Is It Time to Revisit Captive Insurance?

Many businesses, both large and small, use captive insurance companies to meet their risk management needs while controlling costs and reducing taxes. Recent developments have created new opportunities to take advantage of captives. At the same time, new restrictions designed to curb perceived abuses of “microcaptives” may require some companies to modify their captives’ ownership structures.

Captive benefits

Captives can be structured in many ways, but essentially they’re insurance companies owned and controlled by those they insure. Benefits include access to coverage that’s unavailable (or prohibitively expensive) commercially, stable premiums, lower administrative costs, and participation in the captive’s underwriting profits and investment income.

Captives offer significant tax advantages. For example, unlike self-insurance reserves, premiums paid to a captive are deductible. And, as an insurance company, the captive can deduct most of its loss reserves. “Microcaptives” — those with annual premiums of $1.2 million or less — enjoy even greater tax advantages. They may elect to exclude premiums from their income and pay taxes only on their net investment income (although they’ll lose certain deductions).

A captive can also be a powerful estate planning tool. By placing ownership of a captive in the hands of family members, business owners can transfer wealth to their heirs free of gift and estate taxes.

To provide these benefits, a captive must qualify as an insurance company for federal income tax purposes. Among other things, that means premiums must be priced properly based on actuarial and underwriting considerations and the arrangement must involve sufficient distribution of risk.

There’s no “bright-line test” for risk distribution, but the IRS has ruled that it exists when a wholly owned captive:

  1. Insures the parent’s 12 operating subsidiaries, none of which pay more than 15% of the premiums, or
  2. Receives more than 50% of its premiums from unrelated third parties.

A captive that insures only the risks of its parent does not, in the IRS’s view, distribute risk.

Recent developments

Several new Tax Court cases may create fresh opportunities for companies to establish captives. In the court’s view, risk distribution exists when there’s a large enough pool of unrelated risks, regardless of the number of entities involved. In other words, a captive achieves risk distribution if coverage is spread over a sufficient number of employees, facilities, vehicles, products or services, even if they’re all part of the same entity. It’s not certain, though, how the IRS will react to such arrangements.

Last year’s Protecting Americans from Tax Hikes (PATH) Act has a big impact on microcaptives. Beginning in 2017, the premium limit goes from $1.2 million to $2.2 million, making this vehicle available to more companies. But at the same time, to combat perceived abuses, the act establishes a “diversification” requirement that will be monitored through annual information returns. To qualify, a captive must meet one of these two tests: 1) No more than 20% of premiums come from any one insured, or 2) ownership of the captive mirrors (within a 2% margin) ownership of the insured business.

The first test may be difficult for smaller captives to meet. The second test essentially prohibits the use of a microcaptive as an estate planning tool.

Review your insurance arrangements

The recent developments described above may open up captive insurance to more businesses, so if you’ve ever considered establishing a captive, now’s a good time to revisit this strategy. If your business owns a captive, you have until January 1, 2017, to determine whether it meets the new diversification requirement and to restructure it, if necessary, to comply with that requirement.

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