Captive Insurance Company FAQs

by Beckett Cantley[1] and Geoffrey Dietrich[2]

This article is intended to provide a basic set of frequently asked questions on captive insurance companies. The questions are in no way meant to be exhaustive on the subject, but rather solely cover certain basic uniform questions potential captive insurance company owners need to ask before forming one. Please note that the authors only advise captive owners and advisors on specific issues of captive insurance law and do not form or operate captive insurance companies.

Captive Insurance Company FAQs

What is an IRC § 831(b) Captive Insurance Company?

An Internal Revenue Code (“IRC”) § 831(b) small captive insurance company (“CIC”) is, in essence, a corporation formed to offer insurance to a parent corporation or other affiliated entities.[3] The CIC may offer administrative and tax benefits over self-insurance and commercially available insurance. The questions addressed below briefly discuss the history, the structural details, and the potential benefits.

How Did Captive Insurance Start?

Captives emerged as a planning tool in the 1950’s.[4] Fred Reiss created American Risk Management in 1958 to assist U.S. corporations in establishing their own insurance companies as an alternative to conventional risk management.[5] Due to the peculiarities of state insurance laws at the time, most CICs were formed outside the U.S., often in “debtor havens” where the companies experienced few, if any, local tax consequences.[6] After the U.S. passed tax legislation temporarily eliminating many benefits of CIC insurance arrangements for U.S. companies, Reiss formed International Risk Management in Bermuda.[7] This move precipitated the dominance of offshore domiciles in the CIC market for the remainder of the twentieth century.[8]

Historically, CICs were most often utilized by large U.S. corporations.[9] One common motivation was, and continues to be, a company’s inability to purchase commercial insurance at acceptable premium and coverage levels.[10] The taxpayers in Consumers Oil[11] and Weber[12] had operations in areas prone to flooding and neither taxpayer was able to obtain commercial insurance coverage due to the elevated risk.[13] Similarly, the taxpayers in Gulf Oil[14] and Ocean Drilling[15] operated in high-risk industries and were only able to obtain commercial insurance at prohibitively high prices. The companies formed CICs to provide the coverage they could not otherwise obtain under acceptable terms.

Another common theme is a company’s desire for more administrative control over the insurance policy.[16] Beech Aircraft[17] was unable to obtain commercial insurance that would allow the company to control its legal defense in the event of a claim. [18] The company had been sued under a previous policy, and the jury returned a sizeable verdict against the company, the majority of which was designated as punitive damages.[19] After an investigation, the company was convinced that the verdict was a result of a failure by the insurer’s legal team to adequately prepare and try the case.[20] The company had monitored the activity of the insurer’s attorneys during the course of the trial, and even unsuccessfully filed a motion to have those attorneys removed.[21] To afford itself more control over the administrative terms of the policy, the company formed a wholly owned subsidiary CIC.[22]

Throughout the 1970’s and 1980’s, judicial and executive interpretation identified circumstances under which a CIC insurance arrangement would be respected in the U.S.[23] In general, courts ruled captive structures were valid insurance companies when they either insured a sufficiently large number of the parent company insureds[24] or obtained at least 30% non-parent risk.[25] Increased certainty through pro-taxpayer decisions led to increased utilization of CICs as a risk management strategy by major U.S. corporations.[26] States began passing legislation enabling formation of CICs, and more growth to the domestic sector resulted.[27] A concomitant increase in courtroom activity led to a rise in certainty as judges circumscribed the permissibility of CICs.[28] A critical mass accumulated in the 1990’s, and the CIC industry “exploded” as smaller and even privately-held businesses began to view CICs as an attractive alternative to more common risk management strategies.[29] Today, a majority of states have passed CIC-enabling legislation.[30]

What Can a Captive Do?

Generally speaking, a CIC may offer coverage of virtually any type to the operating business, and the terms of the policy are remarkably flexible.[31] By far the most common arrangement is for the parent company to maintain existing coverage through commercially available policies while having the captive fill policy gaps[32] and provide coverage for stochastic (low frequency, higher payout) risks.[33] Also, Congress has provided a tax incentive for the formation of IRC § 831(b) small CICs. In effect, the tax code helps offset the costs of establishing and operating a regulated, small insurance company.

What are the Benefits of a Captive?

A CIC may afford its owners numerous benefits. A CIC can provide niche coverage for unique or specific risks that would not be otherwise transferrable, or not transferrable at an acceptable cost, in the commercial insurance market. This is especially advantageous to an entity with an above average risk profile that seeks to reduce its exposure in a cost-effective manner. Thus, so long as the policies are commercially reasonable, a CIC owner can “create whatever type of coverage for the operating business [he] can dream up.”[34] In his authoritative book on the subject, Jay Adkisson lists dozens of policy types ranging from the relatively mundane, e.g, errors and omissions, and malpractice, to the somewhat esoteric, e.g., confiscation and expropriation, and weather risks.[35] Moreover, as highlighted by the Beech Aircraft case, the policy terms may be tailored to meet the individual needs of the insured, again, subject to commercial reasonableness.

