International Captive Insurance Companies

Captives for now are here we can determine for you if a captive insurance arrangement fits your situation both economically and from a tax standpoint. CB&H can further assist in the formation and funding of
your captive and help you maintain this structure both carefully and competently.
CAPTIVE TYPOLOGIES AND CHARACTERISTICS
The concept of insurance has been around a long time. It revolves around individuals and businesses forming themselves into groups so as to mitigate their exposure to a wide range of risks. The insurance concept has been implemented using a number of organizational structures that serve the interests of both a limited or broad number of constituents for a range of overages. One popular organizational
structure is referred to as a captive insurance company because it operates at the behest of and for the
benefit of a non-insurance parent owner-company or group. The latter is referred to as a multiple-owner
captive. Organizationally, these entities resemble mutual insurance companies but for a limited number
of participants.
Captive structures have suffered from an image problem for reasons such as possibly lacking a business
purpose and for being created in jurisdictions whose laws, customs and tax systems differ from those
within the United States. However, the formation of a special purpose captive insurance company by an
affiliate or controlled company should not be negatively influenced by the jurisdiction of formation; and,
while captives provide insurance primarily in the areas of general liability and workers compensation, the
structure can be employed to address what once were considered more exotic risks, such as kidnapping,
extortion, ransom and terrorism.
Oddly enough, tax advantages are not the principal reason for forming captive insurance companies.
Rather, these arrangements are established for the needs of the owners or members as opposed to
third-party insurance. Although each captive is distinct, there are common advantages that are sought
from a captive.
These advantages include reduced cost of coverage, direct access to reinsurers, provision of broad or
otherwise unavailable coverage, mitigation of the market swings of commercial insurance, improved cash
flow, spreading of risks, improved risk retention capability, and integration with an overall risk management
plan.
The Internal Revenue Service (IRS) has viewed captives as tax avoidance schemes because premium
payments are treated as deductible by members of the economic corporate family – parent, affiliates, or
controlled group members. The IRS has taken the position that premiums paid to captives are equivalent
to self-insurance and, as such, are not deductible. An exception would be captives writing coverage
for third parties. To the members of the affiliated economic group, parent or affiliate, the concept of
stabilizing losses or strengthening earnings is more important than the deductibility of premiums paid
to a captive. The underlying substance is that captives, as an autonomous entity, are special purpose
insurance companies that provide basic benefits to the parent owner-company or members of the group,
such as a special coverage form or a special funding plan.
A fundamental technique of international tax planning, including the use of captive tax planning instruments,
is the shifting of profits from a high-tax jurisdiction to a low-tax jurisdiction. Even if profits are shifted
within a high-tax jurisdiction, tax advantages can be enjoyed. A captive can be resident for tax purposes
in a country different from its country of formation or incorporation when domestic law or a bilateral
tax treaty provides that the seat of effective management” determines the company’s residence for tax
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purposes. Most important with regard to the captive insurance company is whether the captive has a
place of management in the high-tax country, since a place of management may constitute a permanent
establishment (i.e., a fixed place of business).
If such a situation exists, the tax authorities may take the position that such a captive is taxable either on
all of its income on the grounds that it is resident for tax purposes or on a portion of its income because
it is deemed to have a permanent establishment in the high-tax jurisdiction.
TYPES OF CAPTIVES
Three general forms of captives appear to exist – those related by ownership, those related by a
specific area of commerce or coverage, and those possessing a more heterogeneous membership.
These heterogeneous membership captives are those least thought to resemble captive insurers. Pure
captives, those related by ownership, insure only the risks of the owner or members of an affiliated group
of companies.
Group captives, an extension of pure form, have multiple owners or sponsors that insure the risks of the
shareholders or their affiliates, including trade or business groups, comprised of unrelated entities that
join together for the sole purpose of forming and owning an insurance company. Examples of the last
type, those related by a very loose affiliation but drawn together by mutual agreement include sponsored
captives, a near structural clone of rent-a-captives. The latter has been available to many different insured
in offshore domiciles for years. These provide, in exchange for a fee, the advantage of an existing captive
and therefore participants avoid the attendant costs and procedures of setting up a captive. These more
entrepreneurial captive strays from the traditional captives, which insure only the risks of their owner(s).
Captives related by a specific area of commerce or coverage focus upon association and risk retention
via a group of captives. Association captives are formed by a group of entities within a particular industry
with common insurance needs and similar exposures while a risk retention group (RRG) is an association
or group captive formed for the principal purpose of assuming and spreading risk for liability exposure.
It is expected that nearly half of the risks of the U.S. commercial insurance market were placed in the
captive insurance market by the end of 2003. A principal reason for the boom in captive insurance was
the terrorist attacks of 9/11/01. Prior to Sept. 11, insureds were seeing the market become ‘hard,’ meaning
insureds were seeing premiums and deductibles increase.
