10 March 2022ArticleAnalysis

50 years of captives and industry intricacies

Congratulations, Captive Insurance Companies Association, on 50 years of supporting the captive insurance industry!

Captives are at least 50 years old, but did you know that the argument over captives and their tax status is just as old (if not older)? Let’s take a step back into history with a brief outline of some of the historic rulings and court cases that had a profound impact on the captive industry and shaped the current captives sector tax and planning landscape.

As stated above, captives are 50 years old—no, wait, 500 years old, or is it 100? All these answers may be correct, and they may also vary depending on how we define captive. Keep in mind that various forms of alternative risk transfer vehicles and risk financing existed long before anything was even truly called a captive.

In the 17th century, ship owners in London met in Lloyd’s Coffee House to write down their names and the value of cargo in an effort to share the risk of cargo loss between all captains participating on an overseas voyage. Then in the 19th century, textile mill owners formed small mutuals to pool the risk of loss due to fire. While this history is fascinating, most agree that the modern captive insurance structure started with Fred Reiss in 1953, when Steel Insurance Company of America was formed in Ohio. He also coined the term captive, borrowing it from the mining industry, which sent ore to their own “captive” mills.


While the modern era captive may have started with Reiss in the 1950s, one of the foundational court cases dealing with what is insurance for tax purposes, Helvering v LeGierse, endeavored to identify the logic to be used in considering a contract’s qualification as insurance for tax purposes. This “pre-modern captive” case, while addressing a non-captive insurance issue, established the framework for what insurance is for tax purposes and how all associated contracts and arrangements must be viewed in totality when such analysis is performed.

This case paved the initial way to the tax analysis approach still used today, requiring risk “shifting” and risk “distribution”—if the risk of loss is not shifted from one party to another with all facts considered, then it’s not insurance for tax purposes.

In the 1960s there was an explosion of captives in Bermuda, with companies looking to obtain insurance not commercially available, too expensive to commercially purchase and to take back claims management and enhance safety. Businesses realized the benefit of certain potential tax treatments, improved cash flow, better capital management and creating equity in a captive for unforeseen events.

Sidney Pine, attorney to Reiss, was at the forefront of assisting offshore domiciles with their legislation. Equally important, Pine was leading the struggle with the Internal Revenue Service (IRS) on defining a captive’s tax status.


Fast-forward to Revenue Ruling 77-316 (now obsolete), by which the IRS attempted to limit the application of the risk shifting and risk distribution principles from Helvering v LeGierse and other subsequent cases in the context of consolidated/affiliated groups. This ruling set forth the “economic family” theory, stating that transactions were not insurance for tax purposes to the extent that risk was retained within that economic family, which consolidated groups are viewed to be.

This was upheld, and the IRS won seven out of eight cases between 1978 and 1985. For example in Carnation v Commissioner, the taxpayer lost, and the closeness of the captive to its parent and subs was a factor. Adequate captive capitalization was also called into question.


Enter the Tax Reform Act of 1986. This was the most significant tax reform undertaking that impacted insurance companies and changed how an insurance company accounted for its taxable income. More specifically, the act introduced the concepts of loss reserve discounting and the unearned premium “haircut”. Both new adjustments resulted in significant deferred tax assets that insurance companies could now carry on their balance sheet and were aimed at reducing some of the benefits insurance companies have enjoyed for years due to special GAAP and Statutory accounting provisions developed for the industry.

Aside from insurance-specific changes, the act changed certain international tax provisions, thus significantly impacting the tax efficiency of the existing and future offshore captive structures. More specifically, the act changed the definition of a controlled foreign corporation. Owners of offshore group captives now had to declare their share of captive income. The section 953(d) tax election, an election by a foreign insurance company to be treated as a US taxpayer, was subsequently introduced but, at first, resisted by the IRS.

The act also introduced a new tax election, section 831(b) small electing insurance company, to help Midwest farm mutuals grow capital by providing an exclusion of underwriting income from taxation—more on this later.


This was an active period for court decisions. First, the Humana case, a big win for the taxpayer (and the captive insurance industry), was based on the “brother-sister” structure. It established that subsidiary premiums are deductible when paid from one subsidiary to another based on a “balance sheet” approach to determining risk-shifting; accordingly, parental premiums are not deductible. This decision nullified the 1977 Economic Family Revenue Ruling.

Shortly thereafter, the Harper, AMERCO, and Sears cases were all decided in favor of the taxpayer. Harper and AMERCO both clearly laid out the four pillars of insurance—still part of today’s tax captive analyses—that in order to have insurance: 1) the arrangement must involve the existence of an insurance risk; 2) risk shifting, and 3) risk distribution must be present; and 4) the arrangement constitutes insurance in its commonly accepted sense.

Of vital note to the captive insurance industry, the Harper case established that a captive that has at least 30 percent of its business from unrelated parties provides sufficient risk distribution through pooling all risk to allow for deductibility of parental premiums for tax purposes.

Other cases in this period included Gulf Oil, a taxpayer loss due to inadequate capitalization, but within Gulf Oil, the court also provided detail of risk distribution (which the IRS seemingly ignored in the future). In 1993, the Ocean Drilling and Malone and Hyde decisions confirmed the intent of the court to use the four pillars of insurance qualification as its guide.

Around the same time, New York State added its own wrinkle to the mix with a new self-procurement tax of 3.5 percent, which went somewhat unnoticed by taxpayers until Dodd-Frank in 2014. Again, more on this later.


