The Value of an 831(b) Captive
Now that we are in the middle of the IRS’s witch hunt against 831(b) captive insurance companies, it is a good time to reflect upon why these types of companies exist in the first place. Whether the Service realizes it or not, the insurance industry is changing just like every other industry on the planet. Consumers increasingly demand lower prices for more customized services and the mainstay industrial giants struggle to keep up. Once upon a time it was inconceivable that cable television would fade, and now we see Netflix, HBO Go, Amazon, and Hulu tearing it apart. Retailers struggle to keep up with online stores like Amazon and Alibaba. The old oligopolies are fighting the new demands of the marketplace as new business models replace them.
How 831(b) Captive Insurance Changed the Market
Captive insurance is bespoke risk management. Once upon a time, only the largest Fortune 500 companies bothered to create their own in-house insurance companies since the frictional costs of doing so were too high. In addition, the general rule of thumb was that a captive insurance company was basically a traditional insurance company operating as a subsidiary of a larger corporation. The IRS disliked this and routinely challenged the deductibility of premiums from the parent into the subsidiary company on the grounds that there was no real transfer of risk like in a traditional insurance arrangement.
The IRS lost that argument. Then the Service lost it again when they dressed it up in new words. Then they lost it again and again. Frankly, the IRS has a terrible track record against captive insurance companies.
What the Service fails to understand is that American businesses no longer purchase insurance the way they did 50 years ago. Traditionally, a company would call a broker, get quotes, deal with an underwriter, and go with the best deal. In general, this is still the way individuals purchase insurance. However, commercial insurance has evolved. Medium and large businesses can create their own captive insurance companies to cover reasonable risks (i.e., workers’ compensation, general and professional liability, etc.) and then go to the commercial markets for risks too large to cover. In addition, the captives open up the market for wholesale reinsurance products, which lower the exposure of the captive’s risks and create a larger universe of risks insurable by the captive.
Captive insurance is more efficient than traditional insurance because it creates value. The value may take the form of lower premiums, or the underwriting profits add a new line of income, or risk management practices streamline the business, or for some other reason. Regardless, businesses achieve economic benefits from the use of captive insurance. These increased economic efficiencies lead to a more competitive company, putting pressure on the remainder of the market to follow suit.
Widespread adoption of captive insurance also transforms the marketplace. As fewer companies purchase commercial insurance for self-insurable interests, commercial premiums rise and increase the demand for captive insurance companies.
As goes the middle market, so goes the market for smaller businesses. Small businesses need to keep competitive with middle market companies if they want to survive. Section 831(b) in the tax code creates a realistic mechanism for smaller businesses to create a captive insurance company. The election permits a captive with less than $2.2 million in premium to elect not to pay any income tax on its premium income. Without this tax benefit the annual costs of operating a captive become excessive for the majority of businesses.
In addition, small businesses see an increasing need for better insurance. While insurance is generally not at the top of the entrepreneur’s to-do list, commercial insurance premiums and coverages can mean the life or death of a business. Traditional carriers brag that their big data analytics produce quality insurance products for the market, but the reality is that this led to a homogenization of commercial insurance offerings. Businesses face an uphill battle when trying to find products that meet their narrow needs.
The IRS attacks captives for their tax breaks but fails to understand that the existence of the tax election is necessary for businesses to remain competitive in the market. If small businesses are crowded out of the captive arena, then only the middle market and large companies will realize those efficiencies. The rich get richer and the poor get poorer.
Traditional Carriers & IRS Misunderstand Coverage Needs
One of the great jokes in the captive industry is to laugh at the ill-advised business owner who writes a terrorism policy and pays $980,000 in insurance premium to a corporate director who lives in Wichita, Kansas. The IRS routinely cites this example as one of their badges of fraud when investigating whether a captive insurance company is a tax shelter or a legitimate insurance enterprise. While that particular example may be an unrealistic threat, the joke isn’t funny.
Americans laughed about terrorism before 9/11, but now we take it seriously. Does this mean that only residents of New York are entitled to terrorism coverage? Do we have to wait for a biological attack in Tampa, Florida before we permit a captive to write biological coverage for a small business in Eugene, Oregon? What about kidnap and ransom insurance? Obviously, kidnapping is not the norm in modern America, but there was a time when Mexico was not plagued by cartels using kidnapping as their primary means of income. Do we have to wait until extremists decide to start committing the crimes before we prepare for them? Isn’t the entire concept of insurance rooted in the idea of preparing for disasters before they happen?
