I recently got a phone call from one of the chief legal counsels at the Internal Revenue Service, who wanted to better understand a corporation’s ownership of a particular captive insurance company — or an entity created to insure its parent corporation — domiciled in Vermont.
There are currently about 6,000 such companies worldwide, up from 4,900 in 2005, and forecasts suggest there will be 10,000 by 2015. A majority of captives are based offshore, but there are 30 U.S. states that have laws allowing captives to be domiciled there, with Vermont by far the most prominent.
In the current economic climate, the IRS is looking for income and captives are the only significant growth area in the insurance industry, making them a target. Captives are not legally bound to adhere to industry guidelines and regulations, but if they stray too far they risk being audited. In essence, the IRS expects a captive to function like a traditional insurance company.
The case at hand involves a $50 million expense deduction for the premium the corporation paid annually for several years to its wholly owned captive insurer for property, general liability, auto liability, and workers’ compensation insurance. For a traditional insurer, a policy with a one-year premium of $50 million would be a substantial account, requiring significant underwriting information and insurance-company expertise.
The IRS was drawn to the fact that although the captive in Vermont was a significant insurance company with substantial exposures, none of its executive officers or board members had ever worked in a traditional insurance company. That is one reason it was questioning whether the expense deduction was legitimate.
I confirmed that pricing an insurance policy indeed requires very detailed work, as well as the ability to understand and implement numerous insurance concepts, such as loss costs, loss-cost multipliers, expense costs, reinsurance costs, insurance management costs, and captive insurance company profit margins. It was, indeed, reasonable for the IRS to question the board’s qualifications.
We then discussed a captive manager’s role in drafting and pricing various coverage policies. I pointed out that the underwriting of insurance coverages needs to be benchmarked against pricing and underwriting guidelines. Such guidelines are formulated by insurance companies and approved by regulators.
The IRS attorney also wanted to get my take on the differences between a captive insurance company and a traditional one. I explained that the captive, as a limited-purpose insurer, has a completely different focus. Captive owners continually look to expand the insurance coverages provided by the captive, with major emphasis on coverage for nontraditional risks. In fact, you can expect captives to develop into more important profit centers for their parents.
Captives allow their parents to avoid paying underwriting fees and brokerage commission, and they invest their capital as any insurance company would. Captives also provide enhanced focus on loss prevention and claims handling. And the parent company can get coverage from a captive that may be overpriced or even unavailable in the traditional insurance market.
To be sure, captives do present challenges. Because they often insure nontraditional and high-risk exposures, there is a risk of higher-than-expected claims volume. But in this case, claims were lower than expected. In fact, the premiums were paid for several years during which the parent suffered no losses covered under the insurance policies the captive underwrote. While the IRS has yet to resolve the case, that is another clear red flag that the premiums might not be legitimate business expenses.
Meanwhile, CFOs should note that if the parent company takes back some of the surplus cash from a captive when losses are lower than expected, whether through dividends or low-interest loans, the IRS will be interested in that as well.