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Captive Life Insurance Companies

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Captive Insurance Company

A Captive Insurance Company (a “Captive”) is a company owned by another company (the “Parent”) or the owners of the Parent in order to finance the risks of business operations that are owned or controlled by the Parent. In other words, “finance the risks” means to provide insurance.

For example, a holding company with seven different lines of business operating out of various subsidiaries might choose to organize a Captive to insure the risks of the seven businesses.  The subsidiaries would pay tax deductible premiums to the Captive which would insure their losses just as any other insurance carrier, and might also lay off a portion of the risk with re-insurers, just as any other insurance company might do.

It should be emphasized that using a captive company is an advanced life insurance planning strategy. Thus, the discussion to follow would only apply to those individuals and business entities in this category, similar to other strategies such as estate tax planningprivate placement life insurance or life insurance for high net worth estate planning.

Reasons to Consider a Captive Life Insurance Company

There are several business reasons why a company would choose to use a Captive.

Risk Management 

One reason is for risk management purposes. Presumably the owner/operator of businesses knows its risks better than a third party insurer and is in a better position to gauge the risks.  Insurers may place a company in a risk pool with businesses which, although similar, possess characteristics rendering them far more susceptible to losses.

The Captive may also be able to monitor risks more closely and act as an in-house watchdog over the risk related activities of the management of the subsidiaries.

Further, if one of the businesses of the Parent is considered a high risk business by the insurance industry, insurance may be unavailable or unavailable at a reasonable premium.

As a bit of review, life insurance may be utilized by the businesses for any number of powerful purposes including but not limited to funding executive bonus plans, split dollar life insurance planning, or for financing deferred compensation plans for private and family businesses. Even more basic, is using key man life insurance to protect family businesses against the loss of a key person OR funding a business continuity succession plan in accordance with a buy sell agreement.

Self Insurance 

The Parent may wish to self-insure through a Captive, and take an umbrella re-insurance policy at a very high level.  And it is always worth remembering that, insurance companies operate at a profit.  The Parent may wish to capture that profit for itself by operating its own insurer.

The majority of Captives are domiciled in Bermuda (19.3%), Cayman Islands (15.4%), Br. Virgin Islands (8.2%), Guernsey (7.4%), Luxemburg (5.3%), Barbados (5.2%), and Ireland (4.5%).

These numbers may not be entirely accurate, however.   A number of states in the United States have recently adopted legislation encouraging the formation of captive insurance companies.  The most popular States in the USA for Captives are Vermont, Hawaii, and South Carolina, Nevada, Arizona, and Utah.

Incidently, a company may strategically use a jurisdiction that favors captives and also is a strong asset protection jurisdiction such as Nevada.

Tax Incentives and Regulatory Advantages

The reasons for incorporating under the laws on one jurisdiction as compared with another relate primarily to capitalization, local taxation, and regulation provisions of local law.

Incorporation overseas does not produce the tax advantages thought possible in the public imagination because of US tax provisions regarding controlled foreign corporations.  However, if overseas domicile is being considered, it is best to review the bilateral US tax treaty with the prospective country to determine the tax consequences.

Also, please remember that the IRS and Homeland Security have stepped up monitoring of international fiscal transfers and activities.  This is likely to impose greater regulation in the future over such transactions, and greater scrutiny over all.

Internal Revenue Code Section 831(b) permits an insurance company with less than $2,200,000 in premium income to escape taxation on its premiums (but not on its investment income).  This provides a tremendous opportunity to generate tax savings, by paying deductible premiums into an entity in which the receipt of such income is not subject to taxation.

In order to qualify for these tax benefits, however, it is necessary that the arrangement be classified as true insurance, not merely the creation of a loss contingency pool.

The key here is risk shifting.  Only if there is risk shifted from one person to another is there true insurance.

IRS Considerations with Captive Insurance Companies

In the parent-subsidiary structure, the IRS historically took the position that no risk was ever shifted when the subsidiary accepted premiums from a Parent or brother/sister company because risk stayed within the economic group.  However, IRS lost cases under this theory.

In response to these losses, it issued rulings which define its current posture.

  • In Rev. Rul. 2002-89, the IRS said that if the Parent’s business accounts for 90% of the Captive’s premiums the requisite risk shifting had not occurred, but if the Parent’s premiums constituted less than 50% of the Captive’s premiums the Captive’s operations would be recognized as independent of the Parent’s. This leaves open the question of how IRS will treat cases falling within the 90%/50% gap.
  • In Rev. Rul. 2002-90, a brother/sister Captive insured the risks of 12 other brother/sister companies, with no company representing less than 5%, nor more than 15%, of the total premiums. The IRS recognized the deductibility of the premiums.
  • In Rev. Proc. 2002-75, the IRS announced that it will rule in advance on the proper treatment of captive insurance companies. Thus, we may be able to obtain guidance if we are uncertain as to the consequences of a proposed insurer.

There are a number of ways of satisfying these requirements, and the choice of method will depend upon the particular needs and circumstances of the individual client.

A warning is in order, however.  The IRS continues to view captive insurance companies with great suspicion.

It is important that the policies be structured property, the company administered in a prudent manner, and the premiums priced in accordance with reasonable business practices.

Additionally, special tax reporting requirements are applicable to some entities.  There are few areas in which it is so essential to obtain and rely upon reputable administrators and competent counsel.

Eric S. Ratliff, JD, LLM
Ratliff Law Firm
740 Pollard Road
Kodak, TN 37764
(865) 932-3441 x704
eratliff@ratlifflawfirm.com

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