The IRS and Captive Insurance Companies

The use of captive insurance companies have been used to manage costs and risks and realize tax benefits has been legitimate for years. The IRS has recently focused audit resources on small and mid-market companies that are forming small captive insurance companies. These companies seek to benefit from Section 831(b) of the tax code, which allows insurance companies with less than $1.2 million in premiums to be taxed on their investment earnings rather than on their gross income.

We are seeing this first-hand while we are representing small and medium size companies who have captive insurance companies in audit with the IRS. At its core, the main concern for the IRS is that some of these small and medium companies forming captive insurance companies are not engaged in true insurance. In response to this situation, the IRS recently added captive insurance to its annual “Dirty Dozen” list of tax scams for the 2015 filing season. This means that the IRS is taking a hard look at captive insurance companies and the people who manage these companies. The language from the IRS announcement is: “In the abusive structure, 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 oftentimes 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.”

Based on our experience, we have learned that the IRS repeatedly focuses on these main questions:

1) Why was the captive insurance company created?

2) How did the captive insurance manager market his product to the captive owner?

3) Do annual premiums vary in tandem with the business’s taxable income for the year, or conversely, do premiums hover at or near the $1.2 million mark year in and year out?

4) Were there any claims made against these policies?

5) Were there claims made against the risk pool that is often a part of the small captive setup?

6) Do coverages appear warranted and do premiums appear correctly calculated?

7) Do the premiums vary by reason of underwriting on an annual basis?

8) Who owns the captive?

9) Is the captive insurance held in trust for the benefit of others or future generations?

10) What kinds of investments are present?

11) Has life insurance been purchased?

Note: The fact that the captive insurance company may have been OK’d by the state insurance commissioner will get you halfway with the IRS. It is important for CPAs to understand these two things:

1) While the IRS may first contact your client in the context of a promoter audit, you need to treat the contact with the IRS with utmost seriousness, even if it was initially just a third-party contact.

2) Even if your client is doing things properly, if the client is part of a larger risk pool of insured-and if one of the other members of that pool is not squared away-the entire pool is potentially in jeopardy, including your client. Bear in mind that the stakes are high. If the IRS finds that the captive insurance company doesn’t pass muster, it means losing not only the premium deduction, but also incurring a 20 percent penalty, along with interest on top of that. The IRS is also considering imposing economic substance penalties and the 20% goes up to 40%.

The best practice for CPA firms with clients who own captive insurance companies is to have a review conducted to ensure that the captive is conforming to tax law requirements both in form and substance with a deep look at the insurance provided and the overall insurance pool. This is best done before the IRS comes knocking at your door. The risks of adverse IRS action can be managed if done proactively on a voluntary basis. If your client has already heard from the IRS, be aware that this is a highly technical area of tax law which involves a detailed understanding and knowledge of insurance questions from a tax law perspective.

The mere fact that captive insurance is on the “Dirty Dozen” list means you can anticipate a thorough audit that is closely managed by technicians and senior officials at the IRS.

Lance Wallach’s success with his clients has come from having a good understanding of the IRS’s concerns and priorities and also from what he has experienced with his clients in past cases. The key is knowing what the IRS is willing to accept, when the IRS is willing to let the taxpayer correct and what it takes to resolve an examination or an audit. CPAs do play a vital role as the most trusted financial advisor for most small and medium companies. For those CPAs who do have clients with captive insurance companies, now is the time to explain to them that they are in trouble and assist them in safely getting out of this mess.

Choosing A Captive Insurance Company Will Garner Bigger Profits Annually

A captive insurance company is making quite a positive impact on the business world and their employees; businesses that are becoming active with it are: transport, construction, consulting services, real estate development, healthcare, engineering and hospitality. These are only a few that are seeing the bright light at the end of the tunnel. So if you would like to become more educated on the subject then contact a captive insurance manager for more information.

With the economy failing and still getting worse daily it would be in your best interest if your company manager thought about forming a “captive”. You would be able to save on premium costs, as well as increase cash flow. If you became the captive insurer you also would have almost total control over claims for your company. If you remove the other insurance companies out of the equation, you will improve your gain because you will be your own captive manager.

