A shorter Launch for you to Attentive Insurance
Within the last 20 years, many small businesses have begun to insure their particular risks by way of a product called “Captive Insurance.” Small captives (also known as single-parent captives) are insurance companies established by the owners of closely held businesses looking to insure risks which can be either too costly or too difficult to insure through the traditional insurance marketplace. Brad Barros, a specialist in the field of captive insurance, explains how “all captives are treated as corporations and must certanly be managed in a method in line with rules established with both IRS and the correct insurance regulator.”
In accordance with Barros, often single parent captives are owned by a trust, partnership and other structure established by the premium payer or his family. When properly designed and administered, a business can make tax-deductible premium payments to their related-party insurance company. Depending on circumstances, underwriting profits, if any, may be paid out to the owners as dividends, and profits from liquidation of the business might be taxed at capital gains.
Premium payers and their captives may garner tax benefits only when the captive operates as an actual insurance company. Alternatively, advisers and business owners who use captives as estate planning tools, asset protection vehicles, tax deferral and other benefits not linked to the real business intent behind an insurance company may face grave regulatory and tax consequences.
Many captive insurance companies tend to be formed by US businesses in jurisdictions outside the United States. The reason for this is that foreign jurisdictions offer lower costs and greater flexibility than their US counterparts. As a rule, US businesses may use foreign-based insurance companies so long as the jurisdiction meets the insurance regulatory standards required by the Internal Revenue Service (IRS).
There are several notable foreign jurisdictions whose insurance regulations are recognized as safe and effective. These include Bermuda and St. Lucia. Bermuda, while higher priced than other jurisdictions, is home to many of the largest insurance companies in the world. St. Lucia, a more reasonably priced location for smaller captives, is noteworthy for statutes which can be both progressive and compliant. St. Lucia is also acclaimed for recently passing “Incorporated Cell” legislation, modeled after similar statutes in Washington, DC.
Meeting the high standards imposed by the IRS and local insurance regulators can be quite a complex and expensive proposition and should only be completed with the assistance of competent and experienced counsel. The ramifications of failing continually to be an insurance company may be devastating and may include these penalties:
In general, the tax consequences might be greater than 100% of the premiums paid to the captive. In addition, attorneys, CPA’s wealth advisors and their clients might be treated as tax shelter promoters by the IRS, causing fines as great as $100,000 or maybe more per transaction.
Clearly, establishing a captive insurance company is not a thing that needs to be taken lightly. It is important that businesses seeking to establish a captive use competent attorneys and accountants who have the requisite knowledge and experience essential to prevent the pitfalls associated with abusive or poorly designed insurance structures. A general principle is a captive insurance product must have a legal opinion covering the primary elements of the program. It is well recognized that the opinion should be given by an independent, regional or national law firm.
Risk Shifting and Risk Distribution Abuses; Two key elements of insurance are those of shifting risk from the insured party to others (risk shifting) and subsequently allocating risk amongst a big pool of insured’s (risk distribution). After several years of litigation, in 2005 the IRS released a Revenue Ruling (2005-40) describing the primary elements required to be able to meet risk shifting and distribution requirements.
For many who are self-insured, the utilization of the captive structure approved in Rev. Ruling 2005-40 has two advantages. First, the parent does not have to generally share risks with every other parties. In Ruling 2005-40, the IRS announced that the risks may be shared within exactly the same economic family as long as the separate subsidiary companies ( at the least 7 are required) are formed for non-tax business reasons, and that the separateness of those subsidiaries also has a business reason. Furthermore, “risk distribution” is afforded so long as no insured subsidiary has provided a lot more than 15% or significantly less than 5% of the premiums held by the captive. Second, the special provisions of insurance law allowing captives to have a current deduction for an estimate of future losses, and in certain circumstances shelter the income earned on the investment of the reserves, reduces the money flow had a need to fund future claims from about 25% to nearly 50%. Put simply, a well-designed captive that fits the requirements of 2005-40 may bring about a price savings of 25% or more.
Though some businesses can meet the requirements of 2005-40 within their particular pool of related entities, most privately held companies cannot. Therefore, it’s common for captives to purchase “third party risk” from other insurance companies, often spending 4% to 8% per year on the amount of coverage necessary to generally meet the IRS requirements.
