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Captive insurance is the pinnacle of risk management. In general, captive insurance is a form of self-insurance with a litany of financial advantages. Surprisingly, captive insurance eludes a basic definition since the Internal Revenue Code declines to define the term “insurance.” As a result, the courts are left to decide when a financial arrangement is actually insurance. Over the years, a 4 part test has been developed to assess whether insurance exists:

• Whether the arrangement involves the existence of ‘insurable risks.’
• Whether the arrangement is ‘insurance’ in the commonly accepted sense.
• Whether risk shifting occurred.
• Whether risk distribution occurred.

As with all legal matters, there are lines of case law exploring each word of these 4 standards (arguably there are only 3 standards as some courts combine risk shifting and distribution into a single rule). At the end of the day, the test for whether captive insurance actually exists is a bit of a sniff test. If the arrangement looks like normal insurance, then the IRS is likely to determine that your arrangement is, in fact, insurance.

So why all the questioning? Why can’t you just create a captive insurance company, fill out an application with the commissioner of insurance, and be done with the whole exercise. The answer is because insurance companies have tremendous flexibility with regard to how they recognize income, deduct premiums from the parent company’s gross revenue, and pay dividends to shareholders. The financial power of a captive is fantastic. A quick example provides more clarity:

Take Company X. Company X has profits of $100 last year with nearly no losses. Company X decides that it’s overpaying insurance premium because it is a very safe company. Company X now creates a captive insurance company as a subsidiary company. Last year Company X paid $20 in insurance premium to its insurance carrier. After establishing the captive, now Company X pays $15 in insurance premium to its subsidiary captive insurance company. That $15 is a tax deduction from Company X’s gross revenue. The captive does not immediately recognize the income as taxable gain since the captive needs funds on hand to pay out potential claims. As a result, Company X has now shifted taxable income from the parent company to the captive subsidiary without a taxable event.

Assume further than Company X’s captive now enters into a reinsurance arrangement with another captive insurance company and reinsures the risks of an unrelated captive insurance company. Now the captive is receiving premium both from Company X but also from the unrelated entity. The captive has 2 separate streams of income and will have to pay out claims from either party in the event of a loss.

Is this legal?

Absolutely.

So why is this such a headache for the IRS? The IRS takes an aggressive stance with these entities because some unscrupulous businesses abuse captive insurance companies. Let’s do a variation on the above arrangement.

Company X makes a captive. Assume the captive insures all of Company X’s risks. Let’s further assume Company X hires an actuary to calculate a premium to cover exotic risks, such as terrorism insurance. Company X pays terrorism insurance premium in the amount of $30 to its captive insurance company and deducts every dollar in premium from gross revenue from the parent company. Those tax deductible dollars are retained by the captive, invested in the market, and returned later to Company X’s owners in the form of dividends at some date in the future. This creates a huge tax savings for the parent company while the captive provides insurance for Company X.

Is this legal?

Eh… Maybe, but likely not. Remember the sniff test we had above? This smells fishy. There is no problem insuring liability, workers’ compensation, or healthcare benefits through a captive. There is also nothing wrong with insurance exotic risks you can’t place through a traditional carrier in your captive (e.g., a dynamite factory can’t find insurance). However, creating insurable risks out of thin air in order to create a phony baloney tax deduction is not allowed.

But is terrorism insurance inherently illegal? If you are doing business in New York City, Belfast, Paris, or Madrid then you have a legitimate risk of terrorism affecting your business. However, if you’re doing business in Wichita, Kansas, then your terrorism insurance looks more like a tax scam than a real insurance interest.

So, can you only insure against terrorism, ransom, kidnapping, or other similar types of insurance if you live in cities that have had incidents of terrorism in the past 10 years? Of course not, that rule wouldn’t make sense. As a result, the courts have had trouble coming up with brightline rules to ferret out the difference between legitimate insurance and the troublemakers.

Back to the rules, here they are one more time:

• Whether the arrangement involves the existence of ‘insurable risks.’
• Whether the arrangement is ‘insurance’ in the commonly accepted sense.
• Whether risk shifting occurred.
• Whether risk distribution occurred.

Future blog posts will explore each of these in greater detail, but a general concept emerges when the rules are viewed from 30,000 feet. If your captive insurance company operates like an insurance company, then you have a legitimate insurance arrangement. If your insurance company looks effectively reduces the parent company’s taxable income to zero while insuring low probability risks like terrorism, then you’ve probably run afoul of the law.