Also, a CIC may be used as a means of cost stabilization for an insured who has grown weary of premium increases in a hardening commercial insurance market. These increases may be based on market forces or underwriting software rather than the claims experience of the insured entity. For a company with a better than average loss experience, a CIC can save premium dollars that would otherwise be used to subsidize the loss experience of other market members.

Next, a CIC can reduce or eliminate brokerage commissions and marketing and administrative expenses, which are typically wrapped into commercial insurance premiums. Thus, a CIC arrangement allows a business to potentially lower its overhead while leaving more premium dollars in reserve for claims payment and surplus investment. If the CIC “wins its gamble” with the insured, it can generate profit for the parent corporation that would otherwise accrue to the commercial insurer. As surplus funds accumulate, the funds can be invested. Moreover, a parent corporation may generally exercise some control over the investment decisions of the CIC.

In addition to these benefits, Congress has provided a tax incentive for CIC formation under IRC § 831(b). In effect, § 831(b) helps offset the costs of establishing and operating a regulated, small insurance company. A valid IRC § 831(b) CIC may allow a parent corporation to manage risk exposure without incurring the income tax problems associated with self-insurance. Whereas contributions to a reserve account for self-insurance are generally not tax deductible, premiums paid to a CIC by its insured entity may be deductible, similar to the deductibility of premiums paid for commercial insurance. IRC § 162(a) provides that “there shall be allowed deductions on necessary and ordinary business expenses incurred in carrying on a business.” Treasury Regulations § 1.162-1(a) states that business expenses include insurance premiums paid on policies covering fire, storm, theft, accident, or similar losses in the course of business. Thus, provided that the CIC is considered an “insurance company,” issuing “insurance” through arrangements that are considered “insurance contracts,” as discussed above, the parent corporation should be able to deduct premium payments to the CIC.

Furthermore, a CIC may earn premiums, within limits, without incurring federal income tax. IRC § 831(a) provides that tax shall be imposed under IRC § 11 on the taxable income of any insurance company other than life insurance companies. However, IRC § 831(b) provides that a non-life property and casualty insurance company, which receives annual premiums not to exceed $2.3 million, can elect to receive these premiums tax-free. Thus, the CIC would incur no tax on underwriting income earned on premiums paid, so long as the aggregate premiums total less than $2.3 million annually.

Notably, the CIC is still taxed on income earned through investment activity. Assuming that the CIC is profitable in its underwriting and investment operations, profits will be distributed to the CIC shareholders in the form of dividends. Alternatively, a CIC shareholder could realize profits through the sale of his shares in the CIC. In either the case of a qualified dividend or sale of stock, the income would be taxed at the long-term capital gains rate, under current law, rather than at the rate applicable to ordinary income.

How is a Captive Owned?

Typically, a CIC is either owned directly by its parent corporation or by the shareholders of the parent corporation. The organizational structure of a CIC closely resembles that of a mutual insurance company, albeit for a more limited number of participants. “CIC” refers to a brother-sister arrangement in the discussion below unless otherwise noted. Without belaboring the details of the day-to-day operation of an insurance company, this discussion seeks to give a brief overview of selected topics. The CIC and its insured should independently operate in an arms-length relationship to the greatest extent possible.[36] Thus, while the CIC should be tightly woven into the parent company’s overall business plan to maximize efficiency, the CIC should maintain its own business goals and plan for success.

Who Manages a Captive?

The ongoing management of the CIC is critical in ensuring the success of the enterprise. The CIC should recruit appropriately credentialed professionals to fulfill management, underwriting, accounting and audit duties. The insurance manager fills the fundamental role of determining which risks to underwrite and drafting the policies that insure the chosen risks. The insurance manager must seek actuarial assistance in evaluating risks and determining premium and reserve levels. Also, it is ultimately the insurance manager’s responsibility to ensure that the CIC complies with its license terms, regulatory requirements, deadlines, and the like.

Are Captives Audited?

Most jurisdictions require annual audits of insurance companies by an accounting firm approved by the Insurance Commissioner. Choosing a firm that is experienced in CIC insurance may help the CIC avoid the myriad pitfalls that await CICs in the IRC.

The CIC should undergo periodic reevaluation to maximize efficiency. Such reevaluation may allow a CIC to underwrite more risk given its capital structure, and the goals of management. Moreover, risks currently underwritten by the CIC may have become more inexpensive to insure in the commercial market, again, subject to management goals. Typically, a CIC must provide notice to the Insurance Commissioner of its jurisdiction when there will be significant changes to its operations or ownership structure.[37]

How are Captive Insurance Companies Formed?

Aside from what structure the CIC will take, many factors must be considered before undertaking the formation of a CIC. First, an experienced attorney or consultant should be engaged to perform a feasibility study.[38] This will provide the prospective owner with an independent, clinical opinion as to whether a CIC is an appropriate vehicle to achieve the desired benefits, given the owner’s business and overall financial plan. This step should also begin to educate the proposed owner of the regulatory and compliance requirements associated with operating an insurance company according to the statutory regime of the licensing jurisdiction.

Also, a detailed actuarial study should be prepared, and, in fact, generally must be submitted with the insurance license application. The actuarial study should determine the amounts and types of coverage that will be underwritten. The study should also include information as to how the premium amounts will be determined and the capitalization requirements associated with the new CIC. There should be no communication between the potential insured, the party supervising the study, and the actuary that attempts to manipulate the numbers to arrive at tax-friendly numbers. Once the feasibility and actuarial studies are completed, the insurance license application can be submitted in the jurisdiction of choice.