The events of Sept. 11 accelerated this trend so that many risk managers were having a difficult time
finding affordable insurance coverage with commercial carriers. One alternative was the establishment of
captive insurance companies. Another reason for the current popularity of captives is that many smaller
companies are now entering markets historically dominated by large companies.
The specific types of captives found today are:
• Single-parent captives. The most common form of captive insurance company continues to be
a subsidiary of a single parent that only underwrites the risk of its parent and related affiliated
companies.
• Senior or diversified captives. Captives that underwrite risks of unrelated companies in addition
to underwriting group business.
• Association captives. Captives formed by members of an industry or a trade association (e.g.,
doctors) in order for the members to share the risks of such industry or association.
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• Agency captives. Brokers or agents who write insurance, reinsuring a portion of such insurance
with a captive. Under an agent captive arrangement, the agents and the insureds may share
profits based on their respective contributions.
• Captive pools. Pools formed for the exchange of insurance business among captives in order to
spread the risks and enhance participation in a nonrelated business.
• Excess loss or maxi-captives. Captives formed to provide coverage where insurance coverage
is otherwise unavailable in the commercial insurance market at a reasonable price. Such captives
generally provide excess coverage and are strongly capitalized.
• Rent-a-captive. Captives owned by unrelated sponsors that provide insurance for a fee. In a renta-
captive endeavor, the insured will be required to provide some capital to supplement the risk of
the captive. A rent-a-captive is often used by a company for a program that is too small to justify
incorporating its own captive.
• P&I clubs. Captives that under write protection insurance, indemnity, and other risks for their
members in the shipping industry.
CAPTIVE INSURANCE BENEFITS, IN GENERAL
Tax advantages are generally not a key goal in the formation of a captive, but certain advantages may
be available. For example, a U.S. company that is currently self-funding a layer of exposure for workers’
compensation risks may choose to provide for this exposure through an association captive. The company
could then deduct the premiums paid to the captive, rather than deferring the deduction, under the selffunding
plan until the claims are actually paid. While tax advantages may be established through a
properly planned captive, many new owners/members of captives have unrealistic expectations regarding
the availability of tax savings from these companies. This may be partly due to the lack of experience and
expertise of the potential owner of a captive in the rather complex U.S. tax rules relating to insurance and
international taxation.
The formation of a captive is usually the first foray of the owner/member into the insurance business,
other than as a policyholder, and may also be the company’s first involvement in international business.
Therefore, proper planning is especially important in order to identify and maximize any available tax
advantages and avoid any risks that may detract from the many nontax advantages of the captive.
BUSINESS REASONS FOR CREATING A CAPTIVE INSURANCE COMPANY
• Obtaining insurance coverage when commercial insurers are unwilling to do so. Often,
commercial insurance companies will not provide certain types of coverage. For instance, risks
that are often currently uninsurable frequently involve environmental issues such as hazardous
waste, nuclear risks, and pollution. Captives can be used to provide coverage in these areas.
• Reduced premium payments. Creating a captive enables the parent to reduce certain costs
that are often added to the premium by a commercial insurer. Such costs can include general
overhead, the administration and settlement of claims, various taxes, brokerage fees, and
miscellaneous fees. Captive arrangements can reduce these fees, enabling the parent to obtain
the same coverage at a lower cost.
• Control of risk. Effective risk management allows a captive to control subsequent losses. Net
retention can be adjusted as market conditions change to achieve cost-effective risks.
• Cash-flow. The commercial insurance industry has traditionally relied on investments as a
principal source of income. While this principle can be taken advantage of by the captive insurance
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industry as well, the investment income may be tax free to the captive, depending on where it is
domiciled, unless an election is made to have the foreign insured treated as a U.S. company for
tax purposes.
• Access to the reinsurance market. A captive may gain direct access to the international
reinsurance market, i.e., the wholesale market for insurance. Frequently, captives are able to
obtain reinsurance that is less expensive than the reinsurance available in the commercial market.
It should be noted that access to the reinsurance market can be accomplished only through a
licensed insurer.
• Diversification into a profit center. A parent cannot insure its risks in a wholly owned captive
unless there is a certain amount of third-party risk held by the captive. The sale of insurance to
third parties provides leverage if the parent holds most of the risks. It is possible for a captive
to diversify and offer insurance services to independent third parties and operate as a separate
commercial profit center. Not only will this allow the captive to generate more investment income,
but will also provide more risk distribution (a common way to accomplish this is through the sale
of warranties).
• Balanced coverage. Economic fluctuations, poor underwriting, and normal commercial industry
changes often lead to significantly increased premiums in the commercial insurance world.
Captives are less affected by these external factors, and as a result, have steadier premiums that
can be factored into the parent’s long-term budget, allowing the parent to be in a better position
to reach its financial target.
