Captive Insurance - Practical Applications

SINGLE MEMBER LLC’S – A CAPTIVE TAX TRAP

 

 

G. Kristin Delano, Esq.

 

In the Article published on this site on February 14, 2008, “Deductibility of Premium – Federal Tax Requirements”, there is a brief discussion of the need for risk distribution as a condition precedent to premium deductibility.  In Rev Rule 2002-90, the IRS analyzed a structure involving twelve corporate operating companies, each wholly owned by a corporate holding company.  It was found that the twelve operating companies could insure their risks with a affiliated insurance company, also wholly owned by the corporate holding company.  The premium paid qualified as insurance and was deductible.

 

In Rev Rule 2005-40 (a copy of which is in the side bar to this site), the IRS analyzes the same sort of structure where the twelve subsidiaries are single member limited liability companies.  In this case, the premium paid to the group captive isn’t deductible.  The single member limited liability companies are disregarded entities for tax purposes.  It is as if the holding company and its operating subsidiaries were a single company.  Therefore, the captive had only one insured for purposes of determining risk distribution, and the arrangement did not qualify as insurance for tax purposes.

 

The issue and the result is a bit of a trap for those who are not aware of it.  Once the issue is identified, it is easily solved by simply adding a second member to each limited liability company and electing to be taxed as a partnership.

 

Copyright © 2008 by Biber O’Toole Delano Fowler and Clarkson P.L., St. Petersburg, Florida.  All rights reserved.

CAPTIVES, SEGREGATED CELL COMPANIES OR RENT-A-CAPTIVES – WHICH IS RIGHT FOR YOUR COMPANY

G. Kristin Delano, Esq.

 

Lets Define Some Terms

 

The general label, “captive insurance” can be used to refer to a variety of structures.  The following definitions are borrowed from recent work of the Insurance Managers Association in Cayman.

 

Pure Captives. 

 

The structure that is ordinarily called a “captive” is sometimes called a pure captive to distinguish it from “Group Captives” or “Rent-a-Captives”.  A “Pure Captive” is a parent only captive company.  These are formed primarily to insure the risks of their non-insurance parent or affiliates and write no third party business.  When most people hear the word, “captive”, this is the form that comes to mind.  One company owns a captive to insure the risks of its wholly owned subsidiaries. 

 

Rent-a-Captive. 

 

Rent-a-Captives are used by business entities (as well as agents and insurance brokers) to enjoy the benefits of captive ownership without the need to form their own captive, deal with audits or otherwise keep an insurance company in compliance with the laws of the captive’s jurisdiction of domicile.  Generally, the total exposure on any policies written in favor of a given insured entity (plus their share of administrative expenses) will be backed with a combination of premium paid by the insured and capital (cash, notes backed by letters of credit) supplied by the insured entity’s ownership group.  The facility is often used for programs that are too small to justify establishing a separate captive insurer or for groups that don’t want to be bothered with the details of establishing a their own captive. 

 

Group Captive. 

 

These are captives jointly owned by a number of companies to meet a common insurance need.  They may be owned by unrelated businesses in a number of industries, or wholly within the same industry group, association owned or broker sponsored.  Benefits include preferential rates and conditions, sharing of fixed costs, pooling of risk management expertise and similar.  The principal difference between a Group Captive and a Rent-a-Captive is that there is some relationship between the insured interests in a Group Captive.  Otherwise, it is usually a distinction without a difference.

 

Segregated Portfolio Companies or Segregated Cell Companies. 

 

In this format an insurance company is able to segregate the assets and liabilities of different participating shareholders, whereby the assets of one segregated portfolio are not subject to the liabilities of another.  This allows each program to be operated independently of other programs and of the company as a whole.  Use of a segregated cell captive also allows a single captive owner to avoid “contaminating” low volatility with high volatility business, and to have different mixes of capital, retained risk and reinsurance appropriate to the type of business underwritten by each cell.

 

Choosing One Format Over Another – The Issues. 

