty that a particular risk and corresponding economic loss actually exists. For example, hurricane insurance policies are understandably appropriate for the Carolina coastline and throughout Florida. However, the risk of a hurricane damaging a business in Montana is non-existent, and payments for a Montana hurricane policy likely would not meet the criteria for legitimate risk transfer.
It has become common for captive platforms to allow companies to insure themselves against “boutique” risks. Examples of boutique risks can include the loss of a major customer or losses due to a data breach or cyber-attack. As long as there is a potential for loss and the rate structure for the premiums are appropriate with the occurrence of loss, the coverage of esoteric risks through the use of a captive can meet the standards of legitimacy established by the IRS.
Any company considering a captive strategy should clearly understand that the captive insurance company must operate at an arm’s length from its parent organization. A captive needs to be viewed as a separate insurance company from which premiums are paid and losses are settled. Cash reserves in the captive should not be loaned back to or otherwise invested in the parent organization.
Risk distribution is another concept at the core of insurance. Also known as risk sharing, risk distribution is the premise that premiums paid by the collective members in the coverage group are used to cover the losses encountered by the group. Risk distribution works in large part off the principle of large numbers as an insurer reduces the likelihood that the cost of a single significant claim will exceed the total amount available to cover that single claim. As a part of the IRS Safe Harbor provisions, Rev. Rul. 2002-89 requires that the captive must derive more than 50 percent of its overall revenue and collective risk from non-parent entities.
Within the area of risk distribution, the IRS has also begun looking for risk homogeneity, meaning that each line of coverage insured by a captive must separately comply with the tests for risk distribution. The prevailing opinions of captive insurance observers disagree with the IRS position on risk homogeneity.
Risk Pools & Multiple-Insured Captives: Strategies for Achieving Risk Distribution
Two approaches that can be utilized by captives to achieve risk distribution are risk pools and multiple-insured captives. While risk pools are used by many smaller captives, some larger companies entering the captive market find the pool approach to be an option as they work toward building a multiple-insured structure.
As the term suggests, a risk pool brings together a variety of insured risks from a collection of companies. Smaller companies typically work with their respective captive managers on finding the optimal risk pool to enter. The owners of the individual captives are then able to share particular risks through their respective captive companies’ collective resources within the risk pool. Despite the careful selection, the risk pool presents a potential pitfall and a possible deal breaker because it’s conceivable not all companies in the pool place the same value on the commitment to risk management.
Organizations considering implementing a risk pool strategy should be aware of the potential for increased IRS scrutiny. As part of its effort to identify and address the development of captives disguised as tax shelters, the IRS is continually looking for what has been termed as notional risk pools. Captives participating in risk pools that have limited or no claims, accompanied by large premiums for the coverage provided, can fall into this category.
A multiple-insured captive places a group of insureds within one insurance entity. The IRS safe harbor for a multiple-insured captive can be found within Rev. Rul. 2002-90, which requires that a captive entity must underwrite risk for at least 12 different legal entities. Another requirement under this rule limits the risk percentage among the entities in the captive. None of the entities can make up less than five percent of the risk for the captive, and none can exceed 15 percent of the captive’s overall risk.
An example might be a group of 12 independent plastic surgeons who establish a captive to insure the excess of $1MM per occurrence of their medical malpractice claims, which are commercially insured below $1MM. The surgeons all have similar size practices, perform essentially the same procedures and have similar historical frequency of claims. This achieves risk distribution for the surgeons without having to utilize a risk pool involving unknown insureds. The arrangement’s success depends on all of the surgeons maintaining an optimal commitment to risk management. Because the “pool” of insureds is limited, a catastrophic loss will have a significant impact on the reserves of the captive and the future premiums required of all 12 surgeons. Removing a poorly performing insured from the captive is not only going to be a legal and organization matter that will be costly, but it may also decrease the level of risk distribution below what is required for the captive to be a valid insurance company.
Increased Scrutiny of Captives & New Legislation on the Horizon
The IRS Criminal Investigative Department has continued to place a spotlight on captives. In a February 2015 press release discussing what the agency calls the “Dirty Dozen” list of tax scams, it is clear that the IRS has captive insurance on its radar. According to the press release, the IRS is wary of “policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums,’ while maintaining their economical commercial coverage with traditional insurers.”
Meanwhile, legislators appear to be embracing changes that may help smaller captive companies. In early February of 2015, the Senate Finance Committee voted to expand the alternative tax liability limitation for small property and casualty insurance companies. The proposed legislation is seen by many captive insurance observers as recognition of the role smaller, 831(b) captives play in protecting small and mid-size businesses. Currently, captive platforms with premiums of less than $1.2 million can elect to be taxed only on net investment income as opposed to total underwriting income. The proposed legislation would increase the maximum premium limit to $2.2 million and allow for future adjustments as the result of inflation.
Finding the Right Fit
At the end of the day, well-run and properly managed captive entities can deliver numerous benefits for those organizations which are able to make the investment of time and money. Captives are continuing to evolve with the changes in the market, and they require a captive management group which can keep an organization up to date with changes in policy which impact the operation of a given captive platform.
As detailed throughout this series, captive insurance is not for every business. Yet, for those companies which identify specific and viable opportunities to develop a captive platform, the savings achieved and the long-term benefits realized can make all the efforts to establish and maintain captive policies worthwhile.
We Can Help!
Elliott Davis Decosimo has assembled a strong team of experienced professionals who can help your company initiate a feasibility study and walk you through every step of building a strong captive insurance program for your business. For more information concerning captive insurance, contact an Elliott Davis Decosimo subject matter expert.