Recently 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 company’s 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 company’s 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.
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 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 2007-47, 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 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. 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 IRS’s main position was first articulated in Helvering v. LeGierse in 1941. It was the first case dealing with the important notion of risk distribution, and has served as the IRS’s 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 company’s 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 participants 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 arms-length 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.
This article first appeared in the September 2012 issue of Financial Executive magazine.