A regulator of captive insurance is responsible for many aspects of the business of captive insurance companies. He or she must coordinate the application process for obtaining a license, including the financial analysis and financial examination of each captive insurance company. The regulator is also a key marketing person in promoting the domicile as a favorable place to do business, thus fostering economic development for the state. The captive regulator is not, however, a tax adviser. No statute and regulation in any domestic domicile requires an analysis of the potential tax status of the captives under consideration or under regulation. If the application complies with the stated statutory and regulatory requirements, the regulator must favorably consider the application and allow the new company to be licensed as an insurance company under state law. That new insurance company may not, however, be considered an insurance company under federal tax law. The Internal Revenue Service recently listed captives as one of their annual “Dirty Dozen” tax scams, citing “esoteric or improbable risks for exorbitant premiums.” And at least seven captive managers (and therefore their clients) have been targeted for “promoter” audits, for allegedly promoting abusive tax transactions. Yet all of these captives received a license from a regulator, mostly in the U.S. Obviously these regulators did not consider the pricing of the risks to be transferred to the captive, except perhaps at the macro level. Should the domicile care about the potential tax status of licensed captives? David Provost, Vermont’s Deputy Commissioner of Captive Insurance, has said, “We do not license Section 831(b) captives; we license insurance companies.” While that statement is technically correct, this paper argues that, with respect to small captives, regulators should care about the tax implications of licenses in extreme cases, consistent, of course, with the laws and regulations under which it operates. Small captives, i.e. those with annual premiums of no more than $1.2 million, can elect under section 831(b) of the Internal Revenue Code to have their insurance income exempt from federal taxation. This provision, combined with certain revenue rulings and case law, creates a strong tax and financial planning incentive to form such a captive insurance company. This incentive can lead to an “over-pricing” of premiums being paid to the new captive, to maximize the tax benefits on offer. The premiums may be “over-priced” relative to market rates, even after being adjusted for the breadth of policy form, size and age of the insurance company and, in some cases, the uniqueness of the risk being insured by the captive. But “over-priced” in whose eyes? Insurance regulators are usually more concerned with whether enough premium is being paid to a captive to meet its policy obligations. From that perspective, “too much” premium can never be a bad thing. Indeed, captive statutes and regulations generally use the standard of being “able to meet policy obligations” as the basis of evaluating captive applications or conducting financial reviews. And actuarial studies provided with captive applications generally conclude that “…the level of capitalization plus premiums will provide sufficient funds to cover expected underwriting results.” These actuarial studies do not usually include a rate analysis, by risk, because none is required by captive statute or regulation. Small “831(b)” captives, therefore, may easily satisfy the financial
A regulator of captive insurance is responsible for many aspects of the business of captive insurance companies. He or she must coordinate the application process for obtaining a license, including the financial analysis and financial examination of each captive insurance company. The regulator is also a key marketing person in promoting the domicile as a favorable place to do business, thus fostering economic development for the state. The captive regulator is not, however, a tax adviser. No statute and regulation in any domestic domicile requires an analysis of the potential tax status of the captives under consideration or under regulation. If the application complies with the stated statutory and regulatory requirements, the regulator must favorably consider the application and allow the new company to be licensed as an insurance company under state law. That new insurance company may not, however, be considered an insurance company under federal tax law. The Internal Revenue Service recently listed captives as one of their annual “Dirty Dozen” tax scams, citing “esoteric or improbable risks for exorbitant premiums.” And at least seven captive managers (and therefore their clients) have been targeted for “promoter” audits, for allegedly promoting abusive tax transactions. Yet all of these captives received a license from a regulator, mostly in the U.S. Obviously these regulators did not consider the pricing of the risks to be transferred to the captive, except perhaps at the macro level. Should the domicile care about the potential tax status of licensed captives? David Provost, Vermont’s Deputy Commissioner of Captive Insurance, has said, “We do not license Section 831(b) captives; we license insurance companies.” While that statement is technically correct, this paper argues that, with respect to small captives, regulators should care about the tax implications of licenses in extreme cases, consistent, of course, with the laws and regulations under which it operates. Small captives, i.e. those with annual premiums of no more than $1.2 million, can elect under section 831(b) of the Internal Revenue Code to have their insurance income exempt from federal taxation. This provision, combined with certain revenue rulings and case law, creates a strong tax and financial planning incentive to form such a captive insurance company. This incentive can lead to an “over-pricing” of premiums being paid to the new captive, to maximize the tax benefits on offer. The premiums may be “over-priced” relative to market rates, even after being adjusted for the breadth of policy form, size and age of the insurance company and, in some cases, the uniqueness of the risk being insured by the captive. But “over-priced” in whose eyes? Insurance regulators are usually more concerned with whether enough premium is being paid to a captive to meet its policy obligations. From that perspective, “too much” premium can never be a bad thing. Indeed, captive statutes and regulations generally use the standard of being “able to meet policy obligations” as the basis of evaluating captive applications or conducting financial reviews. And actuarial studies provided with captive applications generally conclude that “…the level of capitalization plus premiums will provide sufficient funds to cover expected underwriting results.” These actuarial studies do not usually include a rate analysis, by risk, because none is required by captive statute or regulation. Small “831(b)” captives, therefore, may easily satisfy the financial
A regulator of captive insurance is responsible for many aspects of the business of captive insurance companies. He or she must coordinate the application process for obtaining a license, including the financial analysis and financial examination of each captive insurance company. The regulator is also a key marketing person in promoting the domicile as a favorable place to do business, thus fostering economic development for the state.