DOMICILE, REGULATORY AND INFRASTRUCTURE CONSIDERATIONS
An important decision in establishing a captive insurance company is determining where it will be
domiciled. U.S. companies have the option to have the captive domiciled onshore, located within the
jurisdiction of the United States, or offshore (located outside the jurisdiction of the United States). The
various alternatives have advantages and disadvantages for the parent. Three key areas a company
should focus on when choosing a domicile for a captive are the regulatory environment, the infrastructure
of the country (if it is not the United States) selected, and the tax consequences.
FUNDAMENTALS OF CAPTIVE TAXATION
Tax consequences must be looked at before choosing a domicile. Every potential domicile has a unique
tax structure, which can be especially important when choosing between onshore and offshore domiciles.
The choice of a domicile can have an effect on premium taxes and excise taxes.
While many offshore countries offer premium or income tax advantages that are unavailable to onshore
domiciliaries, selection of an offshore domicile will often trigger U.S. excise taxes.
The end result may be of little or no tax advantage in establishing a captive insurance company in
an offshore location. There is a U.S. federal excise tax of 1% on gross reinsurance and life insurance
premiums and a 4% excise tax on direct property and casualty premiums paid to foreign insurers. While
offshore captive insurance companies may be subject to certain foreign taxes and excise taxes, one
advantage to being domiciled offshore in such domiciles as Bermuda and the Cayman Islands is that no
premium tax will be applied to captives in those domiciles.
CFC Status: Subpart F of the Internal Revenue Code requires every person (and entity) who is a U.S.
shareholder of a controlled foreign corporation (CFC), and who owns stock in such corporation on the last
day of the CFC’s taxable year, to include in gross income a deemed dividend equal to the shareholder’s
pro rata share of the CFC’s “tainted earnings”, which includes “insurance income”. Subpart F applies only
to a CFC.
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Another rule exists for allocating Subpart F insurance income to U.S. shareholders. A company is an
insurance CFC if its 10% U.S. shareholders own more than 25% of the vote or value of the offshore
captive.
Finally, yet another rule applies for purposes of allocating insurance income derived from the insuring of
related parties (“related person insurance income”). Here, all U.S. shareholders, not just 10% or more,
are included for purposes of the 25% test. Thus, if a foreign captive is a CFC, the U.S. shareholders must
include in taxable income their pro rata share of the CFC’s Subpart F insurance income, thus negating
any deferral of such income, whether repatriated or not.
DOMESTIC COMPANY ELECTION
Certain CFCs can elect to be U.S. domestic insurance companies, under IRC Section 367, if they meet
three requirements. First, the entity is a CFC for purposes of allocating related person insurance income
(RPII). Second, such CFC would be taxed as an insurance company if it were a domestic company.
Finally, the CFC waives all treaty benefits otherwise available to it.
Under this “domestic company election”, the CFC is deemed to have transferred all of its assets and
liabilities to a new U.S. corporation in exchange for that corporation’s capital stock. In addition, U.S.
shareholders of such an electing CFC are required to include in gross income certain untaxed E & P
(i.e., retained earnings) in gross income; though, for a newly formed company, there would be no such
gain. Available under IRC Section 367(b), and in tandem with a “domestic company election,” is an
opportunity, made available as a consequence of the Tax Reform Act of 1986, which liberalized IRC
Section 501(c) (15) in two important respects. It allows stock companies to qualify for exemption as well
as mutual insurers in an attempt to create parity between stock and mutual insurance companies. And, it
changes the measure of the dollar ceiling from a gross-receipts test to a premium-income test. This point
is discussed in further detail below.
A “domestic company election” must be filed by the due date of the corporate return, including any
extensions. The electing company is generally required to execute a closing agreement and post a letter
of credit with the IRS. The letter of credit is waived if the electing company maintains an office or other
place of business in the U.S.
• Once the election is made for the offshore captive under IRC Section 367, it may then be eligible
to elect tax-exempt status under IRC Section 501(c) (15). Such tax-exempt status provides
that a non-life insurance company qualifies as tax exempt under this section if its “net written
premiums” (or if greater, direct written premiums) for the taxable year do not exceed $350,000
and the insurer satisfies other specified requirements. This effectively makes available to small
and middle size businesses an extremely tax-efficient structure to establish a captive offshore
arrangement. Premiums of all members of the taxpayer’s controlled group (as defined in IRC
Section 1563) are aggregated for the purposes of this $350,000 test. For a given tax year, to
gain tax exempt status under IRC Section 501(c) (15), an organization’s primary business must
generate or issue insurance contracts or the reinsurance of risks, hence, the required presence
of risk shifting and risk distribution.
• Alternately, Section 831(b) of the IRC provides for the total exemption from taxation of underwriting
profits (but not investment income) if total premiums paid (gross written premiums) do not exceed
$1.2M annually.
