Avoiding Potential Pitfalls Is Key to Long-Term Captive Success

Current commercial insurance market conditions, emerging risks, and a continuously growing understanding of the value captive insurance can offer have driven considerable interest in captives in recent years. But, to ensure captive insurance success, those considering forming a captive need to make sure to address potential pitfalls, according to a recently released paper.

The report, Captive Formation and Tax Pitfalls, from Ernst & Young LLP (EY), notes, "Over the past couple of decades, the captive insurance industry has undergone tremendous growth worldwide and specifically within the United States. For many US companies looking to insert a captive insurance company into their structure, the process of quickly building one has revealed certain areas that need to be addressed early on when forming a captive insurance company."

Organizations considering forming a captive must avoid those potential pitfalls in forming a captive insurance company and selecting a domicile, the EY report says.

Captive insurance experts frequently note that while a captive may provide tax benefits, it's a mistake to make taxes the reason for forming a captive. Indeed, the EY paper lists "assuming it's acceptable to form a captive insurance company primarily for tax reasons" as pitfall number one.

"Don't let the tail wag the dog," EY advises. "While certain federal and state/local tax benefits may be one of the outcomes from forming a captive, they cannot and should not be the primary reason to do so." A captive insurance company must be formed for valid business, capital, and risk management purposes, the paper notes.

The second pitfall to be avoided is assuming that the Internal Revenue Service (IRS) will view the captive insurance company as an insurance company for purposes of tax treatment, the EY report says.

Indeed, the lack of clear guidance from the IRS on what constitutes an insurance company for tax purposes has resulted in captive owners looking to the courts for guidance on what a captive insurance company must do to pass IRS muster for insurance tax treatment.

As the EY report notes, court rulings in various captive insurance tax cases have produced four pillars necessary for achieving insurance company tax treatment from the IRS. Those pillars are risk distribution, risk shifting, commonly accepted notions of insurance, and insurance risk.

The EY paper suggests that those looking to form a captive insurance company and hoping to achieve federal insurance tax treatment seek professional advice to ensure that their captive will address the four pillars.

"Failure to satisfy these requirements can create significant legal, tax, and public perception problems for an organization," the EY report says. "For these reasons, owners should consult with tax and other professionals to be certain these requirements are met."

Given the complexity of tax issues and regulations surrounding captive insurance, the third pitfall cited in the EY paper is not seeking professional assistance in forming a captive and structuring the insurance program.

"Even the most intelligent, creative, and business-savvy business owners may unintentionally run afoul of certain ambiguous or overly complex areas of regulatory and tax laws that govern the insurance business," EY says. "Prospective owners would be well advised to consult experienced professionals in accounting, actuarial, investment, legal, risk management, and tax, among others."

The right outside assistance can help ensure that the captive is structured properly with insurable risk and sound premiums, a tax opinion, and a solid investment strategy, EY says.

While federal taxation can be a significant issue for those forming captive insurance companies, state tax issues can be a factor as well, leading to the fourth pitfall in the EY report: not understanding how states will tax the captive.

"State taxation of captive insurance companies is a very complex area and encompasses much more than income tax," EY says. "In fact, a majority of states assess premium tax in lieu of income tax."

EY notes that depending on the captive's ownership structure and state law, the captive might be required to file income tax returns on a separate company, combined, or unitary method. And, beyond income and premium taxes, captive insurance companies might need to consider self-procurement taxes applied by some states when a company operating in the state purchases coverage from an insurer not licensed in the state.

The fifth potential pitfall noted in the EY report is assuming that income generated by an offshore captive will be tax-deferred or that deferral is the only international tax consideration.

EY notes that prior to the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA), tax on the income of a US-owned offshore captive insurance company could be deferred if certain requirements were met. The TCJA made the tax implications around offshore captive income more complex, however, EY says.

There could be other tax issues surrounding an offshore entity that prospective captive owners should consider as well, EY says.

"While domiciling a captive offshore may be a powerful and prudent planning tool for an organization for a number of business reasons, the tax issues involved are highly complex and the advice of a CPA or tax attorney versed in the taxation of offshore insurance income is recommended if you are considering any domicile outside of the [United States]," the EY report says.

Ultimately, the EY report notes that while captive insurance companies are powerful tools to help organizations better manage risk and capital, failure to avoid the pitfalls cited could have a negative effect on the parent's risk management strategy or even on the reputation of the business.