ReplyDeleteThe captive regulator is not, however, a tax adviser. No statute and regulation in any domestic domicile requires an analysis of the potential tax status of the captives under consideration or under regulation. If the application complies with the stated statutory and regulatory requirements, the regulator must favorably consider the application and allow the new company to be licensed as an insurance company under state law.
That new insurance company may not, however, be considered an insurance company under federal tax law. The Internal Revenue Service recently listed captives as one of their annual “Dirty Dozen” tax scams, citing “esoteric or improbable risks for exorbitant premiums.” And at least seven captive managers (and therefore their clients) have been targeted for “promoter” audits, for allegedly promoting abusive tax transactions.
Yet all of these captives received a license from a regulator, mostly in the U.S. Obviously these regulators did not consider the pricing of the risks to be transferred to the captive, except perhaps at the macro level.
Should the domicile care about the potential tax status of licensed captives? David Provost, Vermont’s Deputy Commissioner of Captive Insurance, has said, “We do not license Section 831(b) captives; we license insurance companies.” While that statement is technically correct, this paper argues that, with respect to small captives, regulators should care about the tax implications of licenses in extreme cases, consistent, of course, with the laws and regulations under which it operates.
Small captives, i.e. those with annual premiums of no more than $1.2 million, can elect under section 831(b) of the Internal Revenue Code to have their insurance income exempt from federal taxation. This provision, combined with certain revenue rulings and case law, creates a strong tax and financial planning incentive to form such a captive insurance company.
This incentive can lead to an “over-pricing” of premiums being paid to the new captive, to maximize the tax benefits on offer. The premiums may be “over-priced” relative to market rates, even after being adjusted for the breadth of policy form, size and age of the insurance company and, in some cases, the uniqueness of the risk being insured by the captive. But “over-priced” in whose eyes?
Insurance regulators are usually more concerned with whether enough premium is being paid to a captive to meet its policy obligations. From that perspective, “too much” premium can never be a bad thing. Indeed, captive statutes and regulations generally use the standard of being “able to meet policy obligations” as the basis of evaluating captive applications or conducting financial reviews. And actuarial studies provided with captive applications generally conclude that “…the level of capitalization plus premiums will provide sufficient funds to cover expected underwriting results.”
These actuarial studies do not usually include a rate analysis, by risk, because none is required by captive statute or regulation.
Small “831(b)” captives, therefore, may easily satisfy the financial
A regulator of captive insurance is responsible for many aspects of the business of captive insurance companies. He or she must coordinate the application process for obtaining a license, including the financial analysis and financial examination of each captive insurance company. The regulator is also a key marketing person in promoting the domicile as a favorable place to do business, thus fostering economic development for the state.
ReplyDeleteThe captive regulator is not, however, a tax adviser. No statute and regulation in any domestic domicile requires an analysis of the potential tax status of the captives under consideration or under regulation. If the application complies with the stated statutory and regulatory requirements, the regulator must favorably consider the application and allow the new company to be licensed as an insurance company under state law.
That new insurance company may not, however, be considered an insurance company under federal tax law. The Internal Revenue Service recently listed captives as one of their annual “Dirty Dozen” tax scams, citing “esoteric or improbable risks for exorbitant premiums.” And at least seven captive managers (and therefore their clients) have been targeted for “promoter” audits, for allegedly promoting abusive tax transactions.
Yet all of these captives received a license from a regulator, mostly in the U.S. Obviously these regulators did not consider the pricing of the risks to be transferred to the captive, except perhaps at the macro level.
Should the domicile care about the potential tax status of licensed captives? David Provost, Vermont’s Deputy Commissioner of Captive Insurance, has said, “We do not license Section 831(b) captives; we license insurance companies.” While that statement is technically correct, this paper argues that, with respect to small captives, regulators should care about the tax implications of licenses in extreme cases, consistent, of course, with the laws and regulations under which it operates.
Small captives, i.e. those with annual premiums of no more than $1.2 million, can elect under section 831(b) of the Internal Revenue Code to have their insurance income exempt from federal taxation. This provision, combined with certain revenue rulings and case law, creates a strong tax and financial planning incentive to form such a captive insurance company.
This incentive can lead to an “over-pricing” of premiums being paid to the new captive, to maximize the tax benefits on offer. The premiums may be “over-priced” relative to market rates, even after being adjusted for the breadth of policy form, size and age of the insurance company and, in some cases, the uniqueness of the risk being insured by the captive. But “over-priced” in whose eyes?
Insurance regulators are usually more concerned with whether enough premium is being paid to a captive to meet its policy obligations. From that perspective, “too much” premium can never be a bad thing. Indeed, captive statutes and regulations generally use the standard of being “able to meet policy obligations” as the basis of evaluating captive applications or conducting financial reviews. And actuarial studies provided with captive applications generally conclude that “…the level of capitalization plus premiums will provide sufficient funds to cover expected underwriting results.”
These actuarial studies do not usually include a rate analysis, by risk, because none is required by captive statute or regulation.
Small “831(b)” captives, therefore, may easily satisfy the financial