 

The principal factors to be considered in selecting the form of structure that is best for a particular situation are:

 

Companies believe that their loss experience will be superior to the loss experience of other unrelated insureds.  They are concerned that their capital and “profits” from their own insurance program will be used to pay unrelated claims;

 

The tax requirement for distribution of risk as a condition to premium deductibility.  Reference is made to the article on this site entitled, ““Deductibility of Insurance Premiums – Federal Tax Requirements”, February 14, 2008; and

 

Cost in relation to the benefit. 

 

Segregated Cell Companies. 

 

Many have gone to segregated cell companies to insulate their capital from unrelated risks.  Unfortunately, the tax requirement of risk distribution has been frequently ignored.  It is not unusual for a single risk to be insured within a given cell.  The IRS took up this subject in Rev Rule 2008-08, a copy of which has been attached in the side bar on this site.  It found that where a cell insured the risk of a single entity, there was no insurance, because the risk had not been distributed among other risks.  The law of large numbers is not in play to spread the risks of several insureds. However, where the risks of twelve separate entities were insured, the IRS found that risk had been distributed.  This is basically a restatement of the rule set out in Rev Rule 2002-90, a copy of which is also attached in the sidebar. 

 

Given that analysis, other than in the context of reinsurance, it seems to me that, as regards related party insurance (where the insured entity and the parties supplying the capital to back the risk are related) there would be few occasions when a segregated cell company would be preferable to either a Pure Captive, a Group Captive or a Rent-a-Captive.  I don’t see any advantage, and I see disadvantages:

 

The cell companies are not recognized in every jurisdiction.  A given cell may have assets in a jurisdiction where they have not yet been recognized.  Are those assets going to be immune from the creditors of other cells?

 

The IRS in Notice 2008-19, a copy of which is in the side bar, the IRS is struggling with the treatment of cells.  Should each cell be able to make its own election to be taxed as a U.S. company under § 953(d) (or on the contrary, elect not to be)?  Is any election available to a segregated cell?  While it appears the IRS is leaning in that direction, nothing has been decided.

 

I believe the needs of those who would benefit from some sort of captive structure can almost always be well served with one of the other more traditional structures.

 

Rent-a-Captives.  As noted above, a primary concern of those seeking to put a captive structure to work, is whether their capital is going to be at risk for losses of unrelated insureds.  In my experience, this issue is totally and adequately addressed by making certain that policies and administrative expenses of one insured entity (or related entities) are covered 100% with a combination of the premium paid by the insured entity and capital supplied by the insured entity’s ownership group – capital that is supplied in a combination of cash and notes backed by letters of credit.  Assuming the captive’s management does its job in underwriting each policy, their capital can not possibly be exposed to the losses of unrelated insureds. 

 

There are those who would question whether risk has been distributed under such an arrangement.  I think it is.  While each group has supplied sufficient capital to back their own exposure, the capital supplied is not within a segregated cell.  Instead it is part of the general capital of the captive and, available to satisfy all of the liabilities of that captive – policy related or otherwise. Assuming there are twelve separate insured entities (the exception for single purpose limited liability companies will be taken up in a future article in this site), the insurance arrangement should qualify as having distributed the risk. 

 

The Rent-a-Captives with which I am most familiar use tracking stock (sometimes called “preference shares”).  An insured entity’s ownership group will purchase 100% of a given separate series of tracking stock shares issued by the captive.  The tracking stock performs like common stock.  It is assigned its own separate line item on the captive’s balance sheet that tracks to the performance of the insurance written for the benefit of the related insured as if there were a separate profit and loss statement.  Stated another way, an insured entity’s ownership group will own the all of the profits and suffer all of the losses of the insurance written for the benefit of their related insured. 

 

Pure Captive.  These are for larger groups of related insured entities.  It may be more cost effective for them, due to their volume and size, to have their own captive.  They likely have their own risk management team, and are in a position to manage their own captive, although typically a management company must be engaged to make certain that the captive is in compliance with the jurisdiction of domicile. 

 

Conclusion.  Each group seeking a captive insurance solution will bring their own facts and circumstances, to the analysis of 1) whether a captive structure is right for them (a good place to start) and 2) which style of structure is the best to address their needs.

 

Copyright © 2008 by Biber O’Toole Delano Fowler and Clarkson P.L., St. Petersburg, Florida.  All rights reserved.