Where are Captive Insurance Companies Formed?

A CIC can be formed and licensed pursuant to the laws of a U.S. state, or those of a foreign country. The company will be “domiciled” in the jurisdiction where it was formed. Many factors impact the decision as to whether to form the CIC domestically or offshore and the choice between domiciles in either arena. Those factors include, but are not limited to: (1) the CIC’s exposure to the U.S. tax system; (2) the capitalization burden required at formation; (3) the flexibility the CIC is allowed in investing its resources; and, (4) the asset protection afforded the U.S. shareholders of the CIC.[39]

The tax and compliance burdens imposed by U.S. law on a CIC and its U.S. shareholders may be a consideration in deciding whether to form a CIC domestically or offshore. Notably, an organization in an offshore jurisdiction will not preclude the IRS from assessing and collecting U.S. income tax. Therefore, the decision as to whether to form a CIC in a domestic or offshore jurisdiction should be made based on the local reporting requirements and taxation to which a CIC would be subject, accepting as fact that the IRS is quite capable of visiting federal income taxation on an offshore CIC.[40]

Both domestic and offshore CICs are subject to U.S. income taxation. A foreign CIC may elect to be taxed as a domestic entity under IRC § 953(d).[41] A company making such an election directly subjects all income earned globally to U.S. federal income tax, rather than indirectly through its U.S. shareholders under IRC subchapter F.[42] The benefits to a U.S.-owned offshore CIC making an IRC § 953(d) election include exemption from the federal excise tax (“FET”), simplified compliance and administration and, at least theoretically, communication to the IRS that the CIC need not be subjected to heightened scrutiny by virtue of its offshore domicile.[43] An IRC § 953(d) election is irrevocable absent IRS consent.[44]

A CIC that chooses not to make an IRC § 953(d) election could find itself categorized as a controlled foreign corporation (“CFC”) if more than 25% of its shares are held by U.S. owners.[45] A CFC classification would render the CIC income currently taxable its U.S. shareholders. Under these circumstances, the U.S. shareholders of the CIC would be required to currently include all CIC profits not directly allocable to insurance contracts issued on risks outside the U.S. in the CIC owner’s taxable income, irrespective of the timing of the distributions.[46]

What are the Disadvantages of Forming a Captive Insurance Company Offshore?

The disadvantages of forming a CIC under the laws of a foreign country potentially include subjecting the policy premiums to the FET and increasing the compliance burden of the CIC by exposing the company to a greater risk of an intrusive audit.[47] Policy premiums paid to an offshore CIC by a U.S. insured may be subject to the FET if the IRS views the arrangement as an “importation” of a foreign service. Foreign services imported to the U.S. are subject to the FET. Specifically, property/casualty premiums paid to an offshore CIC by a U.S. insured are subject to a FET of 4% for original insurance and 1% for reinsurance.[48] Because the offshore CIC provides insurance, actuarial, and management services to its U.S. shareholders, the IRS may view the arrangement as an “importation” of foreign services, thus exposing its U.S. shareholders to the increased U.S. tax burden of the FET. While some domestic jurisdictions charge premium taxes, shareholders of a domestic CIC can generally avoid the additional tax liability in the form of premium taxes by simply choosing to organize the CIC in a state that does not require premium taxes.[49]

An otherwise compliant CIC should have nothing to fear from the mere fact that it is domiciled offshore. However, that offshore domicile alone may be enough to subject the company to an “ever-changing and perilous compliance burden” and a risk that the company will be swept up in the increasing number of IRS audits of offshore entities.[50] Around 2005, the Senate Permanent Subcommittee on Investigations (“PSI”), under the leadership of Senator Carl Levin, began to view U.S. taxpayers’ offshore holdings with increasing suspicion.[51] This sentiment grew out of the government’s reduced ability to monitor its citizens’ offshore holdings. When PSI investigations began to uncover empirical evidence supporting this suspicion, Congress, the Department of Justice, and the IRS became engendered with a belief that U.S. holdings in offshore arrangements were potentially abusive and evasive. Congress has enacted and continues to propose, numerous legislative schemes to assist the IRS in enforcing U.S. tax laws offshore. Without addressing the details of the various enacted or proposed legislation, it is sufficient to say that organizing a CIC offshore to reduce one’s exposure to U.S. tax laws is by no means a foolproof strategy.

How are Captives Capitalized?

The capitalization burden, or the sum of money required under local law to be contributed to a reserve account upon formation, will likely affect whether one decides to organize a CIC domestically or offshore, and the choice of domicile within these categories. Domestic jurisdictions have historically required between $300,000 and $300 million capitalization to form a CIC, depending on such factors as the type of CIC, the proposed coverage offered by the CIC, and the relationship between the CIC and the insured. Laypeople, and indeed some tax and insurance professionals, have long espoused the relaxed offshore regulatory environment as a benefit of organizing a CIC offshore. This perception arises in part from the lower minimum capital contributions typically required in offshore jurisdictions and the less restrictive rules and regulations many offshore jurisdictions impose on insurance and financial institutions. For example, offshore regulators generally rely on independent CPA verifications, whereas domestic regulators typically require examinations by state regulatory bodies and state-approved audit firms.

