As I said in part one of my blog on captive insurance companies, the exploding popularity of captives cannot be denied, and it is not difficult to understand why. A business that forms a captive insurer often enjoys lower premium costs simply by virtue of eliminating the middleman. In addition, up to $1.2 million in annual insurance premiums paid to a captive subsidiary are tax-deductible.
Captive owners can also prepare unique insurance policy forms that provide the owner with the precise coverages needed, and eliminate the ones that are not. Captives turn the headache of commercial insurance into a potentially exciting opportunity, if planned and managed properly.
The increasing popularity of captives has, however, led to increased scrutiny, particularly from the Internal Revenue Service. The IRS is rightfully concerned with businesses and individuals that form captives purely for the substantial tax benefits, rather than to serve the traditional “risk transfer” role that every captive insurance company must play.
To explain, “risk transfer” is an essential element of every insurance policy. Auto insurers accept the financial risk posed by auto accidents, just as homeowner insurers accept the financial risk that flows from an insured house burning down.
At a fundamental level, every insurer accepts a fee (i.e., the insurance premium) in exchange for the insurer’s agreement to pay in the event a certain contingency (auto accident, fire, flood, etc.) occurs. No contract is an “insurance policy” without the transfer of risk to the insurer.
There are some recently publicized examples of businesses that have allegedly tried to reap the financial benefits of captive formation without actually transferring any risk to their captive. The core of many of these purported scams is to use the captive to insure against so-called “risks” that are so unlikely that no claims would ever be paid.
To use an extreme example, the captive might charge its owner a $1.2 million annual premium to protect against the “risk” of an alien invasion. The parent business takes the annual $1.2 million tax deduction secure in the knowledge that its captive subsidiary is accumulating a large pile of cash and investments that will never be reduced by the payment of an actual insurance claim.
(No offense to those who are expecting an imminent alien attack is intended. The likelihood of an alien attack seems fairly remote to this insurance attorney, and in any event, should such an attack occur, it seems unlikely that handling claims under this policy will be at the top of anyone’s “to do” list).
To use perhaps a better, real-world example, the New York Times recently reported on an IRS challenge to tax deductions made by a dentist who set up a captive to insure against a terrorist attack in his dental practice. The IRS lost that case, because risk was transferred. Apparently, legitimate “risk” can sometimes be in the eye of the beholder.
This case highlights the need for entities that are considering a captive to retain an insurance attorney to assist in ensuring legitimate risk transfer, and with the many additional regulatory issues that may arise with the formation of an insurance company.
If you think an insurance captive might be right for your company, or you would simply like more information about the benefits of captives, please contact Alex J. Brown, Esq., a partner and Insurance Group practice leader at Shapiro, Sher, Guinot & Sandler, P.A., at 410-385-4220 or at firstname.lastname@example.org.
Mr. Brown is a former Senior Counsel to the Maryland Insurance Administration and Assistant Attorney General for the State of Maryland who has substantial experience helping clients evaluate and address insurance and captive issues of all types.