Small is beautiful

The passage of the Protecting Americans from Tax Hikes (PATH) Act by the US Congress in December 2015 created significant changes to the current Internal Revenue Service (IRS) provisions around small insurance companies—so-called ‘micro’ captives that elect 831(b) tax status.

These changes come against a backdrop of growing interest in 831(b), which exempts small insurance companies from paying tax on underwriting income; instead, they are taxed only on investment income.

“The current IRS code provisions have encouraged captive growth, which promotes good risk management and sustains many jobs in the industry,” says Anne-Marie Towle, senior vice president and senior consultant for the Global Captive Practice at Willis Towers Watson.

“However, since the end of the last decade, the IRS has imposed additional scrutiny on small captives due to abusive practices, for example, the use of the tax exemption in estate planning.”

This will be explored later. First, let’s address the unique—and growing—appeal of this tax election.

A boon for smaller players

Originally introduced for the benefit of farmers and New England fishermen, 831(b) status has proved useful for small insurance companies that insure traditional risks, either in a group or single parent arrangement, and for other small insurance companies which insure niche risks that are low frequency and high severity, and that are not easily insurable in the commercial market at a reasonable price.

“If one has confidence that other risks are properly priced, then these risks can be diversified by a reinsurance programme,” says Chaz Lavelle, senior partner with law firm Bingham Greenebaum Doll.

“Others bear a portion of this risk, in exchange for the small insurance company assuming a small portion of other risks. A small group captive can also accomplish this.”

The popularity of 831(b) has grown since its introduction in 1986, with business owners realising the benefits of harnessing their own underwriting profit.

“It’s growing in popularity because there is a focus on the middle market sector—the entrepreneurial mindset of a business owner who wants to insure some of his risk through solid risk management practices thereby capturing the underwriting profits that would have otherwise been spent in the traditional market without the potential for dividends on their good loss experience,” says Sandra Fenters, president of Capterra Risk Solutions.

Derek Martisus, small captives sales leader, Marsh, agrees that the middle market is the main reason for the growth of these small captives.

“The sector continues to grow because insurance brokers and captive consultants are now bringing the idea to the middle market,” he says. “While every Fortune 500 company either has a captive or knows exactly why they don’t need one, there are some middle market companies that have no idea what a captive can do for them.

“At Marsh, our middle market brokerage footprint has grown significantly over the past six years. Our clients have retained risk just like large companies, and using a small captive that makes the 831(b) election is a very effective financing mechanism for these retained risks. In the absence of such a funding mechanism, a catastrophic retained loss could potentially be very damaging to their financials.”

Increased understanding and awareness are indeed real drivers of growth in the sector, says Lavelle. Alternative risk management (ARM) has become more ‘mainstream’ and owners of closely held businesses are much more attuned to the overall concept of ARM, and captive insurance companies in particular.

“More prospective captive owners feel better informed and more comfortable in considering owning their own insurance company,” he says.

Additionally, the insurance departments in many states are actively seeking captive insurance companies; this has increased the education of those considering organising such companies, says Lavelle.

Finally, the service providers have learned to ‘right size’ their fees, so that small insurance companies have a reasonable amount of overhead costs.

While 831(b) is presently available only to companies that receive a maximum of $1.2 million in annual premiums, new changes coming into play next year will increase the limit to $2.2 million. This is expected to further increase the number of middle market players who make use of 831(b).

“It’s going to get a lot more people’s attention,” says Jeffrey Simpson, director of law firm Gordon, Fournaris & Mammarella.

“There was a segment of the market that could have been interested in this type of captive but were too big to benefit from the election; it didn’t swing the needle enough for them at $1.2 million but at $2.2 million and growing then it might be interesting—so we are going to see more people take advantage of this.”

A particular subset of small captives is focused on covering risks that have not been covered historically, filling gaps in commercial programmes through deductible reimbursement or covering exclusions from the commercial programme, says Simpson.

“They are working for small privately held businesses—and sometimes there are ancillary financial benefits such as estate planning or wealth transfer associated with the ownership. That subset is surging in popularity because it’s an efficient way of covering risks that small businesses were previously unable to cover, and didn’t understand that they could cover, through this mechanism.

“When people learn about it they are very interested. There are mechanisms coming into the market that drive costs down, which makes it even more accessible, and that’s why people are doing it—they now understand it and know about it, and they can now afford to do it.”

The wealth transfer problem

On the downside, the issue of wealth transfer has been gaining the sector a significant amount of bad press recently. Individuals have been creating small captives which are owned by a trust set up for the benefit of their children—or they simply make their adult children owners of the captive. If the captive performs well, the profit is transferred to the children, and operating tax and transfer taxes are both avoided.