While the local regulatory environment is important in choosing a jurisdiction in which to found a CIC, a planner must not overlook the requirements superimposed on all insurance companies by the IRS The IRS must consider the CIC an insurance company for premiums to be deductible under IRC § 162, and for a CIC to receive the tax benefits of IRC § 831(b), and the policies issued must reflect an insurance arrangement. To consider a policy an insurance arrangement, the IRS must find that the risk of economic loss was shifted from the parent-insured to the CIC, i.e. “risk shifting”. Without adequate capitalization, the CIC may have insufficient reserves to cover its insureds’ current and anticipated claims. Because an insured would bear the entire risk of loss if his insurer failed to satisfy the insured’s claim, adequate capitalization factors heavily in determining whether risk has shifted between an insured and a CIC. Therefore, any CIC seeking to participate in the benefits bestowed upon insurance companies by the IRC may be subject to substantially higher capitalization requirements than those imposed by the offshore jurisdiction.

Notably, some U.S. states have made their minimum capitalization requirements more palatable in recent years. For example, Delaware reduced its requirement to $250,000 combined capitalization among separate CIC entities formed and administered as part of the same series. Under such an arrangement, a group of individual CIC entities may share the same capitalization. Thus, provided that all other CIC law is strictly observed, the individual entities can maintain the reserves necessary for proper risk-shifting while keeping their individual capitalization requirements reasonably low. Such domestic options at least warrant a second look from a prospective owner seeking to minimize his initial capital contribution without inviting IRS scrutiny.

What Investments Can a Captive Insurance Company Make?

One consideration in choosing whether to organize a CIC domestically or offshore is the investment flexibility a jurisdiction affords a CIC with respect to its surplus. Surplus is the income that a CIC retains in excess of the funds needed to satisfy its current claims. Some foreign jurisdictions permit a CIC to invest its surplus in any investment vehicle, provided the investment does not impair the capital base or run afoul of the foundational requirements of the insurance arrangement, including making investments so unreasonably illiquid as to potentially prevent the payment of its actuarially anticipated claims.[52] Because the primary responsibility of an insurance company is to pay claims as they arise, a CIC that fails to abide by its solvency requirements would not be considered a valid insurance company for any purpose. As such, while a foreign jurisdiction may permit a CIC greater investment flexibility, the CIC is still subject to the IRC requirements applicable to all insurance arrangements. A CIC not primarily engaged in the business of underwriting insurance or reinsurance activities would not be considered an insurance company.[53] Thus, CIC compliance with the regulations of the foreign jurisdiction is significant in assessing whether a CIC is primarily engaged in the business of insurance, but the controlling factor in analyzing whether a CIC qualifies as an insurance company is the nature of the business transacted in the taxable year.

IRS pronouncements warn that certain arrangements where an insurance company’s insurance business is outweighed by its investment activities may not withstand this analysis. While some of this guidance appears in the context of life insurance, which a CIC may not insure, the issues raised with respect to life insurance companies should apply with equal force to companies that insure risks other than life. IRS Notice 2003-34 warned taxpayers that investing in certain U.S. shareholder-owned offshore purported life insurance companies to defer recognition of ordinary income, or to re-characterize ordinary income as capital gains, may present a compliance risk. The IRS recognized that arrangements of this type are used to invest in hedge funds or those investments in which hedge funds ordinarily invest, typically resulting in a relatively small proportion of genuine insurance activities in comparison to the offshore entity’s investment activities.

These arrangements result in the offshore entity earning investment income substantially in excess of the entity’s ordinary insurance business needs. Shareholders often eschew any current distribution, claiming that since the appreciation arises from the conduct of insurance business rather than passive investment income, the appreciation constitutes capital gain instead of ordinary income. The IRS recognized that operating an insurance company will almost certainly involve investment activity. However, genuine insurance companies use the returns from their investments to satisfy claims, underwrite more business, and fund distributions to the company’s shareholders. A foreign jurisdiction’s certification of an entity as an insurance company under the jurisdiction’s local rules does not necessarily equate to IRS recognition of the entity as an insurance company, especially where the entity is not primarily occupied in the issuance or reinsurance of insurance or annuities. For federal income tax purposes, an entity is only considered an insurance company when it primarily employs its capital in the pursuit of income from underwriting additional insurance risks. In making this determination, the IRS will analyze an entity’s aggregate operations and sources of income.

The IRS may determine that an offshore CIC is not an insurance company for federal income tax purposes if the CIC is predominantly used as a conduit for hedge fund investment. Under such circumstances, the IRS could impose current taxation on those U.S. persons earning passive income through the offshore entity under the Passive Foreign Investment Company (“PFIC”) rules.[54] Under IRC § 1279(a), a foreign corporation is a PFIC if (1) 75% or more of the entity’s gross income is passive income, or, (2) at least 50% of the entity’s assets produce, or are held for the production of, passive income. Corporations engaged primarily in the active conduct of insurance business are outside the purview of the PFIC rules, as they are subject to federal income taxation under the IRC subchapter L U.S. life insurance company rules. IRS Notice 2003-34 stated that the IRS will challenge the validity of these types of investment schemes, through the application of the PFIC rules, on a finding that a foreign corporation is not an insurance company for federal tax purposes. Thus, the latitude a foreign jurisdiction gives a CIC with respect to investing its surplus may be significantly circumscribed, at least to the extent that the entity’s investment activities may not exceed its insurance activities, lest the CIC find itself challenged as a PFIC.

