White Paper: Audit Risk for Captive Insurance Companies

Use of Small Captive Insurance Companies as Abusive Tax Shelters

Executive Summary

The issue:

Significant abuse of small captive insurance companies (CICs) as tax shelters has earned CICs a place on the IRS’s 2015 “Dirty Dozen” list of tax scams. Tax advisors, companies with CICs, and companies looking to establish CICs should be aware of the increased tax audit risk related to CICs.

Challenge:

How do you avoid the IRS’s perception of an abusive tax shelter? This requires establishing a reasonable economic basis and properly pricing insurance premiums.

Insurance policies were developed to hedge against contingent and uncertain economic losses. Typical insurance vehicles pool risk across numerous individuals or companies. CICs, by design, are limited to an individual company; therefore, the insured risk must be suitable for a CIC. Additionally, the pricing of insurance premiums should be equivalent to third-party, arms-length pricing.

 Solution:

ValueScope’s team of experts have the knowledge and experience to determine if existing CICs have the economic substance necessary to survive audit scrutiny. Additionally, we have the skills and expertise necessary to assist CICs to properly structure their policies in order to avoid potential issues.

Captive Insurance Companies

A Captive Insurance Company (CIC) is an insurance company established by an operating parent company for the purpose of covering the parent company’s specific risks. CICs are effectively a type of “self-insurance.”

Insurance Company

The Internal Revenue Code 831(b) permits businesses to create CICs, whereby the premiums paid by the operating company are tax deductible.

Premiums paid to the CIC are invested in a portfolio, referred to as the captive assets. The CIC can exclude taxable income of up to $1.2MM per year in net written premiums; therefore, most CICs pay taxes only on the investment income from the captive assets. In the event of an insurance

claim, the CIC must pay the claim out of the captive asset investments. Amounts not paid as claims accumulate over time and are sheltered from taxes. The taxes on the sheltered income are deferred, and the income could potentially be re-characterized as capital gains.

Issue: Small CICs as Tax Shelters

On February 3, 2015, the United States Internal Revenue Service (IRS) added Captive Insurance to its so called “Dirty Dozen” list of tax scams (See: IR-2015-19). The Dirty Dozen is an “annual list of tax scams” produced by the IRS that informs the public, as well as the accounting community, of the IRS’s focus areas.

The tax deductions described above have led to significant abuse of the CIC provisions. According to the IRS, “unscrupulous promoters persuade closely held entities to participate in this scheme by assisting entities to create captive insurance companies onshore or offshore, drafting organizational documents and preparing initial filings to state insurance authorities and the IRS. The promoters assist with creating and ‘selling’ to the entities often times 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.”

Below is a hypothetical example that illustrates the tax sheltering of parent company’s income in a CIC.

Captive Insurance Companies

In this hypothetical example, without the CIC, the operating company has $1.1MM in taxable income in year 1 net of its $100,000 in insurance premiums. After paying taxes at 35%, the company’s net profit is $715,000. With the CIC, the company pays the $1.2MM (i.e., the $1.1M in taxable income plus the $100,000 that would have been paid to a third party insurance company) to its CIC. The CIC has operating expenses of $75,000 annually that it pays to the captive manager and also pays any insurance claims filed by the parent. In the example above, we assume the claims paid by the CIC to the parent are $100,000 annually. The assets in the portfolio are invested and generate an investment return, assumed to be 5%. The only taxes associated with the CIC are on the investment income. The economic benefit of the CIC in this example is $325,000 in year 1 and over $3.9 MM over ten years. This economic benefit is created purely by forming a CIC and sheltering income for taxation.

