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Not All 831(b) Captives Are Created Equal

Apr 30, 2019 Decorative image. Businessman holding money and crossing fingers behind back

An 831(b) captive insurance company, also known as a micro-captive, can be a beneficial risk financing tool for companies that meet certain risk qualifications. In addition to securing necessary insurance coverage, captive members retain underwriting profits and pay taxes only on investment income allowing for the expedited accumulation of surplus.

However, some captive programs have come under increased scrutiny by the IRS for abusing the system. Companies should perform their due diligence before committing to a captive manager and program.

Here is what you should know.

831(b): Valid Tool Under IRS Scrutiny
Around since 1986, section 831(b) of the IRS Code was established as part of a U.S. tax overhaul. This section of the IRS code was meant to benefit small, mostly agricultural-based mutual insurance companies that had sprung up in the Midwest.

Over time, it became apparent that some captive managers were using these legitimate small insurance companies as illegal tax shelters. The IRS added 831(b)s to its 2015 “Dirty Dozen” list of tax scams and implemented new guidelines and reporting changes meant to curb abuses. The agency also warned that it would begin actively targeting offenders.

The IRS is targeting larger, poorly run captives. A properly structured and operating captive will withstand an IRS audit.As promised, the IRS identified several large 831(b) “promoters” and began auditing the captive managers. These promoters had compiled hundreds of 831(b)s, all with identical insurance programs and each one having premiums at the 831(b) premium threshold. Further, each program was structured so that few or no claims were reported to the captive.

The IRS determined that many of these captives did not qualify as insurance companies for federal tax purposes. Subsequently, the captive owners were hit with significant tax penalties.

One specific area the IRS has focused on is the use of risk pools to achieve the risk diversification necessary for a captive to qualify as an insurance company for federal income tax purposes. A risk pool is essentially a reinsurance structure that allows participants to reinsure a portion of their risk to the pool and ultimately reinsure back a pool of premiums from the other pool participants representing third-party risk. This third-party risk allows each of the participants to achieve the necessary risk diversification that ultimately allows them to receive the favorable tax treatment afforded to 831(b) captives.

Similar to how many of the captive program advisers designed 831(b) captives to avoid claims, many also have designed their risk pools such that the risk pool is insuring only high excess layers of risk where the likelihood of a claim is very remote, or the insured is reinsuring to the risk pool those obscure risks where the likelihood of a claim is very remote. The IRS looks at risk pools because if it can prove that an underlying risk pool is ineffective and not properly distributing risk among the pool participants, it can effectively win its case against every 831(b) captive participating in that pool.

831(b)s That Withstand IRS Scrutiny
The ultimate goal of a captive program should be to provide protection for an organization’s bottom line—not to avoid claims or avoid paying owed taxes—by insuring those key business risks that can result in earnings volatility if a claim occurs. These programs should be designed to address each client’s unique business risks and to become part of its overall risk management strategy.

Companies considering forming a captive should work with an experienced team that has a methodology for ensuring the validity of the structure for risk management and risk financing. The captive management team should study the company’s risk profile to identify those risks that are underinsured, uninsurable, or inadequately priced through the commercial market. Using the risk assessment results, the team should develop a captive program specifically modeled for the company.

If the captive program includes the use of a risk pool, the company should ask its captive team about how risks are being reinsured through the pool and whether they are valid. The pool should be structured in such a way that it provides a combination of first-dollar coverage (i.e., losses covered up to a specified amount without a deductible) and excess layer protection (i.e., extra protection above and beyond the primary insurance coverage), in case of a large, catastrophic claim.

Companies should ask their captive team about the resources they use to determine that the risk pool is functioning properly and providing appropriate risk distribution. Part of these inquiries should also include asking about the pools historical loss ratio, and if that loss ratio has historically been at or very close to 0%, this may be an indication of a pool lacking proper risk transfer and risk distribution.

Final Thoughts
Although all 831(b) captives are under increased scrutiny and audits are more likely for these programs than in the past, the IRS has made it clear that it is targeting larger, poorly run programs. They have also clearly articulated those program characteristics they are targeting. A properly structured and operating captive will withstand an IRS audit.

Hylant’s captive risk management experts use proprietary R3™ software to help clients understand their risks and the best ways to manage them, which potentially could include the formation of a captive insurance company. If a captive is formed, we provide customized financial reporting services that deliver the performance insights our clients need and work with them to ensure that their company remains in compliance with insurance laws and regulations. We help ensure that the program continues to meet the desired risk management goals.

The above information does not constitute advice. Always contact your insurance broker or trusted adviser for insurance-related questions.

By Kip Irle, Senior VP, Strategic Risk Advisor, Hylant Alternative Risk and Captives Practice Leader