There are many package deals that insurance companies usually offer you. These may no be changed; they are kind of well, a package deal. Most of the things that they have are not particular to your own specifications, but you still have to get the policy because, quite simply, they do have what you need. Captive insurance only gives you you what you need and nothing more. So, basically, the costs will be more efficient and based purely on “need” not greed.

Through the years this companies have been on the rise. Today, it is possible for middle sized companies to become involved and utilize their own captive for their business. This will be able to save the company a lot of money over time with this type of alternative risk strategy. If you become your own captive insurer you may be able to cover claims for up to $250,000 dollars.

The dollar amount may be higher so that is when a fronting company will be needed; they can take care of the claim when the denomination is over that amount. Another thing is that some states require a licensing insurance company to meet the claim. Here is where a fronting company will serve you well. You will be able to collect premiums, pay claims and issue policies when you are a captive for your own company.

Negotiating Fronting Fees On Behalf of Owners Of Captive Insurance Companies

Whether you are negotiating a fronting fee with an insurance company for the first time, as you have a “start up” captive insurance company, or you are looking to renegotiate a “renewal” captive company fronting fee, you are going to be in for the insurance education of a lifetime.

The cost of “fronting” goes up on the very basis that there is a shortage of insurance companies willing to “front.” The insurance market losses companies like Quanta Capital, Alea, etc. and thus reduces the options available. Where are the new fronting insurance companies going to come from? Hurricanes Katrina, Rita, and Wilma have brought havoc to the property captives, where we see fronting fees rising to 15%. The new Bermuda companies will acquire U.S. insurance company platforms and will be the “fronting” insurers of the future.

Owners of captive insurance companies must realize that “fronting” insurance companies need to be approached on various levels of management, with preferably senior management getting into the decision making process early on in the negotiations.

Underwriting Departments are playing a greater role in captive fronting, with the financial departments looking closely at the credit risk of the parent transaction. For instance, several years ago, construction companies would capitalize captive insurance companies just to insure the self-insurance deductible under their Owner Contractor Insurance programs. Now “fronting” insurance companies are examining the financial statements of these same construction companies to make sure they can sustain the ownership of the captive insurance companies. Interestingly enough, captive owners need to continue to monitor the financial statement of their fronting insurer, and to be on top of any potential rating downgrades by the rating organizations. Insurance company management historically has had a tendency of “failure to disclose” negative results.

Fronting insurance companies are playing a greater role in the selection of the domicile for the captive insurance company. Domestic versus offshore domicile continues to be debated. Even on shore domiciles like New York State, with its 35 captive insurance companies, are trying to expand the captive concept by reducing the threshold, $100 million parent net worth to $25 million parent net worth captives. More advertising needs to be injected into the New York captive initiative.

Most of the experienced, fronting insurance companies, have shown the ability and expertise to “front” captives from Vermont domiciles to Hawaiian domiciles, and from Barbados to Bermuda. The focus has been to continually drive down overhead expenses and those domiciles doing this are attracting all the new captive formations.

Interestingly enough, domestic captive domiciles did not lead in 2005 formations, with Bermuda and the Cayman Islands accounting for 134 captive formations. Vermont with 37 captive formations led the United States.

Fronting insurance company pricing for the risks going into captives are getting a closer look by the actuarial profession. Captive owners have come to recognize they need their own actuarial support when disagreeing with the fronting insurance company’s assessments of what is the correct price for the risk. Whether you are a residential contractor in California or a nursery home in Florida, your captive requires adequate pricing executed by the fronting insurer. We are going to see more litigation in the future between captive owners and their front insurance companies, as the disagreements over pricing continue to persist on each renewal.

Captive owners want their front insurance companies to come up with independent prices for each risk, and that concept continues to be a problem with the front company. When it is admitted, and has to use their filed rates. Insurance company market conduct reports are going to expose front carriers that they are violating their rate filings when writing primary insurance products which are reinsured back to the captive insurance company.

The more mature captive insurance company, with over five years of financial history, needs to have a committee of its Board of Directors look closely into the entire costing structure of the fronting fee. This would be a great excuse for members of the captive board to understand this important transactional cost.

What are the detailed components of the fronting fee? How are they monitored by the captive owner? When was the last time a new fronting company was asked to quote on the captive? Once the captive board gets this training, the Boards will not be “rubber stamps” and exercise more judgment at insurance decision making.

