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SEPTEMBER 2012 FinancialExecutive

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iSTOCKPHOTO / THINKSTOCK

Creating a captive insurance company has become

a popular alternative risk management strategy for
middle-market businesses. But as captives become
more commonplace, regulation and scrutiny
is likely to increase and become more sophisticated.

Insurance

Effective
Risk Analysis
Offers Protection
For Captives
BY KEN KOTCH

his summer, the world was introduced to the most powerful and destructive computer virus
in history: the Flame Virus. This pervasive data-snatching virus swept through the Middle
East and many other countries, seemingly overnight. The long-term effects of such global malware will not be realized for many years to come.
The United Nations issued an urgent warning that the Flame Virus and copycat
cyberweapons could be used to bring entire countries to a standstill. Imagine the effects on a
companys bottom line.
The field of alternative risk management relating to cyberwarfare and other
esoteric global exposures is evolving rapidly. Financial executives may
be prepared with state-of-the-art antivirus technology, but are they
prepared for the economic implications of the inevitable business disruption associated with cyberterrorism and other global risks?
Setting aside a rainy day fund for such an event sounds like a prudent
idea. Setting aside this fund on a pre-tax basis is better still.
Creating the companys own bona fide insurance company, with congressionally mandated benefits, to indemnify the business for such a loss (and
reward it for associated underwriting profit) would seem to be even more advantageous. This option is available to all U.S. companies under the general concept of
captive insurance, as discussed below.
But a word to the wise: the benefits of a captive insurance company are only realized
with the proper identification and underwriting of insurance risk.
Creating a captive insurance company has become a popular way for middle-market business owners to participate in alternative risk management a form of risk retention for risks
not efficiently covered by commercial insurance. With more than 6,000 captives in operation
worldwide, the basic tenets of captive administration are well established.
The rapid growth in captives within the middle market, however, has caused some state
and federal watchdogs to scrutinize the legitimacy of the insurance transaction. Of particular
interest in recent years among regulators, as well as the Internal Revenue Service, has been
whether captives are assuming and distributing true insurance risk.
Failure to meet these requirements can have disastrous effects on the success of a risk management plan. The subtle nuances surrounding these traditional notions of insurance require
highly specialized management expertise and sophisticated risk analysis for mid-market companies to enjoy the benefits of a robust captive insurance program.

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FinancialExecutive SEPTEMBER 2012

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Risk Shifting: Insurance or

Investment Risk?
Neither the Internal Revenue Code nor
the regulations define insurance or
insurance contract. The federal courts,
however, have ruled that an insurance
arrangement will only be respected for
federal income tax purposes if the risk
transferred is one of economic loss, not
merely an investment risk or inevitable
future cost.
As early as 1979, the U.S. Supreme
Court set the standard to determine what
constitutes the business of insurance.
In Group Life & Health Ins. Co. v. Royal
Drug Co., the Court concluded that
agreements between Blue Shield of
Texas and three pharmacies for the
provision of prescription drugs to Blue
Shield policyholders did not constitute
the business of insurance, noting that
the theory of insurance is the distribution of risk according to hazard, experience and the laws of averages. These
factors are not within the control of insuring companies in the sense that the
producer or manufacturer may control
cost factors.
From an insurance standpoint there is
no risk unless there is uncertainty. Even
death is uncertain because the time of its
occurrence is beyond control. This lack
of control or uncertainty is called
fortuity. Hence, losses that are substantially certain to occur are not the result
of fortuitous events, and therefore do not
constitute insurable risk.
If a captive enters into an arrangement that lacks fortuity, the government
may re-characterize the transaction in
any number of ways a deposit, a
loan, a contribution to capital, an option
or indemnity contract, etc. and disallow the corresponding I.R.C. 162(a)
business expense deduction taken by the
insured. Over the years, transactions
purporting to shift risk that only appear
fortuitous (but lack uncertainty) have
been unwound by the IRS.
In Revenue Ruling 89-96, the
taxpayer experienced a catastrophic loss
and subsequently purchased insurance
from an unrelated insurer. Although the
exact amount of the liability was

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SEPTEMBER 2012 FinancialExecutive

uncertain, the insurer was able to calculate an appropriate amount of

premium that would yield investment
earnings and tax savings equal to, if not
greater than, the maximum policy claim
limits.
There, the IRS concluded that the
arrangement did not involve the requisite risk shifting necessary for insurance,
because: 1) the catastrophe had already
occurred; and 2) the economic terms of
the contract demonstrated the absence
of any risk apart from the loss of time
needed to capture investment earnings.
An insurance company should not be
asked to provide coverage for an expense
of doing business that is reasonably
certain or expected to occur.
Similarly, in Revenue Ruling 200747, a company was engaged in business
that was inherently harmful to people
and property. The future cost of the environmental remediation attached itself

