Current Tax Issues with Captive Insurance Companies

Large U.S. companies have been forming captive insurance companies (wholly owned insurance subsidiaries) since the 1950s. In general, such large captives are formed for one of three main reasons. First, some companies are unable to obtain necessary insurance coverage. For example, certain nuclear power companies formed a captive named Nuclear Electric Insurance Limited, because they could find no other insurance coverage. Second, some companies seek to obtain cheaper insurance. For example, the trucking market is currently “hardening” (premiums are increasing), leading to trucking companies forming captives. Third, some companies seek to gain more control over their current insurance program. 
The insurance code offers a small insurance company a strategic advantage: Internal Revenue Code (IRC) § 831(b) allows insurance companies with less than $1.2 million in premiums to be taxed on their investment earnings rather than on their gross income. As a simple example, suppose a small insurance company had $500,000 in income but earned 5 percent on its total portfolio earning $25,000 for the year. The company would use the $25,000 figure as their gross income figure for the year. 
A captive can also be formed offshore and still be deemed a U.S. captive, provided it makes an IRC § 953(d) election agreeing to be taxed as a domestic company. For many large captives, forming offshore may provide a great deal of flexibility not found onshore. However, it should be noted that the Internal Revenue Service (IRS) is currently spending a great deal of time focused on offshore tax enforcement. Recently, the IRS refused to issue a positive private letter ruling to a number of foreign captives seeking 831(b) status, which may be an indication of tougher IRS scrutiny in this area. Thus, while a compliant captive should ultimately have nothing to fear from operating internationally, there is at least some chance that doing so may result in some additional compliance costs if it gets caught up in the IRS dragnet. 
This article will: (1) provide a brief history of captive insurance companies; (2) outline key requirements for captive insurance including insurance risks, risk shifting, risk distribution, and reinsurance; and (3) discuss certain IRS enforcement areas in captives, including excessive premiums and IRC § 831(b) tax shelter issues.
A Short History of Captive Insurance Companies
The IRS defines a captive insurance company as a “wholly owned insurance subsidiary.” According to the case law of that time, companies started forming captives in the 1950s because they couldn’t find insurance, could only find very expensive insurance, or simply decided that forming their own insurance company made more sense. The taxpayers in both United States v. Weber Paper Co., 320 F.2d 199 (8th Cir. Mo. 1963) and Consumer’s Oil Corp. of Trenton, NJ v. United States, 188 F. Supp. 796 (NJ 1960) owned property for which they could not procure flood insurance, leading both to form an insurance company. While the taxpayer in Beech Aircraft Corp. v. United States, 797 F.2d 920 (10th Cir. Kan. 1986) did have an insurance policy, its carrier had complete control of its attorneys during litigation. When Beech was sued under a products liability claim in the early 1970s, it filed a motion to remove its insurer-appointed counsel several weeks before trial. The court denied this mo