Does a Captive Insurance Company Provide Asset Protection?

Adding a layer of asset protection may enter into the calculus when deciding whether to organize a CIC domestically or offshore. Various offshore jurisdictions claim that their regulators hold information about CIC assets in strict confidence, allowing a CIC to be organized and operated in secrecy. Many people also believe that disclosure of the identity of the parent entity to the IRS can be avoided through a valid IRC § 953(d) election, on the rationale that the CIC itself is the U.S. taxpayer and owner of all CIC assets. Avoiding disclosure to both foreign and domestic authorities may seem a beneficial attribute of offshore CIC organizations. Such secrecy may render a creditor unable to follow the money, leaving him less enthusiastic about the prospect of costly, protracted litigation, given the uncertainty as to whether the debtor is “judgment proof.”

Moreover, an IRC § 953(d) election could force a creditor to file suit against the CIC in the courts of the offshore domicile, effectively allowing the CIC to choose both the venue and the controlling law. Such a result is possible because a valid IRC § 953(d) election applies only to the IRC, and not to any other titles of the U.S. Code, including the Federal Rules of Civil Procedure. Thus, a creditor would be unable to argue that the CIC was domiciled in the U.S. and would have to prove that the U.S. court had personal jurisdiction over the CIC. A U.S. court could only exercise personal jurisdiction over the corporation on a showing that the corporation had the requisite minimum contacts with the jurisdiction or had purposefully availed itself of the U.S. court’s jurisdiction. An offshore CIC that collects substantial premiums from a U.S. insured in exchange for insurance may indeed have sufficient contacts to fall within the U.S. court’s jurisdiction. However, assuming a U.S. court could not exercise personal jurisdiction over a foreign CIC, creditors would effectively be forced to bring suit against the CIC in the foreign domicile’s courts, under the foreign domicile’s laws. Creditors may be unwilling to undertake such a daunting task, particularly where the offshore domicile has strict asset protection and account secrecy laws. Furthermore, even if U.S. courts are able to exercise personal jurisdiction over the CIC, and a creditor secures a judgment against the corporation, the foreign jurisdiction may be unwilling to enforce the U.S. judgment. Such a blow could be fatal to a creditor in the case of a debtor who has few assets outside the offshore jurisdiction.

If a creditor secures a judgment against a U.S. citizen, a U.S. court may very well declare a transfer offshore illegal or invalid at its source. The Court may be hesitant to relinquish jurisdiction over a transfer it perceives as a fraudulent attempt to evade the transferor’s creditors, especially if the creditor successfully maneuvers the transferor into a bankruptcy action. U.S. bankruptcy courts have broad powers to invalidate transfers that hinder or delay satisfaction of a creditor’s claim, and often use these powers to frustrate offshore asset protection arrangements. A hypothetical debtor could transfer significant assets offshore and outside the debtor’s control and beneficial enjoyment in the form of premium payment to a foreign CIC in an effort to become insolvent. Once found insolvent, creditors could position the debtor into bankruptcy, and the bankruptcy trustee would take control of the debtor’s estate. The trustee may be able to force a waiver of the attorney-client privilege, and obtain any information provided to the debtor by an asset protection attorney. This would likely allow the bankruptcy trustee to uncover documents and information revealing the location of the debtor’s offshore assets. In the case of a CIC, this information would likely include the non-public records of where the CIC assets are located. Once the bankruptcy trustee uncovered this information, it would be an easy task to unwind an asset protection arrangement designed to render the debtor insolvent. Then, the bankruptcy trustee could reclaim the assets, or repatriate premiums paid to the CIC or assets purchased with those premiums to satisfy creditor claims.

U.S. courts have declared that it is against public policy to enforce the laws of a foreign jurisdiction where those laws violate established principles of U.S. law. Foreign jurisdictions that are known for asset protection often intentionally draft legislation to circumvent the laws of other jurisdictions, including the U.S. As such, a U.S. judge may be loath to apply a foreign law that is unlikely to withstand an attack on public policy grounds. Thus, if a U.S. court finds that foreign laws are being used in contravention of public policy, the Court may unwind an offshore CIC.

A creditor may successfully void a transfer of funds from a U.S. party to an offshore CIC if the creditor can convince the Court that the transfer was made for improper asset protection purposes. Thus, a court may rule that capitalization or premium payments made to an offshore CIC by a U.S. shareholder or insured are void ab initio, especially if the debtor is before the U.S. bankruptcy court, as discussed above. Moreover, if the IRS and DOJ suspect that a CIC was formed for asset protection, they may question whether the CIC is being primarily operated as an insurance company, irrespective of creditor claims.

How Do Captive Insurance Companies Operate?