the day the business began. The company was required by law to remediate
the environmental impact as soon as the
business ceased.
The exact time and cost, however,
were uncertain so the company purchased insurance from an unrelated
insurance provider and deducted the
corresponding premium amount from
its taxable income.
The IRS disallowed the deduction,
concluding that the only risk assumed by
the insurer was whether the actual cost
of remediation would exceed the investment earnings on the premium.
The environmental remediation risk
was actually an amount risk as opposed
to the risk of a premature event occurring
this year, like death or a car accident.
Despite some elements of uncertainty, it
was certain that a future cost must be
paid by the company and a corresponding duty would be imposed on the insurer; in other words, no fortuity.
Despite this guidance from the IRS,
questions surrounding fortuity and riskshifting continue to arise in the context
of mid-market companies. In some respects this is not surprising given the
nature of captive insurance as an
industry one built on innovation and
the drive to find profitable ways of managing risk. The evolution of financial
products in particular has spawned
arrangements that appear to be or
mimic insurance products in terms of
shifting risk.
Unfortunately, promoters of these
insurance arrangements do not rely on
principles of insurance in design or operation. Accordingly, it is imperative that
mid-size companies interested in forming
a captive consult with professionals to
identify the appropriate fortuitous risk.

Risk Distribution: Insurance

Or Rainy Day Fund
Increased caution surrounding the issue
of insurance within mid-market captives
may lead one to believe that this is a
new problem. To the contrary, the IRSs
main position was first articulated in
Helvering v. LeGierse in 1941. It was the
first case dealing with the important

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Despite IRS guidance,

questions surrounding
notion of risk distribution, and has
served as the IRSs foundation for attacking the tax deductibility of captive insurance arrangements.
Building on that foundation the IRS
issued Revenue Ruling, 2005-40, evidencing a renewed interest in the concentration of risk.
The ruling outlines three scenarios
where no less than 90 percent of the
total premium was attributed to a single
taxpayer. Citing the failure of the insurance company to distribute the risk
among a number of policyholders, the
IRS determined that each of the three
arrangements did not qualify as insurance for federal tax purposes. Courts
have recognized that risk distribution
necessarily entails a pooling of premiums, so that a potential insured is not in
significant part paying for its own risks,
the ruling reads.
In other words, the insured had simply been setting aside funds for a rainy
day. In the event of a claim, the insured
would receive a substantial amount of its
money back.
To prevent this, the IRS has taken the
position that if more than 50 percent of
an insurance companys total premiums
is attributed to a single insured, it has
failed to meet the essential elements of
risk distribution. Captives are
particularly susceptible to challenges on
this basis.
An ideal solution for captives is to
participate in a well-designed risk pool.
Risk pools allow large numbers of partic-

fortuity and risk-shifting

continue to arise in the
context of mid-market
companies. In some respects this
is not surprising given the nature
of captive insurance as an
industry one built on
innovation and the drive to find
profitable ways of managing risk.
ipants to exchange tranches of risk with
unrelated parties. Structured properly, a
risk pool not only distributes risk but can
also strengthen the overall profitability
of a captive.

Benefits of Electing Internal

Revenue Code 831(b)
Treatment
Owners of mid-size captives are profiting
from the affordable long-term risk management solutions offered through IRC
831(b). In general, a captive electing
Code 831(b) treatment is not all that dissimilar from other insurance providers.
It is a licensed insurance company,
created for non-tax purposes, to insure
the risks of its owners and affiliates. It
issues policies, collects premiums, pays
claims and earns profits. To the extent
that annual claims do not exceed reserves, the captive may issue dividends,
invest profits or pursue new business
ventures at the discretion of the owners.

Captives electing Code 831(b)

treatment, however, are different in that
1) they are limited to receiving no more
than $1.2 million dollars in annual premium and 2) they only pay federal taxes
on taxable investment income, as defined
in I.R.C. 834. Specialized management expertise and a credible armslength underwriting process are essential to provide the proper risk analysis
and distribution.
Structured properly, captives electing Code 831(b) can become valuable profit centers, providing cost-effective coverage while earning dollars that
would have otherwise been paid to a
commercial carrier.
The emerging risks of captive ownership are not only limited to the risk insured by the captive but also those inherent in its structure and operation. As
captives become more commonplace,
regulation and scrutiny is likely to increase and become more sophisticated.
In such an environment, experience
is essential. Only companies that identify and insure true insurance risks will
ultimately enjoy the significant financial
benefits afforded to captive owners.
Ken Kotch, Esq., is a principal and Captive
Insurance practice leader for Ryan LLC
(www.ryan.com). Headquartered in
Dallas, Ryan is the largest indirect tax
practice in North America and the
seventh-largest corporate tax practice
in the United States.

Complimentary Webcast for FEI Members and Non-members

What is a Captive and How Can it Help

Transfer Risk and Increase Earnings?




Sept. 27, 2012

10 a.m. to noon (PST)
CPE Credits 1.5

Program Description

Sept.
1.5 CPE27, 2012
Credits

This session will address the opportunities and

key benefits of captive insurance companies and
explore captives as they relate to IRS guidelines, estate
planning, turnkey programs, qualifications and premium pricing.

Hosted By
Ryan LLC (a global tax-services firm)

Registration

https://ryanco.webex.com/Captive_Insurance_Companies  click on Register.  Password: Ryanci2012  Session Number: 808 487 706

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