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Last week (2/3/15), the IRS came out with a warning to captive insurance companies making 831(b) elections by including a discussion of captives under “Abusive Tax Structures” in the “Dirty Dozen List of Tax Scams.” (See www.irs.gov/uac/Newsroom/Abusive-Tax-Shelters-Again-on-the-IRS-Dirty-Dozen-List-of-Tax-Scams-for-the-2015-Filing-Season) The IRS does state that a captive insurance company is a “legitimate tax structure” before making some broad statements about the abuses of captives. Several of the less flattering statements in the IRS release are worth digging into further.
The first noteworthy statement is that “unscrupulous promoters” are selling “poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums,’ while maintaining their economical commercial coverage with traditional insurers.” There are several problems with this statement.
First, captive insurance was never intended to replace the admitted market in situations when markets are competitive and coverage is available, but rather complement it when coverages were neither affordable nor readily available.
Second, it ignores that a majority of captive insurance formations in recent years have been in onshore domiciles like Delaware, Kentucky, South Carolina, Tennessee, and Utah. This means that the coverage forms were subject to regulation in domiciles compliant with NAIC accreditation standards. This regulatory scrutiny applies not only to captive forms, but rates and capitalization/solvency as well.
Third, the statement appears to forget that the 831(b) tax election was developed so that business owners could accumulate a tax deferred “rainy day fund” to protect them and finance losses when low frequency, high severity events like natural disasters (or today, cyber attacks and product recalls) occurred.
The IRS then states that “(t)otal amounts of annual premiums often equal the amount of deductions business entities need to reduce income for the year; or, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the Code provision.” There is nothing new or different about adjusting coverage limits and deductibles to match an insurance buyer’s economic ability to pay. Isn’t this exactly what Progressive’s “Name Your Price Tool” and countless other personal insurance products that craft the coverage to meet your price point do?
Next, the IRS takes on the actuaries and underwriters by stating that “(u)nderwriting and actuarial substantiation for the insurance premiums paid are either missing or insufficient.” Again, most captive insurance formations making 831(b) elections in recent years are in U.S. domiciles. These jurisdictions not only require an actuarial funding study as part of the captive application, but commission an independent actuarial review of the funding and feasibility study to ensure that the data, methods, and assumptions underlying the premium estimate and pro forma financial statements are actuarially sound and reasonable.
Finally, the IRS states that “(t)he promoters manage the entities’ captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance to continue the charade.” Putting the charade comment aside, this seems to ignore the amount of competition in the captive space. The sheer number of captive managers vying to assist businesses in forming their captive has ensured that captive management fees remain efficient and competitive. Further, the economics of forming a captive insurance company simply do not add up if the captive manager, or any other captive service provider, charges “hefty” fees.
Am I suggesting that all captives have sufficient risk transfer and risk distribution and charge actuarially sound rates? Do I deny that there are some promoters out there more interested in wealth management, investment strategies and tax avoidance? No, I won’t go that far. But the sheer number of well-run, actuarially sound insurers (captives and admitted insurers), managed by professional captive managers that make 831(b) elections far outweigh the few bad eggs. This begs the question “are captive insurers making 831(b) elections really as ‘dirty’ as the IRS thinks?”
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