Among the essential elements of the purchased risk is that there is a fair likelihood of loss. Because of this exposure, some promoters have attempted to circumvent the intention of Revenue Ruling 2005-40 by directing their clients into “bogus risk pools.” In this somew Bedrijf hat common scenario, an attorney and other promoter can have 10 or maybe more of the clients’ captives enter in to a collective risk-sharing agreement. Included in the agreement is a written or unwritten agreement not to produce claims on the pool. The clients like this arrangement simply because they get all the tax benefits of owning a captive insurance company without the chance associated with insurance. Unfortunately for these businesses, the IRS views these kinds of arrangements as something other than insurance.
Risk sharing agreements such as for example they are considered without merit and should be avoided at all costs. They add up to nothing more than a glorified pretax savings account. If it may be shown a risk pool is bogus, the protective tax status of the captive may be denied and the severe tax ramifications described above will undoubtedly be enforced.
It established fact that the IRS looks at arrangements between owners of captives with great suspicion. The gold standard in the market is to purchase third party risk from an insurance company. Anything less opens the doorway to potentially catastrophic consequences.
Abusively High Deductibles; Some promoters sell captives, and then have their captives participate in a big risk pool with a high deductible. Most losses fall within the deductible and are paid by the captive, not the chance pool.
These promoters may advise their clients that considering that the deductible is indeed high, there is no real likelihood of third party claims. The situation with this sort of arrangement is that the deductible is indeed high that the captive fails to generally meet the standards set forth by the IRS. The captive looks more like a sophisticated pre tax savings account: no insurance company.
A different concern is that the clients might be advised that they may deduct all their premiums paid into the chance pool. In the case where the chance pool has few or no claims (compared to the losses retained by the participating captives employing a high deductible), the premiums allocated to the chance pool are merely too high. If claims don’t occur, then premiums should be reduced. In this scenario, if challenged, the IRS will disallow the deduction created by the captive for unnecessary premiums ceded to the chance pool. The IRS can also treat the captive as something other than an insurance company because it did not meet the standards set forth in 2005-40 and previous related rulings.
Private Placement Variable Life Reinsurance Schemes; Through the years promoters have attempted to produce captive solutions designed to supply abusive tax free benefits or “exit strategies” from captives. Among the very popular schemes is in which a business establishes or works together a captive insurance company, and then remits to a Reinsurance Company that part of the premium commensurate with the part of the chance re-insured.
Typically, the Reinsurance Company is wholly-owned by a foreign life insurance company. The legal owner of the reinsurance cell is a foreign property and casualty insurance company that’s not at the mercy of U.S. income taxation. Practically, ownership of the Reinsurance Company may be traced to the money value of a life insurance policy a foreign life insurance company issued to the principal owner of the Business, or even a related party, and which insures the principle owner or even a related party.
Investor Control; The IRS has reiterated in its published revenue rulings, its private letter rulings, and its other administrative pronouncements, that the master of a life insurance policy will undoubtedly be considered the income tax owner of the assets legally owned by the life insurance policy if the policy owner possesses “incidents of ownership” in those assets. Generally, to ensure that the life insurance company to be viewed the master of the assets in a different account, control over individual investment decisions must not maintain the hands of the policy owner.
The IRS prohibits the policy owner, or even a party linked to the policy holder, from having any right, either directly or indirectly, to require the insurance company, or the separate account, to get any particular asset with the funds in the separate account. In effect, the policy owner cannot tell the life insurance company what particular assets to invest in. And, the IRS has announced that there can’t be any prearranged plan or oral understanding in regards to what specific assets may be committed to by the separate account (commonly referred to as “indirect investor control”). And, in an ongoing series of private letter rulings, the IRS consistently applies a look-through approach regarding investments created by separate accounts of life insurance policies to find indirect investor control. Recently, the IRS issued published guidelines on when the investor control restriction is violated. This guidance discusses reasonable and unreasonable degrees of policy owner participation, thereby establishing safe harbors and impermissible degrees of investor control.