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10 January 2017Analysis

Oversight and expectations

2016 was another year where captives came under regulatory scrutiny, primarily at the extreme end of the spectrum. The very large captives—the XXX and AXXX life assurance and annuity reinsurance captives—have been reviewed by the National Association of Insurance Commissioners (NAIC) and it appears that the parties have worked out an arrangement that satisfies the NAIC.

At the other end of the spectrum the more visible scrutiny has come on the small captive industry, particularly those utilising the 831(b) tax election. For the past two years, the Internal Revenue Service (IRS) has included them in the so-called “dirty dozen” list. It is frustrating from the captive industry’s perspective to be included on the dirty dozen list, when in fact the IRS is looking at a very narrow segment of the captive industry.

The Captive Insurance Companies Association (CICA’s) position on 831(b)s and other small captives has always been ‘do them right, or don’t do them at all’, and we’ve created a position paper on how to properly form a small captive. As long as they are legitimate risk transfer/distribution insurance vehicles, then great! That’s what they’re there for and Congress has chosen to give them that tax election. Indeed, Congress deliberately increased the 831(b) ceiling from $1.2 million to $2.2 million effective next January and indexed it thereafter when it passed the Protecting Americans From Tax Hikes (PATH) Act of 2015.

"All indications are that captives will continue to grow because they are viable strategic elements of a company’s risk management process."

I expect the current level of regulatory oversight to continue. We’ve specifically seen it at the OECD level, with their base erosion profit shifting (BEPS) report, which again characterises captives as nothing more than a tax shifting process, ignoring all the risk management benefits that captives bring to the industry.

Meanwhile, in the short term, everyone is holding their breath for the US Tax Court decision in the Avrahami case out of Arizona, where the IRS challenged the 831(b) election for this one captive. A lot of people are frustrated because the facts of that case present some problems and we probably won’t get a decision until quite late in 2016 or even early 2017. The people who know this arena best say that this isn’t going to settle this tussle with the IRS one way or another, but it will provide some direction. If the taxpayer wins this case it doesn’t necessarily mean that the IRS won’t challenge other small captives who have taken the 831(b) election.

Eventually the dust will clear. Many people make the observation that really this is no different from how large captives were being treated 15 years ago. The IRS challenged large captives as legitimate insurance companies and the issues were very much the same: ‘this isn’t really insurance; this is business risk, not insurance risk; these are nothing but a tax dodge’. Those were the arguments being made against large captives 12 to 15 years ago. The IRS lost all those cases and it is now well established that captive insurance companies are bona fide insurance companies.

We live in a regulatory world and we will inevitably face ongoing oversight and regulatory challenges, whether it’s from the OECD, from the NAIC, from the Federal Insurance Office, from a particular domicile, or from the tax authorities.

That’s the world we live in. But it is the sign of a mature industry. All indications are that captives will continue to grow because they are viable strategic elements of a company’s risk management process and—if the market ever hardens—the growth in captives will take off as people move from the commercial market to the captive market.

There’s a bright future for captives, bright even in the present soft market. So when the market hardens, it is going to be really exciting!

Dennis Hardwick is the president of the Captive Insurance Companies Association. He can be contacted at: dharwick@cicaworld.com