Challenge: Avoiding Abusive Small CICs

Given recent IRS scrutiny, creating small CICs deemed abusive, like the hypothetical example above, should be avoided. These CICs are formed primarily for the purpose of sheltering income from taxation and lack economic substantiation for the premiums charged to the parent. To shelter income from taxes, abusive CICs set insurance premiums that are well in excess of what would reasonably be expected in any third-party transactions. For example, a recent New York Times article gives an example of a dental practice self-insuring against a terrorist attack, a risk that while (remotely) possible has such an extremely low probability of occurrence that it is unlikely to have any significant impact on the value of the dental practice or to be separately insured against in the real world.

It is important to realize that insurance is typically sold and designed to “share” risk across a large number of insured parties that face similarly ratable risks (a “risk pool”). The traditional economic purpose of insurance is to diversify the risk of adverse events across a large number of insured parties that are individually risk averse. Each insured party is willing to pay a premium to the insurer in order to cover infrequent but extreme risks for the insured. An insurance company sets premiums based on the expected losses in the insured pool (based on the “loss ratio”), the expenses incurred by the insurer, and the profit required by the insurer. In exchange, the insurer provides the capital and organizes and pools the risks sufficiently to reliably protect each insured. The insurer may often join with other insurers to form larger risk pools or obtain insurance against the most extreme events through reinsurance with other carriers. Considering these economics, a CIC is not suitable for certain types of risks faced by businesses because it is not able to pool risks across a large set of insured parties (having only a single insured party) and does not have the size and financial resources required to protect the insured parent against certain types of extreme adverse events.

The challenge, then, is to establish the reasonable economic basis for insurance through a CIC and then properly price such insurance in order to avoid an unfavorable tax audit outcome. Given current IRS scrutiny of this issue, we recommend that a business with a CIC properly documents and measures the adverse risks faced by the business that are insured by the CIC, and then to price the insurance coverage appropriately based on such risks. Absent adequate documentation and support, setting up a CIC could expose a business to significant audit risk.

So, what risks warrant the use of a CIC? Risks that are material to the value of the business and are potentially insurable (i.e., irregular in timing and amounts) are typically the best risks to insure through a CIC. A CIC can be effective at offsetting such risks for the insured parent over time, especially after it has built up a sufficient reserve of captive assets. The CIC may also acquire reinsurance (or a high-deductible policy) to protect against the more extreme risks that a CIC may not be well suited to insure against.

Most Suitable Industry Types for CICs

  • Healthcare
  • Manufacturing
  • Transportation
  • Construction
  • Government Contractors
  • Financial Services

Types of CICs

  • Single parent
  • Series LLCs
  • Risk Retention Group
  • Rental
  • Segregated/Protected Cell
  • Association
  • Agency
  • Special Purpose Vehicles
  • Businesses considering the implementation of a CIC should review the types of CICs listed above because the implications of each will vary depending upon intended use and industry type.

Solution

ValueScope is well versed in matters involving the testing of economic substance. We have experience evaluating hazards and analyzing a number of unique and specialized types of pooled risks as well as the pricing of such risks. Our team of experts has the requisite background in financial economics and statistics necessary to:

  • Estimate hazard rates for common insurance risks,
  • Estimate the amount of coverage that is reasonable and customary,
  • Estimate insurance premiums that would reasonably be charged to the parent in a third-party, arms-length insurance transaction,
  • Identify any unsubstantiated captive insurance premiums, and
  • Document our findings in comprehensive and well-written reports that would survive IRS audit scrutiny.

We can help assess proposed or existing CICs to ensure that they have economic substance and are documented and priced correctly.

ValueScope: Measuring, Defending, and Creating Value for Our Clients

ValueScope is much more than a regional valuation and damages firm. We are a national firm that also specializes in complex litigation support, tax reporting and analysis, transfer pricing between corporate affiliates, management consulting, and transaction advisory. We are here to help—please let us prove it.

Captive Insurance Companies

For more information or to contact us about your CIC, please feel free to write or call. We look forward to speaking with you.

ValueScope Inc.

(Office) 817-481-6350

info@energyvaluationexperts.com

Download a PDF of this white paper regarding Captive Insurance Companies.

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