The IRS has, understandably, become twitchy about this and is scrutinising a large number of these captives to root out those that are in reality mechanisms for wealth transfer.

With this in mind, the 2015 PATH Act requires that the insurance company meets one of two diversification tests. The first one is that no policyholder (including related policyholders) pays more than 20 percent of the premiums.

If that test is not met, the second test prohibits a spouse or lineal descendants from owning more of the insurance company than in the operating companies (there is a 2 percent tolerance).

“The premise seems to be that if the insurance company consistently operates at a profit, then there will be a transfer of wealth from the senior generation to the junior generation, if the junior generation owns a higher percentage of the insurance company. The industry is waiting for further guidance on some aspects of these changes,” says Lavelle.

Fenters, who worked with lobbying support group SIIA (The Self Insurance Institute of America) to ensure that as the new legislation was written there would still be support for the private sector outside the farming industry, says that Congress has for years tried to increase the IRC 831(b) limit of $1.2 million in annual premiums to keep pace with inflation.

Specifically, Senator Charles Grassley of Iowa has long wanted an increase in the premium limit to accommodate small rural mutual insurance companies in the Midwest, such as those providing fire insurance for remote farms and homes for which coverage is commercially unavailable.

In order to achieve this goal, Grassley had to find a revenue offset to make up for the revenue loss from the increased premium limit. The long and short of it is that the outcome was twofold: first, while Congress pushed for the increase, the IRS and Treasury raised an eyebrow and pushed back, causing increased IRS scrutiny of captives taking the 831(b) tax election; and second, wealth transfer was sacrificed as the ultimate tightener to the new legislation. In particular the IRS is scrutinising the promotors of these type of captives.

“There are many captive consultants who utilise estate planning attorneys and CPAs to distribute the small captive idea,” adds Martisus. “These service providers know very well the estate planning benefits of a small captive. Clearly, the intent of the changes was to eliminate this benefit from captive ownership.

“Some firms will struggle to find new ways to promote their services, given their heavy dependence on estate planning. Additionally, ownership will need to be changed for those captives already benefiting from estate planning structures.

“Our insurance brokerage clients have not found estate planning to be of material interest. We expect that captive tax advisors will be challenged towards year-end to ensure that ownership structures are in compliance so that their clients’ captives may still make the 831(b) election in 2017.”

Standing up to scrutiny

If you are considering utilising the 831(b) tax election, it is now more important than ever that your captive can stand up to IRS scrutiny.

“The big win for captive owners and prospective owners is certainly the increase in premium limits to $2.2 million beginning in 2017,” says Martisus. “Having never been adjusted for inflation, the current $1.2 million limit no longer has the impact it once did for insurers making the election.

“Although clearly a win for captives, the industry will need to take great care to ensure that this increase does not simply magnify the abuses that concern the regulators. The industry must continue to educate clients and prospects on the correct reasons to form a captive and the correct way to do it.”

Fenters’ advice is to build a strong business plan that is beyond the economics of taxation—and ask yourself, why did you form this insurance company to begin with? What’s required is being able to identify the risks that need to be mitigated through the use of a captive and utilising third party professionals to establish arm’s length commercially reasonable premiums.

“You need to ensure that it is on strong foundations that are beyond the tax election—then when and if you are under scrutiny and have an audit by the IRS you should be able to pass muster.”
Owners of small insurance companies must be comfortable with the magnitude and volatility of the risks assumed, adds Lavelle. “If they are, the insurance companies can be an excellent element of the overall risk management programme of the insured(s) for those who are involved for true insurance purposes.”

Another positive is that a small insurance company does not have the same marketing costs and other overheads of a commercial insurance company, he adds, while also warning against the ‘extremely exhaustive’ audits carried out by the IRS.

To ensure your captive stands up to scrutiny, Simpson suggests focusing on three key questions: first, business purpose—do you really have risks that you want and need to cover? Second, how are you selecting and pricing those risks; and third, how are you organising yourself to be an insurance company for tax purposes?

“Those are the things the IRS is suspicious of—the IRS believes people are doing this without really having risks to cover; they are not even selecting risks that are remotely applicable to their business and they are not pricing them reasonably—they are inflating the prices so they can maximise their tax deduction, and they use pools not for risk distribution and to minimise volatility but instead to prevent claims from hitting the captive.

“You need to make sure you cover all those bases and do all those things correctly—or you are going to have a tax problem.”