Printer Friendly

The IRS and captives.

In "practical risk Management," David Warren and Ros McIntosh list seven advantages to creating and using a captive insurance company. They include the ability to obtain broader coverage than through the conventional market, lower costs, the prospect of earning investment income, an improved cash flow, ability to move funds through international markets, the chance to develop profitable new lines of insurance, and improved loss control.

Notably absent, however, is the ability to deduct premiums paid to captives from corporate income for tax purposes. It's an interesting omission in light of recent tax rulings and court decisions that would appear to indicate that the IRS has "beaten a slow, grudging retreat" on the deductibility of premiums paid to a captive, in the words of Mark Rosenberg, vice president of federal affairs at the Insurance Information Institute (III).

For risk managers, this issue creates some problems. For one, even if the statement is true that the IRS is moving to disallow deductions to captives, there is always the temptation to create a captive for tax benefits that might lure the non-risk professional into surprisingly costly insurance business arrangements. Whether or not captives create favorable tax advantages, U.S. corporations continue to move into the captive market. As a result, risk managers must educate corporate leaders as to why and how captives are formed -- and also to steer them away from the potential short-term benefit of tax savings and toward the long-term benefits of true risk management.

In effect, according to most feasibility studies on captive formation, seldom do tax breaks rate very high as an advantage. Ronald J. Lamb, risk manager for Digital Equipment Corp., explains that, "Tax breaks did not at all figure into our decision to insure through captives. "For our insurance products, we pay full taxes on premiums," he says. "It was always our intention to do that."

"A company shouldn't create a captive because of taxes, but rather because buying insurance in the traditional market has been excessively expensive or unavailable," says Gary Salt, president of Risk Management Consulting Associates located in Fairlawn, New Jersey. "By going into a captive situation, a company will obtain more reasonable rates, and perhaps for better coverage. If done properly, it can work to the benefit of all involved."

The Issue of Pricing

ACCORDING TO James A. Robertson, director of insurance litigation and risk management services at Coopers & Lybrand, stability in pricing is probably one of the most important issues in captive formation. "Not only stability in the market, but stability in pricing," he adds. "Managers in businesses have difficulty understanding why the price of insurance in the open market should fluctuate as much as it does. Captives have been very successful and very stable for their owners. And they continue to be formed -- probably at the rate of 150-300 new captives a year."

"Allowing tax considerations to dictate the operation or formation of the captive can be disastrous," noted Jon Harkavy, vice president and general counsel of Vermont Insurance Management. "In the 1970s and early 1980s, numerous single parent captives began writing third-party business, in the hopes that by writing outside business the captive would be viewed as a bona fide insurance company, thus allowing the parent a tax deduction for premiums paid to its captive. During this period many captives unwittingly wrote the poorest outside risks imaginable -- asbestos, EIL and DES, just to name a few -- causing heavy losses and many captive insolvencies. These captives, and others like them, failed because the risk manager got away from the risks he or she knew best."

Mr. Harkavy characterizes this "outside business" criteria as being part of a socially and economically useless cat-and-mouse game between the IRS and commercial insureds. "It's over the theoretical question, what is insurance? According to the IRS, insurance must involve a transfer and spread of risk. Captive owners must then go through a number of dysfunctional structural and transactional gymnastics to satisfy this amorphous 'what is insurance' criteria."

Mr. Harkavy argues that the IRS and the tax code should instead concern itself with the more practical consideration as to whether the captive risk financing mechanism used represented a reasonable and sound business practice. "Forcing a policyholder to purchase traditional insurance in order to get a premium deduction makes no economic sense and adversely affects the competitiveness of American industry," he declares.

So Which Approach Makes Sense?

"BY PERMITTING A deduction for premiums paid to a U.S. captive, both treasury and corporate insureds would be well served," notes Mr. Harkavy. As the loss reserves of U.S. captives are subject to discounting for tax purposes just like any other U.S. insurer, the treasury's objection that the policyholder is getting an accelerated loss deduction should be largely addressed by the fact that the captive's deduction will be lessened to reflect the time gap between when the premium is taken in and the claim actually paid. Furthermore, Mr. Harkavy adds, as a state-licensed insurer, the captive would be subject to all other federal taxation, thus further lessening potential revenue loss to the U.S. treasury. Modeling such legislation within the ambit of the Humana decision would allow the tax code to be modified within existing legal precedent.

However, this best-of-all-possible-worlds ruling is unlikely to become a reality; IRS watchers report rumors of a special Service task force, created explicitly to capture more revenue from captives. In the current political climate, where tax increases are anathema, anything that even appears to be a special treatment -- for insurance or any other industry -- is probably outside the pale.

There is also the point that the insurance community is split on the tax issue. "The agent and conventional insurers are scared of competition," says Mr. Harkavy, adding that up to 30 percent of domestic insurance business is underwritten with captives or in other alternative market vehicles. "Conventional insurers and their agents are frightened about that, and leery of any legislation that could accelerate that change."