A CIC is, first and foremost, an insurance company, and must be operated in a manner consistent with being predominantly in the business of insurance. To avail itself of the favorable tax treatment the IRC bestows upon insurance companies, a CIC must, of course, meet the definition of “insurance company.”[55] Failure to meet this requirement could result in the exposure of all of the entity’s income to C corporation double taxation. Treasury Regulations § 1.801-3(a) provide that an insurance company is one whose primary and predominant business activity is the issuance of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. Under IRC § 816(a), an “insurance company” is any company more than half the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by an insurance company.

Captives must also comply with the “Harper Test,” so named because it is based on three factors outlined in the Harper case.
The three factors are:
(1) Whether the arrangement involves the existence of an “insurance risk”;
(2) whether there was both risk-shifting and risk distribution; and
(3) whether the arrangement was for “insurance” in its commonly accepted sense.[56]

“Insurance risk” requires the insurance company to specifically define the risk, which is contained in the policy. In addition, the insured must be able to demonstrate a premium was paid and the insurance company issued an insurance policy. Risk shifting and distribution are covered below.

Insurance in its commonly accepted sense requires the transaction to comply with generally accepted industry practice.

The Harper court found adequate capital and arms-length premiums determinative, as was the existence of regulatory authority (here, the Hong Kong government). Other IRS documents have discussed the need for the captive to comply with the state law definition of an insurance company and the existence of standard insurance company documentation.[57]

If a CIC charges commercially unreasonable premiums and/or otherwise engages in non-arms-length transactions, the IRS may not respect the CIC as a legitimate insurance company. While arms-length dealing and separate management fees alone are not sufficient to prove that an entity is an insurance company, such conduct telegraphs the existence of a bona fide “insurance company.” As discussed above, any CIC hopeful of recognition as an “insurance company” must otherwise operate as an “insurance company,” employ professionals with the appropriate credential to fill critical roles within the company and comport with local licensing and capitalization requirements.

Also, an “insurance company” must provide “insurance” through “insurance contracts.”[58] Unfortunately, the IRC provides little guidance in defining these terms. In general, an agreement must transfer the risk of economic loss, contemplate the occurrence of a stated contingency, and comprise something more than a mere business or investment risk to receive insurance treatment for federal income tax purposes.[59] Insurance Services Offices often provide policies for captives.[60] A CIC must show that it has adequately shifted the risk of economic loss from the insured to the insurer (“risk shifting”), and that the insurer has adequately spread that risk among various insurance companies or other unrelated entities such that no single entity bears the entire risk of economic loss (“risk distribution”).[61] A CIC may accomplish this goal using IRS safe harbors or otherwise.

What is Risk Shifting?

In Helvering v. LeGierse, the United States Supreme Court (“Supreme Court”) analyzed the risk-shifting issue. In LeGierse, an elderly, uninsurable taxpayer purchased a life insurance policy and a life-only annuity contract one month before her death.[62] By purchasing the annuity contract from the same insurer, without which the insurer refused to issue the life insurance policy, the taxpayer neutralized the insurer’s risk with respect to the life insurance policy. The taxpayer purchased the life insurance policy primarily to take advantage of favorable estate tax treatment available, and the arrangement had a little net effect on her economic position. The Court held that because the life insurance policy and the annuity contract offset one another, there was no risk shifting from insured-to-insurer.

Risk shifting is only present when a party facing the risk of economic loss transfers some or all of the financial consequences of that potential loss to an insurer.[63] Risk shifting generally requires an enforceable written insurance contract, with premiums negotiated and actually paid at arms-length, and the insurance company to be a discrete entity capable of satisfying its obligations and properly formed under the laws of the applicable jurisdiction. The thrust of the risk-shifting analysis is whether the premium-paying party has truly transferred the economic impact of the potential loss to the insurer.[64]

The Humana[65] court held that an arrangement solely between a parent company and a subsidiary CIC could not be considered insurance for federal income tax purposes because it failed to shift risk from the insured to the insurer. Humana paid premiums on its own behalf to a wholly-owned CIC in exchange for coverage. The Court noted that the similarities between such an arrangement and a reserve account for self-insurance, contributions to which are not tax-deductible, were impossible to ignore. The underlying rationale for the Court’s decision was that Humana did not truly transfer any risk of loss to the CIC, since any loss incurred by the CIC would ultimately be absorbed by Humana as the sole owner of the CIC. Nonetheless, the Humana court held that an arrangement between a subsidiary CIC and several dozen other subsidiaries of the parent entity did satisfy the risk-shifting element. The Court reasoned that a loss incurred by the CIC would not directly transfer to the sibling subsidiaries in the same way a loss would transfer between a wholly-owned subsidiary CIC and its parent.

Notably, the Court stated that the doctrine of substance over form, discussed in greater detail in another of our FAQ articles, could be invoked to challenge the existence of separate and distinct entities, which are required to show the existence of risk shifting. However, the Court went on to state that the doctrine would only be applicable where no valid business purpose exists for the transactions or where a clear Congressional intent to curtail such transactions can be shown. The Humana court concluded that Congress had not yet manifested any intent to disregard the separate corporate entity in the context of CICs and respected the separate identities of the entities.