For a given tax year, to gain tax-exempt status under IRC Section 501(c) (15), an organization’s primary
business must generate or issue insurance contracts or the reinsurance of risks, hence, the required
presence of risk shifting and risk distribution.
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If the captive, now a domestic exempt insurance company, is unable to meet the $350,000 premium
test, the tax-exempt status with respect to insurance income is lost. However, as long as net written
premiums do not exceed $1.2 million in such taxable year, the entity retains the ability to be taxed only
on its investment income.
ANALYSIS OF RECENT IRS GUIDANCE
Based on the recent developments described above, the factors that will be important in the Service’s
analysis of a captive insurance company arrangement, several of which are further discussed below,
include:
• Non-tax business purpose
• Adequate capitalization
• Arm’s-length and commercial dealing
• Regulatory oversight
• Concentration of risk
OTHER CAPTIVE DEVELOPMENTS
A federal excise tax on gross premiums paid to a foreign insurance company attributable to the insurance
or reinsurance of U.S. risks is imposed by Section 4371. The rate of tax is generally 1% for casualty
insurance and reinsurance and 4% for life and health insurance.
The tax does not apply (1) to premiums paid to a foreign insurance company electing under Section 953(d)
to be treated as a domestic insurance company (Rev. Proc. 200347, 2003-28 IRB 55), (2) to premiums
giving rise to related-person insurance income of a foreign captive electing under Section 953(c)(3)(C) to
treat its related-person insurance income as income effectively connected with the conduct of a trade or
business in the U.S. (Section 953(c)(3)(D)(ii)), or (3) to premiums paid to a foreign insurance company
exempt from tax under a U.S. income tax treaty.
The Terrorism Risk Insurance Act of 2002 generally authorized the Treasury to impose a 3% surcharge
on direct casualty insurance (although not reinsurance) premiums of insurance companies covered by
the Act’s program to recoup the federal government’s payments to covered insurance companies to
defray their terrorism-related claims liabilities. For insureds that use domestically licensed captives, or
foreign captives that act as reinsurers for domestically licensed fronting companies, concern presently
exists due to the Treasury’s rejection of special treatment of captives in mid-2003 by defining the scope
of insurance companies covered by the Act.
IRS PROACTIVITY IN CAPTIVE TAXATION
Sensing taxpayers’ reactions to the hard insurance market, commencing in 2001, after a noticeable hiatus
during which the Service worked the courts, IRS recently began what is with relatively short hindsight,
a proliferation of response, limited guidance and warnings in the captive insurance area. The old adage
that “ignorance is bliss” does not apply to sophisticated tax planning and prior to IRS reinvolvement in
the captive arena; our clients were reluctant to include tax planning in their overall business purpose
justification for establishing a captive despite the tax advantages that captive insurance companies can
offer.
This revenue ruling and the flurry of IRS pronouncements shortly following should continue to have
a significant impact on the captive insurance industry and on how the Service will challenge captive
arrangements proving particularly beneficial to taxpayers seeking guidance in matters of premium
deductibility and IRS respect for these arrangements.
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Captive insurance arrangements should be reviewed in light of the criteria that the Service will apply to
determine if the arrangements are acceptable. For example, the captive’s capital and surplus should not
be too small for the level of risks insured and the captive should not rely on parent guarantees. By the
same token, the captive’s capital and surplus should not be too high for its level of insurance business or
loaned back to the parent or affiliates.
Captive insurance arrangements continue to be popular planning tools in the practitioner’s arsenal when
confronted with the increasingly “hard” insurance markets accompanying the terrorist attacks on the
United States on September 11, 2001, coupled with the collateral effects of global recession and abysmal
investment returns, once the anchor of public insurance company earnings and reserves.
Increasingly in the U.S., the captive concept is moving onshore to friendly and progressive jurisdictions,
which include Vermont and South Carolina, as regulation decreases and insurance infrastructures
become progressive.
Prolific use of the domestic company election for offshore captives indicates that the primary reason for
selecting an offshore jurisdiction in the past amounted to the lack of regulation and innovation issues
provided in offshore environments. This may become a relic of the past as onshore jurisdictions rise to
the challenge of the offshore competition of Bermuda and Cayman, in which CB&H works as well.
Employee benefits are emerging as what may be a staple in the captive portfolio of insured risks
prospectively. This is due in large part to the US Department of Labor implementing in late 2003 its
“expedited process” system of fast track approval. This fast track is available to captives insuring such
employee benefits as group long-term disability and life insurance for employees of middle market and
larger sized companies.
This insuring of employee risks provides captives with an essential ingredient in the captive arsenal of
employee benefits counting as the insuring of “unrelated” risks because such employees are deemed
unrelated parties for risk shifting purposes.