UPS v Commissioner: UPS used to provide reimbursement for lost packages up to $100, and for packages of higher value, UPS charged 25 cents per every additional $100 of declared value, paying tax on the 25 cents. Through establishing a captive structure, the 25 cents charge was now insured in a captive structure, and the 25 cents was not taxed. The IRS argued that the 25 cents was a sham and lacked economic substance.

The IRS won the case initially but lost on appeal. Among other things, the importance of “arm’s length” pricing and legitimate non-tax substance was cemented.


Captive practitioners and owners applauded the rulings in 2002, as it finally brought clarity and a safe harbor. This included revenue rulings 2002-89, 2002-90, and 2002-91, and set a 50 percent unrelated business threshold, the “safe harbor” of unrelated business in a captive. This brought forth the “framework” for the number of insured entities for a captive arrangement to be considered “insurance” for tax purposes.

IRS introduced 12, the minimum number of brother-sister-related entities needed to achieve risk distribution, with no one entity having more than 15 percent of the risk.


The applause subsided in 2005, with revenue rulings 2005-27 and 2005-40. The IRS issued additional guidance regarding the required elements for a scenario to qualify as an insurance arrangement for federal income tax purposes. While not directly addressing a particular captive scenario, it certainly had captive insurance ramifications. In essence, the requirement of risk distribution must be met for an arrangement to qualify as insurance. The ruling concludes that an arrangement with an entity that insures the risks of only one policyholder does not qualify as insurance because the risks are not distributed among other policyholders.

Revenue ruling 2005-40 further explains how the conclusion applies to single-member limited liability companies when treated as disregarded and how that may differ if treated as separate from their owners (regarded entities for tax purposes). It was during this time that the industry noted that the IRS had redefined risk distribution in 2002 and moved it away from the actuarial science as detailed in Gulf Oil.


Spurred by the financial crises of 2008, the Dodd-Frank Wall Street Reform and Consumer Protection Act, known as Dodd-Frank, was passed. In 2011, the sub-section “Non-admitted and Reinsurance Reform” Act was added. This regulation, designed to create tax clarity, gave sole authority to tax “non-admitted insurance purchases” to the home state of the insured, which is generally defined as the insureds’ principal place of business.

While arguably not intended for captives, a number of states adopted this principle, augmented state statutes, and began seeking this tax from insureds with captives outside their principal place of business (aka their home state).


In Rent-A-Center and Securitas Holdings cases, both decided for the taxpayer, the Tax Court shared its views on several controversial matters. One of the most noted is that the Tax Court clarified that risk distribution is based on actuarial science and the number of statistically independent loss events insured versus the IRS’s view regarding the number of policyholders insured, ie, in Rent-A-Center, one entity had over 60 percent of the risks insured, but the court looked more at the number of locations and independent risks than legal entities.

The Tax Court also found that a parental agreement between a captive and its parent could be present in a valid insurance arrangement for federal income tax purposes.


Section 831(b) maximum premium increased from $1.2 million to $2.2 million as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015 and was set to increase in future years via an inflation adjustment. As many may know, section 831(b) election allows an insurance company that meets the election criteria to be taxed only on its net investment income. The IRS, refocusing its efforts on the microcaptive space, issued Notice 2016-66, designating microcaptive transactions as “transactions of interest” requiring additional disclosure by owners, managers, and material advisors if a particular transaction met certain thresholds stipulated in the notice.

While drawing numerous criticisms and even an associated court case rising up to the US Supreme Court, Notice 2016-66 and requirements to report still stand at the time of this writing.

2017 to current

The IRS won a number of microcaptive cases, including Avrahami, Reserve Mechanical, Syzygy Insurance, and Caylor Land & Development. These captive arrangements, were, arguably, specifically chosen by the IRS given perceived flaws in their design. It is important to note that the courts have used the landmark court cases in their decisions here, carefully navigating established precedents while tackling issues that did not meet their understanding of the subject transactions.

So, what does the captive insurance tax future hold? Is the notorious saying “history repeats itself” even applicable here? Hopefully not, as we have gone a long way from the 1940s to the 2020s.

There will certainly be continued scrutiny in the microcaptive space (especially since these transactions were re-added to the IRS Dirty Dozen list after a brief removal), but for larger captives, it is unclear. Ideally, the landmark court cases noted above will continue to pave the road to a more technical, risk-based approach to insurance qualification in the tax space vs. a more mathematical approach to the number of entities and policies.

One can hope that IRS’s future revenue rulings will more closely align with the Tax Court’s decisions in the numerous cases noted above and continue to clarify the views and technical merits of various positions currently in the field. Taking a page from an industry’s wish list, maybe we’ll even see some of the older and outdated rulings pulled—one can dream, right?

Until that happens, the captive insurance industry and professional services firms serving it will continue to innovate, plan and work with regulatory bodies and tax authorities to establish solid and sound uniformity in the discussed matters within the captive insurance industry.

Views expressed in this article are those of the speakers and do not necessarily represent the views of Ernst & Young or other members of the global EY organization.

Jim Bulkowski is the Americas captive insurance services co-leader and is a member of EY’s Global Captive Network. He can be contacted at: jim.c.bulkowski@ey.com

Mikhail Raybshteyn is a tax partner in the Ernst & Young Financial Services Organization Insurance Sector and is the Americas captive insurance services co-leader. He can be contacted at: mikhail.raybshteyn@ey.com

Paul H. Phillips III is a tax partner in the Ernst & Young Financial Services Organization and the EY Global Captive Network Co-Leader. He can be contacted at: paul.phillips@ey.com