More and more mature captives are looking to write their Directors and Officers Liability Insurance into their captive. The front insurance company writes the traditional D and O form, and that risk in then ceded back to the captive, acting as reinsurer. The exclusions in the traditional D and O policy are then covered by a direct procurement policy from the captive, eliminating the need for the front. The pricing for the direct procurement policy should be controlled by the owner of the captive. In some aspects, a captive writing direct insurance policies in the United States should apply for an A.M. Best’s rating. If we remember captives are a long time investment and by getting an “A” rating from Best’s, the captive becomes a substantial asset.

Reciprocity among captive owners can be another way of eliminating the “fronting” fee. Each owner uses the “A” rated captive for each other’s risks, and purchases a sophisticated reinsurance program behind both captive insurance companies. When fronting fees approach double digits, it is necessary for captive owners to seek alternatives to “fronts.” Creative solutions need to be implemented, and captive company budgets need to have the financial resources to explore alternatives.

Finding “fronts” for Contractors Pollution Liability Insurance is another area that is getting significant attention. General contractors, residential or commercial, trade contractors, carpentry and plumbing, specialty contractors, foundation and pipeline, and remediation contractors, are all candidates for captives, and in the early years require “fronts.” Captives can substantially reduce the insurance costs of traditional pollution coverage for contractors, especially when layering of policy limits is introduced above the captive retention. Customary pricing above the captive retention follows the simplistic approach that the lower liability layers are priced higher than the upper layers, again giving the captive owner a “pricing” discount.

The identification of the “fronting” carriers has not changed dramatically in the last few years:

1. AIG

2. ACE

3. Old Republic

4. Zurich

5. Liberty Mutual

6. Discover Re

7. Chubb

8. Hartford

9. Arch

The negotiating process with each of these carriers has always been a challenge for captive owners. Insurance company “fronts” are a dynamic group, and with people constantly changing positions, requires that you pay significant attention to your fronting carrier to continually provide favorable relationships and eliminate misunderstandings. When was the last time you asked your fronting carrier, how is my program going rather than react to their letter saying they are going to cancel your “fronting” relationship because they are returning from that particular insurance product line.

There have been a number of studies on what the “fronting fee” includes, or should include. The amount of these fees keep changing but the overall concept remains the same. Focus and concentrated efforts are required to keep this “fee” economically effective.

Among the recent “fronting fees” the following is included:

1. State Premium Taxes (not negotiable);

2. Federal Excise Taxes (not negotiable);

3. Government schemes (not negotiable, but try and get how they are arrived at);

4. TRIA charges (usually not negotiable);

5. Aggregate protection (negotiable, look at the concept of purchasing this yourself from outside the structure); and

6. Profit margin for carrier/fronter (negotiable).

If loss ratios are attractively low for your captive insurance company, make every effort to obtain a lower “fronting fee.” Insurance carriers are always seeking low loss ratio business even as a “front.” If you can, try to influence the decision maker. Many “fronting fees” get renewed as is when they are comparatively high in mature, and it is in the carrier’s interest to renew as is because there is little additional costs in doing renewals. It is the “lifeblood” of the insurance company.

On the basis of regulatory and rating agency fear, “fronting” carriers have made a conscious effort to require and substantially increase the collateral requirements they are asking for from captive owners. This is an area of negotiation and as many Agent Owned Captive Insurance Company Owners have found out, too late, over collateralized programs lead to the inability of the agent to fund the letter of credit and therefore the “front” cancels the program.

Captive Owners need to know that over-funded collateral is another way a “front” company can access additional capital for growth. You need to understand the true components of the collateral required:

1. Loss Reserves (Schedule F – loss reserves plus unearned premium reserves and Incurred But Not Reported losses) … IBNR deserves the most attention since these are estimates, and does the Captive Owner want to pay for an independent actuarial study for the loss payout pattern, and full development.

2. Many “front” companies want funding that would include funding the letter of credit equal to high loss ratios, this is despite the fact they had set the pricing on the “fronted” policy. Owners need to have the expertise to challenge the methodology of the pricing.

In conclusion, “fronting” insurance companies provide “licensed paper,” which is asset value; they provide regulatory compliance and finally support services. Remember if fronting fees are greater than 5%, and mostly in the 6-10% range. When going over 10%, it is imperative that you look for another option.