What about new liabilities? Cybercrimes are increasingly lethal for businesses and yet coverage is generally hard to find with the traditional carriers or is wildly overpriced. Should captives be audited for covering this liability just because the traditional carriers have not responded to the needs of the market? What about reputational risks? There are legitimate economic harms arising out of bad Yelp reviews and other Internet review sites. Should a business be able to make a claim on a policy in order to put a professional reputation management team on the task of repairing the damage?
Then you have the sea of ridiculous risks. It is ridiculous to believe that an employee would tamper with roller skates to watch people fall and hurt themselves in a skating rink. That basically never happens. It is ridiculous to think that a bouncer would intentionally harm patrons of a bar because of ingrained prejudices. That almost never happens. It is ridiculous to insure against the threat of a gunman walking into a shop and shooting everyone. It essentially never happens.
But, every once in a while, these things happen. The IRS takes the position that these types of risks are essentially uninsurable because of their extremely low frequency. Yet, they have all happened in the past. If any of the ridiculous risks come to pass, then the business owner is facing a large uninsured loss. Even if commercial coverage were available for such losses, the deductibles would likely be so high as to render them uninsured.
Comparative Premium Pricing is Improper
There is no question that there are tax shelters in the 831(b) captive industry. We have seen a number of them ourselves. We can fix some of them, and others we have to put into run off. Yet, these are not the norm and the IRS clearly maintains that the vast majority of people enjoy the stress of running a tax scam. The Service’s position is divorced from reality and common sense.
To its credit, the IRS realizes that there are legitimate insurable interests for low frequency / high severity events. As such, Notice 2016-66 references premium rates in the commercial marketplace as a viable comparison in order to assist with justifying a captive’s premiums. Again, the IRS misses the point as this assumes that traditional commercial carriers are some sort of a bellwether for the insurance market.
There is no need for a captive insurance company to compare its rates to the traditional insurance company’s rates. In fact, to do so betrays the concept of captive insurance. One of the key elements of a captive is that the business owner can smooth out its insurance rates and achieve predictability in a volatile company cost center.
Commercial carriers, on the other hand, do not market their premiums based on static pricing. When the insurance market is “soft” (i.e., when reserve returns are high) then premiums generally drop so that the carrier can pad its investments. When the market is “hard” (i.e., when investment returns are low) then premiums are raised in order to counterbalance this effect. Forcing captives to operate within some range of traditional insurance market premiums ignores the fact that large insurance companies use their massive reserves to generate a good portion (or all of) the profit for their organizations. This feature isn’t available to 831(b) captives as they are too small to operate without premiums. Consequently, there are many situations where an 831(b) captive’s premiums will outpace the market for the same insurable interest.
Thus, the proper solution with regard to premium pricing is to drill down on how the premiums were calculated. There is no question that premiums should be within some ballpark of traditional premiums, but pegging captive premiums to the rest of the market limits the utility of the captive insurance company. Third party independent actuarial studies are an ideal way of pricing out premium, but it is conceivable that other methods could be utilized. Regardless of the means of pricing out the premium, the premium should be reasonable as viewed through the lens of an arm’s length relationship.
The Role of 831(b) Captives Moving Forward
The democratization of business is not limited to Silicon Valley. Consumers of all stripes demand greater specificity in their products at better prices. The captive insurance industry is the risk management answer to that demand. While traditional carriers are going nowhere anytime soon, the future for captive insurance is bright.
Specialized coverage for new risks is necessary for startup companies. Not all forms of cybercrime are the same, and insurance policies should tailor themselves to that reality. That is a big ask for a large carrier, but is precisely the value created by a captive insurance company. It is reasonable that businesses will seek to compete with their competitors in the insurance field just as they do in marketing, accounting, and operations. Captives are a useful and flexible weapon in any business owner’s arsenal.
It is important for the IRS to remember that businesses with captives should not be punished for running a good business. A lack of claims is not necessarily an indication of tax impropriety. A company with no claims is a well-run company deserving of accolades. If a captive is a profitable enterprise for an entrepreneur, then the business owner should be financially rewarded.
It is better for the IRS to work with the private sector rather than against it. We recognize that there are problems in the industry and we want to shake them out of the trees even more than the IRS. It’s a much harder sale to create a captive with a business owner who saw his friend get audited by the IRS than with a business owner who saw his friend make 40% annual returns on his investment.