With proper planning and execution, a CIC should have no trouble showing a valid business purpose for maintaining separate corporate entities. Thus, a substance over form argument employed to challenge the existence of risk shifting should be ineffective unless the transaction is found to lack economic substance aside from mere tax benefits (discussed further, below).

Since Humana, the IRS has provided broad “safe harbor” rulings. In the main “safe harbor” provision, found in Revenue Ruling 2002-90, the IRS explained that an arrangement of at least twelve subsidiaries paying premiums to an affiliated CIC constitutes effective risk-shifting where each subsidiary has no more than 15% and no less than 5% of the total risk insured and none of the claimed twelve subsidiaries are disregarded entities.

Since the promulgation of the “safe harbor” provisions, the IRS appears eager to challenge a CIC on the grounds of risk-shifting in only the most egregious and abusive of circumstances. This underscores the importance of adhering to the general guidelines discussed above. Risk shifting may be questioned where guarantees exist to neutralize a CIC risk of loss and where contracts are not entered into at arms-length. Other factors the IRS may consider in a risk-shifting challenge include: whether the insured parties face a genuine hazard of economic loss in an amount which justifies premium payments made at commercially reasonable rates; whether the validity of insurance claims was investigated and established before the claims were paid; and, whether the CIC business operations and assets are maintained separately from the business operations and assets of the parent entity.

What is Risk Distribution?

Risk distribution is also required for an arrangement to be considered insurance. Risk distribution involves the pooling of insurance premiums from separate insured entities so that an individual insured is not paying for a significant portion of its own risk. Rather, the risks, and claims, of an individual insured would be subsidized in large part by the premiums paid by other insured entities in the pool.[66] The law of large numbers dictates that the likelihood of a single claim exceeding premium payments for a given period of time decreases as the length of time and number of insureds in a given pool increase.

A risk distribution analysis is broader in focus than that of a risk-shifting analysis. The risk distribution analysis looks to whether an insurer has distributed the risk of an individual insured over a larger group of entities, rather than strictly between the insurer and the single insured. Unfortunately, authority adequately discussing what constitutes risk distribution where risk shifting is found to exist is scarce. However, the Humana[67] court found that an arrangement where a CIC insured multiple sibling subsidiaries from an affiliated group constitutes valid risk distribution since the premiums paid by each insured could offset the CIC losses as a whole. While decisions have never established the minimum quantity of unrelated business sufficient to constitute risk distribution, courts have ruled that 30% is sufficient and 2% is not.

The IRS has issued several Private Letter Rulings that outline two different risk distribution models. In the first, the insured pays a premium to an insurance company, which then cedes risk back to the insured’s captive. For example, the insured pays a premium of $100,000 to an insurer, which then cedes a percentage of the risk (anywhere between $30,000 and $90,000) back to the captive. Here, the risk distribution occurs within the financial accounts of the insurance company, as the insured's premium is combined with those from other, unique insureds.

In the second, the insured pays the full premium to his captive, which then cedes at least 50% of its risk to a pool where other, unique insureds do the same. Then, after an insured’s pool contribution is mixed with other, unique insureds, the pool cedes most of the original contribution back to the insured.
For example, an insured pays $100,000 to his captive, which then cedes at last $50,000 of its premiums to a pool, which in turn returns a majority of the original funds to the captive.

In summary, to be treated as an insurance company for federal income tax purposes, a Captive Insurance Company must show that its insureds have adequately shifted their risk of loss to the CIC and that the CIC has adequately distributed that risk over various diverse entities. A CIC maintaining its own arms-length operational identity and conducting its business in a manner consistent with standard insurance industry norms will also support such treatment. If a CIC can meet these requirements, many advantages may be available to the CIC and its owner.