Today, captives are still used as a vehicle for taking deductions on captive premiums. However, Bruce Wright, a partner at LeBoeuf, Lamb Leiby & MacRae, doesn't agree with the retreat argument. "Some of the arguments for deductibility are based on five recent cases," Mr. Wright says. "Four had to do with the outside business issue. The Sears Roebuck, Amerco and Harper Group cases came up in tax court, where decisions came down on the same day in January 1991. The fourth, Ocean Drilling and Exploration (ODECO), was resolved in December of 1991 in claims court."

"These cases deal with the issue of unrelated business," explains Mr. Wright. "And all seemed to allow that a captive writing unrelated business qualified its parent for a tax deduction on premiums paid. The problem, however, is that losses from unrelated business underwriting could very well outweigh the benefits gotten from the deductibility of the premiums," he says.

The fifth case, Humana, deals with the "brother-sister" issue -- an insured that owns no stock in its insurance affiliate. That case was decided in favor of Humana's deducting captive-paid premiums. "But the IRS has indicated that it doesn't want to follow Humana," says Mr. Wright. In fact, Wright believes that tax treatment for captive-paid premiums will get more stringent, and that the IRS is not retreating from its position at all.

Robert Willens, senior vice president of tax and accounting for Shearson Lehman Bros., however, disagrees. He believes that the deductibility of captive-paid premiums is pretty much a done deal. "It seems like fairly clear sailing to me. I cannot see the IRS winning a case disallowing deduction of captive-paid premiums ever again."

"There are now apparently two ways to avoid problems with the IRS," declares Mr. Willens. "One tactic involves creating a captive where the company that pays the premiums has no stock interest in that captive -- a brother-sister relationship. The other tactic involves creating a captive that writes some meaningful amount of outside business." By following one of these two strategies, "a company will get a deduction for premiums paid, he says."

No Clear Answer

MR. ROBERTSON contends the deductibility issue has no clear answer. "When I first started working with captives 16 years ago, companies were routinely taking deductions for premiums paid," recalls Mr. Robertson. "There really weren't a lot of court cases that tested the IRS position - though the IRS was known not to like the process. Then, in a number of audits, the IRS denied the captive premium deduction. In turn, those companies filed claims for refunds, which required many years to work through the system."

Now, according to Mr. Robertson, the Humana and ODECO decisions have started to open the question up. "More importantly, regardless of whether the deductibility question is truly resolved or not, it appears that more companies are going to try to take the deduction because of the Humana and ODECO decisions."

"More companies are going to try to take the deduction -- there's the challenge for risk managers," says William Parisi, risk manager for Reliance National Insurance Co. As a result, many companies may be tempted to establish a captive solely for tax advantages. "My former employer, Texas Gulf, looked into forming a captive only because the chairman wanted one. On the other hand, there is the benefit of legitimate tax advantages, if they exist. But a company shouldn't overlook the real reason for forming an insurance company: to retain your risks and reduce costs."

Mr. Parisi explains that when Texas Gulf wanted to create a captive, he persuaded them not to. "Taxes didn't affect our decision. Because of our Canadian holdings, the U.S. tax was almost neutral. In fact, our tax people, because of the credit they were receiving for tax paid to Canada, simply didn't want to get involved with having the IRS examine their books." Texas Gulf was eventually acquired by Elf Aquitaine, which had already established a captive.

Regardless of the reasons why a company may wish to form a captive, what can risk managers look forward to from the IRS on the issue of deductibility? More importantly, what can risk managers tell their corporate clients about the tax consequences of captive formation and management? How can tax breaks be factored in most accurately to the decision-making mix, now and in the future?

First, risk managers should not expect a great deal of understanding from the tax authorities and federal regulators. III's Mr. Rosenberg says captive premium deductibility tends to throw a monkey wrench into the usual two-part insurance regulatory philosophy. "This philosophy aims, on the one hand, to protect the market against sharp practice by insurers and, on the other, to protect consumers," he says.

"In the case of captives or risk retention groups, neither of those considerations applies," he says. "The market doesn't need protection because there's no competition. And because a captive or risk retention group is set up and controlled by a customer for that customer's benefit, there's no innocent consumer involved to be protected either. This prompts the IRS to take an interest in all this. They think, "This doesn't look like insurance as we know it.'"

However, properly educated about the pros and cons of setting up captives, corporate clients should continue to look toward them as effective cost-management tools and as proactive vehicles toward limiting risk.
COPYRIGHT 1992 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:insurance companies
Author:Henry, Lawrence
Publication:Risk Management
Date:Oct 1, 1992
Previous Article:New trends in financial reinsurance.
Next Article:Kidnap & ransom.

Related Articles
Vermont enacts legislation affecting captive insurers.
IRS issues captive insurer guidelines.
Captive premiums deductible.
The truth behind captives and taxation.
Despite IRS attempts, captive wall remains intact.
Insurance in the captive setting.
The consolidated captive.
Workers' compensation and captives.
Seventh Circuit opens door for captive insurance.
A unified approach to captive insurance tax policy.

Terms of use | Copyright © 2016 Farlex, Inc. | Feedback | For webmasters