Your Company Determines That a "Captive Insurance Company" Is Necessary for Risk Management — What Are U.S. Tax Qualification Requirements?
2012 - Issue 49 - In this challenging global economy, businesses face increased pressure to control their business risk costs and risk management plans. The risk manager's option to simply "fully insure" via a third-party policy with low deductibles, a reasonable premium, automatic renewals and "unlimited" or "catastrophic" limits is waning. Rather, companies, facing the current firming insurance market environment, are finding fewer providers interested in their risks, higher self-insurance retentions (SIRs), restricted capacity and often higher premiums.
Facing historically low fixed-income returns, the insurance industry must deal with balancing its internal investment objectives with pricing individual risks to an underwriting profit. Additionally, catastrophic claims of the 1990s and 2000s are included in actuarial models, and consolidation among the insurance providers continues, forcing company risk managers to identify pragmatic solutions for balancing their company's risk management needs, their company's budget restrictions and the treasury management requirements.
One common solution that risk managers consider is forming a captive insurance company — an affiliated or consolidated subsidiary (domestic or foreign) that registers and functions as a controlled group's own insurance company. A captive insurance company can provide a company with several immediate new options for the risk manager:
- Access to the wholesale insurance market or reinsurance markets;
- An ability to manage the investment profile of the insurance reserves of the captive insurance company;
- Improved claims management controls;
- An asset protection vehicle; and
- Coverage customization.
Once a business identifies the need for a captive insurance company and begins the formation process, it is not uncommon for tax professionals in the organization to hear, "do we get a tax benefit?" While the tax classification as an insurance company may result in a benefit to the qualifying company, given the options available to a risk manager through a captive structure, many companies today will move forward with a captive regardless of the potential tax benefits or tax costs associated with the structure.
This is the first of several articles on captive insurance companies and their related tax treatment. This article addresses non-life insurance company rules. Life insurance company scenarios are outside the scope of these articles.
U.S. Income Tax Qualification Issues
Creating an entity that is subject to the insurance regulators of a state or other governmental body is generally not sufficient for that entity to be recognized as an insurance company for federal income tax purposes. To qualify as an insurance company, federal income tax law also requires an entity to satisfy three requirements:
- Risk distribution describes a pooling of risk by an insurer such that there is a reduced possibility that a single costly claim would exceed the amount of the insurance company's reserves. Risk distribution also entails a pooling of various insureds' premiums such that each insured is not substantially paying only for its own risks.
- Risk shifting requires that a risk of an economic loss is transferred from the insured to the insurer such that a loss suffered by the insured would be offset by an insurance payment.
- Insurable risk means that the risk transferred must be the subject of some future contingency, and the insured must face the potential for actual losses.
Although the Internal Revenue Code does not define risk distribution, the Internal Revenue Service has provided safe harbors for that concept in Revenue Rulings 2005-40 and 2002-89. In Revenue Ruling 2005-40, the IRS ruled that an insurer has adequate risk distribution for federal income tax purposes where it issues policies to at least 12 separately-regarded insureds, and each insured represents between five percent and 15 percent of the total risk that the insurer has assumed. Further, the ruling stated that entities disregarded for federal income tax purposes (e.g., a single-member LLC not treated as an association under the check-the-box rules) do not count as separate insureds for purposes of determining risk distribution.
In Revenue Ruling 2002-89, the IRS ruled that a captive insurer had sufficient risk distribution for federal income tax purposes where its parent company represented between 15 percent and 50 percent of the insurer's total risk assumed and the insurer's other insureds were a significant number of unrelated, third-party entities. In addition, the ruling stated that there was adequate risk distribution because the insurer pooled the risks assumed from its parent with the risks assumed from the unrelated, third-party entities.
Finally, under IRC Sections 831(c) and 816(a), an entity qualifies as an insurance company for federal income tax purposes only if more than half of its business activities each year relate to the issuance of insurance, annuity or reinsurance contracts.