  • [1] Beckett G. Cantley, Esq. (University of California, Berkley, B.A. 1989; Southwestern University School of Law, J.D. cum laude 1995; and University of Florida, College of Law, LL.M. in Taxation, 1997) teaches International Taxation at Northeastern University and is a shareholder in Cantley Dietrich, P.C.
    The author may be reached for comment at
  • [2] Geoffrey C. Dietrich, Esq. (United States Military Academy at West Point, B.S. 2000; Brigham Young University Law School, J.D. 2008) is a shareholder in Cantley Dietrich, P.C.
  • [3] Beckett Cantley, Steering into the Storm: Amplification of Captive Insurance Company Compliance Issues in the Offshore Crackdown, Hous. Bus. & Tax L. J. 224 (2012).
  • [4] Beckett Cantley, F. Hale Stewart, Current Tax Issues with Captive Insurance Companies, Bus. L. Today, February 2014, 1.
  • [5] Jay D. Adkisson, Adkisson’s Captive Insurance Companies: An Introduction to Captives, Closely-Held Insurance Companies, and Risk Retention Groups, iUniverse, Inc., (2006) p. xiii.
  • [6] Id.
  • [7] Id.
  • [8] Id. at xiv.
    Beckett Cantley, F. Hale Stewart, Current Tax Issues with Captive Insurance Companies, Bus. L. Today, February 2014, 1.
  • [10] F. Hale Stewart, U.S. Captive Insurance Law, iUniverse, Inc. (2010) p. 5-6.
  • [11] Consumers Oil Corporation of Trenton v. United States, 166 F. Supp. 796, 797-798 (N.J. 1960).
  • [12] United States v. Weber Paper Co., 320 F.2d 199, 201 (8th Cir. 1963).
  • [13] Stewart, supra at 6.
  • [14] Gulf Oil Corp. v. C.I.R., 914 F.2d 396 (3d Cir. 1990).
  • [15] Ocean Drilling and Exploration Co. v. United States, 988 F.2d 1135 (Fed. Cir. 1993).
  • [16] F. Hale Stewart, U.S. Captive Insurance Law, iUniverse, Inc. (2010) p. 5-6.
  • [17] Beech Aircraft Corp. v. United States, Civil No. 82-1369, 1984 WL 988, *1 (D. Kan. 1984).
  • [18] Beech Aircraft Corp. v. United States, Civil No. 82-1369, 1984 WL 988, *1 (D. Kan. 1984).
  • [19] Id.
  • [20] Id. at *3.
  • [21] Id.
  • [22] Id. at *4.
  • [23] Id.
  • [24] Humana, Harper, Amerco
  • [25]
  • [26] Id.
  • [27] Id.
  • [28] Id.
  • [29] Id.[30] Id.
  • [31] Jay D. Adkisson, Adkisson’s Captive Insurance Companies An Introduction to Captives, Closely-Held Insurance Companies, and Risk Retention Groups, iUniverse, Inc., (2006) p. 56.
    [32] Donald S. Malecki, CGL Commercial General Liability, © 2005 The National Underwriter Company, (For example, the commercial general liability policy usually excludes coverage for product recall and damage to “your product.” A captive could write a “difference in conditions” or DIC policy to specifically fill all gaps in the third party policy.)
  • [33] Like commercially available insurance, captives have menu of standard coverages such as administrative actions, legal liability, product liability, product recall, pollution liability, etc…
  • [34]Jay D. Adkisson, Adkisson’s Captive Insurance Companies An Introduction to Captives, Closely-Held Insurance Companies, and Risk Retention Groups, iUniverse, Inc., (2006), 56.
  • [35] Id. at 56-68.
  • [36] Jay D. Adkisson, Adkisson’s Captive Insurance Companies An Introduction to Captives, Closely-Held Insurance Companies, and Risk Retention Groups, iUniverse, Inc., (2006) p. 2.
  • [37] Id. at 54-55.
  • [38] F. Hale Stewart, U.S. Captive Insurance Law, iUniverse, Inc. (2010) p. 31.
  • [39] Beckett Cantley, Steering into the Storm: Amplification of Captive Insurance Company Compliance Issues in the Offshore Crackdown, Hous. Bus. & Tax L. J. 224 (2012), 227.
  • [40] Id. at 269.
  • [41] See IRC § 953(d).
  • [42] Beckett Cantley, Steering into the Storm: Amplification of Captive Insurance Company Compliance Issues in the Offshore Crackdown, Hous. Bus. & Tax L. J. 224 (2012), 269.
  • [43] Id.
  • [44] Id.
  • [45] Id. at 268.
  • [46] Id.
  • [47] Id.
  • [48] See IRC § 4371.
  • [49] Id. at 269-70.
  • [50] Id. at 251-52.
  • [51] Id. at 242.
  • [52] Id. at 272.
  • [53] Treas. Reg. § 1.801-3(a).
  • [54] IRC§§ 1291-98.
  • [55] Beckett Cantley, The Forgotten Taxation Landmine: Application of the Accumulated Earnings Tax to I.R.C. § 831(b) Captive Insurance Companies, 11 Rich. J. Global L. & Bus. 159, 160 (2012), 163.
  • [56] Harper Group and Subsidiaries v. C.I.R., 96 T.C. 45, 58 (T.C. 1991)
  • [57] by F. Hale Stewart and Beckett Cantley, Captive Guidance After The ‘Dirty Dozen’ Listing, Tax Notes, June 8, 2015, p. 1191
  • [58] IRC § 816(a).
  • [59] Helvering v. LeGierse, 312 U.S. 531, 542 (1941); Rev. Rul. 89-96, 1989-2 C.B. 114 (1989).
  • [60] See
  • [61] Humana, Inc. v. C.I.R, 881 F. 2d 247, 251 (6th Cir. 1995) (citing Helvering, 312 U.S. at 539).\
  • [62] Helvering v. LeGeirse, 312 U.S. 531, 539 (1941).
  • [63] Bobbe Hirsh & Alan S. Lederman, The Service Clarifies the Facts and Circumstances Approach to Captive Insurance Companies, 100 J. Tax’n 168, 169 (Mar. 2004).
  • [64] Clougherty Packing Co. v. C.I.R., 84 T.C. 948, 959, aff’d, 811 F. 2d 1297, 1300 (9th Cir. 1987).
  • [65] Humana, Inc. v. C.I.R, 881 F. 2d 247, 251 (6th Cir. 1995) (citing Helvering v. LeGierse, 312 U.S. at 539).
  • [66] See Kidde Indus., Inc. v. United States, 40 Fed. Cl. 42, 53 (Fed. Cl. 1997) dismissed, 194 F.3d 1330 (Fed. Cir. 1999).
  • [67] Humana, Inc. v. C.I.R, 881 F. 2d 247 (6th Cir. 1995).