Corporate counsel and other business attorneys may be most familiar with insurance companies in the context of a specific coverage issue or filing a claim. The CFO, risk manager, and others of similar training are often the ones assigned to explore the nuances of the financial aspects of renewing insurance coverage and negotiating with various brokers and prospective insurance carriers. Therefore, a business attorney asked to assist in the formation of a new entity in the corporate family—a licensed insurance company no less—may feel at a bit of a loss as to how to proceed. This article provides an introduction to the formation of a captive insurance company for business attorneys.
Captive Insurance Companies: The Basics
A captive insurance company is, at its center, an insurance company. It assumes risks from a policyholder and becomes responsible for paying out claims and other costs in accordance with the contract of insurance. In exchange, it receives a premium payment. What makes a captive insurance company unique is that its policyholder is usually also its owner. This makes a captive a formalized form of self-insurance. However, unlike regular self-insurance, where funds are stored on the company’s balance sheet, a captive holds its accounts separately from the parent.
The motivation to form a captive can include a necessity to streamline the company’s balance sheet so that held reserves don’t look like the management is just sitting on cash. A captive insurance company can potentially write independently verifiable contracts of insurance, which may be statutorily or contractually required. In certain cases, a captive can write a contract of insurance to a related third party. This can ultimately generate third-party income for the captive insurance company itself.
A captive insurance company is established by forming a company in one of the over thirty US states or territories, or one of many foreign countries such as Bermuda or the Cayman Islands, that authorize the formation of captive insurance companies. The new entity is then licensed by that domicile’s insurance regulator as an insurance company once all local requirements have been met.
Early in the formation process, the prospective captive owner will obtain a feasibility study that will explore the risks to be insured and make recommendations on the appropriateness of a captive, possible lines of insurance coverage and their relation to existing traditional commercial insurance coverage, and estimates on premiums and overhead expenses. This study is typically led either by a full-service insurance broker or an independent captive manager, with input from other experts such as risk management professionals, accountants, actuaries, and attorneys.
Typically, prospective captive owners will have specific risk exposures in mind before considering forming a captive. Volatile high-severity but low-frequency risks such as extreme weather events, cyber-attacks, or key product liability risks are but several types of risk that may be good candidates to partially or fully cover in a captive insurance program. It can be very difficult to obtain insurance coverage for these risks in the traditional commercial marketplace.
Risks for Starting a Captive
A company seeking to self-insure through a captive must consider all scenarios. An ill-timed adverse event may place both the captive and its parent company in dire circumstances. A new captive will not start out with ample capital on hand to deal with one or more serious casualties; in fact, it may take many years for a captive to build up such capital.
Taxation Issues
Any insurance company, from the perspective of the Internal Revenue Service (IRS), basically collects premiums on one day and holds them for an indeterminate time until they are paid as a claim; used toward overhead; or, in most circumstances, held as taxable income.
The IRS has for more than a decade highlighted potential risks of unlawful tax evasion through the use of captives. A poorly designed captive and one not carefully monitored can bring down significant tax penalties for both itself and its parent.
Certain captive insurance companies, electing a provision under I.R.C. § 831(b) as long as their premiums don’t exceed $2.65 million in 2023, will not pay any tax on any underwriting income but also will not gain any deduction if there is an underwriting loss. The problem with this “micro-captive insurance company” arrangement, from the IRS’s perspective, is that if the insurer-owned insurance company could all but guarantee that no claims would be filed, the taxpayer could defer its tax obligations indefinitely. Aggressive captive insurance promoters can entice business owners with the prospect of substantial indefinite tax deferral utilizing an 831(b) election. Businesses can then fall into the difficult circumstances outlined in Avrahami v. Commissioner, 149 T.C. 144 (2017), where the U.S. Tax Court found that the taxpayer’s wholly owned captive was not bona fide insurance, disallowing deductions for premiums paid into the captive and imposing substantial penalties.
Properly designed captives avoid forcing captive owners to take aggressive tax positions. However, the IRS has been less than clear in providing guidelines to aid business owners who legitimately desire to efficiently use a captive for risk management and risk financing purposes. It is essential for corporate attorneys to temper the enthusiasm of business owners for taking overly aggressive tax positions that may end up doing long-term harm. Corporate attorneys should further encourage business owners to make reasoned decisions about a captive insurance program after receiving quality, independent tax, legal, and accounting advice.
Solutions for Problematic Situations
A captive insurance company can provide a unique solution to what would otherwise be an intractable problem. For example, a corporate acquisition may be at an impasse over the status of a preexisting lawsuit against the target company. A captive insurance company may be able to write a specialty line of insurance, ride out the issue at hand, and help facilitate the transaction.
Public companies also can look to a captive to help facilitate a self-insurance strategy. Businesses that value steady and predictable earnings and expenses sometimes shy away from self-insurance solutions where large, expected losses incurred at inconvenient times can wreck an otherwise attractive balance sheet. By transferring those risks to a captive insurance company, the business can appropriately and steadily account for the costs associated with that risk.
Captive insurance can be an effective risk management and risk financing tool. Companies can use a captive to reap the benefit of better-than-peer risk mitigation efforts. Captives can help smooth out the peaks and valleys of a company’s balance sheet. As captive insurance becomes more regularly utilized by businesses large and small, corporate attorneys are increasingly likely to be called upon to opine on the merits of a captive insurance program. Helping a company form a captive for the right reasons and utilizing best business practices can provide a real long-term benefit.
This article is based on a CLE program that took place during the ABA Business Law Section’s 2022 Hybrid Annual Meeting. To learn more about this topic, view the program as on-demand CLE, free for members.