 

DEDUCTIBILITY OF INSURANCE PREMIUM - FEDERAL TAX REQUIREMENTS

G. Kristin Delano, Esq.

 

For the insurance premium to be deductible to the insured entity, the captive and its policy must satisfy three basic federal income tax requirements:

 

The insured risk (workers comp exposure, windstorm exposure or other peril) must be shifted from the insured entity to the captive;

 

There must be a distribution of risk within the captive i.e. the captive must insure several parties; and

 

The captive must be a real insurance company and not a sham.

 

 

IRS Requirement - Risk Shifting

 

The risk of loss must be shifted in a significant way from the assets of the insured entity to the captive. The IRS has put it this way, “Risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer, such that a loss by the insured does not affect the insured because the loss is offset by the insurance payment.”  Rev Rule 2002-90, 2002-52 I.R.B. 985 (12/30/2002).

 

The bench mark developed by the large national accounting firms for determining whether there is adequate risk shifting is the so called 10/10 rule.  It states that there must be a 10% or greater probability of a 10% or greater loss to the insurance company under the contract of insurance.  Stated another way, there must be greater than one chance in ten that the expected claims under the policy will equal or exceed 110% of the sum of:

 

The premium to be paid under the terms of the policy; plus

 

The expected investment income from the reserves set aside out of the premium pending claims payment.

 

The total capital required by the captive to serve the insured entity will equal:

 

Claims to be paid and reserves to be established within the policy period;

 

The captive’s administrative expenses (license fees, insurance company management fees, audit and actuarial expenses are examples of administrative expenses).

 

To the extent that the captive’s requirement for capital exceeds premium plus investment income to be earned on the premium, the principals who own the insured entity will supply the difference.  Such an arrangement does not violate the requirement for risk shifting.

 

 

IRS Requirement – Risk Distribution

 

The IRS stated in Revenue Ruling 2002-90, “Risk distribution incorporates the statistical phenomenon known as the law of large numbers.  Distributing risk allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as premiums and set aside for the payment of such a claim. By assuming numerous relatively small, independent risks that occur randomly over time, the insurer smoothes out losses to match more closely its receipt of premiums. Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9^th Cir. 1987).  Risk distribution necessarily entails a pooling of premiums, so that a potential insured is not in significant part paying for its own risks. See Humana Inc. v. Commissioner, 881 F.2d 247, 257 (6^th Cir. 1989).”

 

In December of 2002, the IRS promulgated a revenue ruling where the facts involved a holding company with 13 wholly owned subsidiaries one of which was a captive insurance company.  The other twelve subsidiaries were operating companies each of which was insured by the affiliated captive.  The IRS found that twelve insureds were a sufficient number of insureds for risk distribution.  Rev Rule 2002-90 cited above. 

 

The IRS did not say that a minimum of twelve insureds would be required in order to achieve risk distribution, but only that twelve would be adequate.  However, there is no authority for the proposition that fewer than twelve insureds could satisfy the risk distribution requirement.  To the extent that the captive has less than twelve insureds, the parties involved assume some degree of risk relative to the deductibility of premium. 

 

 

IRS Requirement - Insurance Company Not A Sham

 

In addition to the requirement for risk shifting and risk distribution, the third IRS requirement to establish deductibility of premium paid to a captive is that the captive must be a real insurance company and not a sham.  The Sixth Federal District Court of Appeal has established the following seven factors that can be considered in applying an all facts and circumstances test.  Malone & Hyde, Inc. v. Commissioner 62 F.3d 835 (6th Cir. 1995):

 

Whether the insurance company has its own capital or whether the insured or related parties have provided guarantees to the insurance company i.e. the insurance company isn’t really taking the risk;

 

Whether the captive is adequately or thinly capitalized;

 

Whether the captive is loosely regulated under the laws of its jurisdiction;

 

Whether the insureds face real hazards;

 

Whether policy premium is based on market rates;

 

Whether claims are verified before they are paid; and

 

Whether the captive's business operations and assets are kept separate from the insured or parties related to the insured.

 

Generally, persons serious about creating a captive will establish a real insurance company that will not be found to be a sham.

 

Copyright © 2007 by Biber O’Toole Delano Fowler and Clarkson P.L., St. Petersburg, Florida.  All rights reserved.