Qualified Captive — Federal Income Tax Treatment
If an entity qualifies as an insurance company under the standard described above, then an insured can deduct insurance premiums paid to that company under the principles of IRC Section 162. Generally, the initial tax year for the captive insurance company creates a timing benefit for the corporate parent because of the current premium deduction paid to the captive compared with a partial current year income inclusion for said premium income at the captive, as outlined below.
IRC Section 831(a) states that an insurance company is subject to tax at the usual corporate tax rates. However, an insurance company computes its taxable income under special rules set forth in Section 832 and related IRC sections. An insurance company's taxable income is equal to the sum of its underwriting income and its investment income.
The definition of investment income is relatively straightforward: it means all interest, dividends and rents received during a year plus the change during the year in the value of the company's accrued interest and accrued dividends.
The definition of underwriting income is more complicated. IRC Section 832(b)(3) defines underwriting income to mean an insurance company's premiums earned on insurance contracts during a year less (a) its losses incurred and (b) its expenses incurred. Each of the three components of underwriting income is itself a defined term:
- "Premiums earned" means gross premiums written on insurance contracts during a year less reinsurance premiums paid with respect to those insurance contracts. To that amount, IRC Section 832(b)(4) adds 80 percent of any unearned premiums on outstanding business at the end of the previous tax year and subtracts 80 percent of any unearned premiums on outstanding business at the end of the current tax year. In short, this provision effectively places an insurance company on a cash method with respect to 20 percent of its unearned premiums on contracts written during a tax year, and defers recognition of the remaining 80 percent of unearned premiums until those amounts are earned in a future year.
- "Losses incurred" is defined, by IRC Section 832(b)(5), to mean losses actually paid during a tax year plus the discounted value of unpaid losses at the end of the current tax year minus the discounted value of unpaid losses at the end of the preceding tax year. Unpaid losses include (a) reported but unpaid losses, (b) incurred but not reported losses, (c) unpaid adjustment expenses and (d) resisted claims. Thus, the definition of losses incurred effectively allows an insurance company to deduct the discounted value of a reasonable estimate of its losses associated with particular insurance contracts when it receives the premium income (similar to the matching principle) from that insurance contract. Note that the tax accounting for insurance losses differs from the typical regulatory accounting method for those losses, in that federal tax law requires an insurance company to discount the value of its expected future losses, while regulatory accounting reports those future losses at a nominal value. The Internal Revenue Service has set forth detailed rules that control the manner in which future losses are discounted.
- "Expenses incurred" is defined, by IRC Sections 832(b)(6) and 832(c), as expenses outlined in the National Association of Insurance Commissioners report. The report includes usual expenses deducted by corporate taxpayers, including ordinary and necessary business expenses, interest, taxes, losses incurred, certain capital losses, certain worthless debts, tax-exempt interest, depreciation, charitable deductions, certain itemized deductions and the dividend-received deduction.
Alvarez & Marsal Taxand Says:
The most significant point about the general computation of insurance company taxable income under IRC Section 831(a) and Section 832 is that an insurance company can (1) deduct the discounted value of a reasonable estimate of its unpaid losses and (2) use a net loss from its underwriting income to offset its investment income. The ability of an insured to obtain a current deduction for its insurance premium payments, combined with the ability of an insurance company to deduct currently the discounted value of its unpaid losses, can present a significant timing benefit for companies that expect to pay future losses.
If a business determines that a captive insurance company supports the company's risk management needs, its tax department may achieve a tax deduction for funding self-insurance retentions that have previously been trapped on the corporate balance sheet as a general liability reserve or an incurred but not reported (IBNR) reserve.
This article has addressed the general U.S. federal tax qualification requirements for a captive to meet the IRC definition of an insurance company under IRC Section 831(a). Next week we will address the evolving landscape of state tax considerations for captive insurance companies.
Disclaimer
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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