7 January 2015Bermuda analysis

The rightful place of 831(b)s

James Rawcliffe, vice president, captives at Sagicor seeks to make sense of 831(b) captives, and explains how they can be used the way the IRS statute originally intended, and how pitfalls can be avoided.

831(b) captives: are they an embarrassment to the industry, or a useful risk management tool? The story below appeared on the Captive International website on September 9, 2014.

“A leading independent captive manager has confirmed that it is involved in the US Internal Revenue Service (IRS) investigation into the captive industry. The investigation relates to captives that use the tax code 831(b), which means they have less than $1.2 million in annual written insurance premiums and have elected to pay tax only on investment income. They pay no tax on their underwriting profits. The company’s president has confirmed that an investigation is ongoing and believes it involves quite a number of other captive managers who specialise in 831(b) captives and that it will likely spread to others.”

The 831(b) captive has received considerable attention from the trust and estate planning industry, being promoted to their high net worth clients as part of a tax planning strategy with insufficient attention to whether these companies are truly insurance companies and meet the requirements of operating as a legitimate insurance company with risk shifting, risk distribution, and arm’s-length pricing.

As a result, the reaction of the more established domiciles such as the Cayman Islands and Bermuda has been to regard proposed Section 831(b) formations with suspicion, whereas domiciles new to the captive scene, such as Arizona and Nevada in the US, and Anguilla and the Bahamas in the Caribbean, welcome these micro-captives as a growth opportunity.

Guidance from the past

When the Internal Revenue Code 831(b) election was first introduced by Congress in 1986, it was intended to extend the benefits of self-insurance from the large publicly quoted companies to small and medium-sized closely held business entities, in order to assist with the creation of new jobs and encourage innovation, especially in America’s heartland. This was combined with hardening insurance rates from the traditional insurers in the 1980s, caused by enormous and unexpected liabilities such as asbestos exposure.

"The 831(b) represents an opportunity for captive owners to build up a pool over time to deal with these infrequent, severe and plausible losses."

In keeping with the spirit of the legislation it is my belief that the type of insurance programmes best suited to the 831(b) are those involving short tail business, where losses are reported and settled within a reasonable time line from when the claim was first incurred. In view of the fact that underwriting results are not subject to tax, just investment income, whether the 831(b) incurs an underwriting gain or a loss is irrelevant from a tax perspective. The 831(b) is not suitable for long tail business with its potential for underwriting losses being carried forward, which of course cannot be used.

Uses of a 831(b) captive

• To fund the deductibles for a property all risks programme. When insuring into the market, it is customary for a property all risks policy to require the insured to assume a self-insured retention (the deductible) from zero dollars upwards to a certain level. In some US states particularly the Gulf and Mid-West states which are vulnerable to catastrophic losses such as hurricanes, tornadoes or flood damage, the level of property deductible sought by insurance companies can be very high.

Rather than the insured bearing this cost at the time of a claim, the insured can pre-fund at a premium level set at a market rate applied to the sum of the deductible to be borne, into the captive, and can build up a pool over time, thus leveraging the captive with the insurance company for a lower premium rate by increasing the deductible over time.

This can be of particular benefit for owners of a property portfolio where the combined deductible is sufficiently high to generate the premium volume, provided this remains within the $1.2 million limit

• Participation in an overall reinsurance strategy. An insurance company may find that it is not possible to cover all its exposure in the reinsurance market where the premium rate on line offered by the market pricing is uncompetitive for the layer priced, or if there is insufficient capacity in the market to cover the entire 100 percent. This gap can be left unfunded and you hope for the best, but a more considered approach would be the use of the 831(b) captive to participate in the reinsurance programme.

This is an example of a finite risk suited to the 831(b) captive and the premium level can be controlled by the exposure assumed. Provided the rate on line is within reasonable proximity to the market, then this can be regarded a valid insurance use.

• Covers not available in the market. Certain covers, although not deemed uninsurable risks, are nevertheless unobtainable in the market, for example environmental clean-up or terrorism coverage, which represent infrequent yet severe losses where it is difficult for the market to offer at an actuarially determined rate. Also there are exposures so unique to insured entities that there is insufficient demand in the market for a common approach to pricing, for example loss of key employees, or legal defence costs from employee lawsuits. For these types of exposure the 831(b) represents an opportunity for captive owners to build up a pool over time to deal with these infrequent, severe and plausible losses.

Pitfalls to consider

If the premium breaches the $1.2 million per annum limit, the election is automatically terminated and the entire profit of the captive is taxable. The premium is an allowable expense in the shareholder’s tax return, yet there is a greater scrutiny by the IRS for the premium to meet the risk transfer and risk distribution criteria to be considered a valid insurance transaction and to qualify for the deduction.

Premiums which are subsequently found not to meet the criteria produce a knock-on effect on the 831(b) election such as potential loss of the election status and the captive being taxed as either as a Controlled Foreign Company or as a Passive Foreign Investment Company, each giving rise to a higher tax liability at the shareholder level and possible interest and penalties. Care must be taken that in the attempt to keep the premium below the $1.2 million threshold, risk transfer criteria in premium setting are not disregarded.

Positive steps to demonstrate validity as an insurance company

• A sensible capital to premium ratio, such as 4:1.

• Insurance premiums to be actuarially determined with best attempt to use loss history unique to the insured or failing that, industry average for similar sized entities in the state in which they operate.

• Insurance policies to follow the market convention regarding wording and clearly define the contract, the exposure and how losses are settled, and display what perils are covered and what is excluded.

• The policy must pass the risk shifting and risk distribution test to be deemed insurance. Involve an actuary in setting the premium and also ask the auditor to check the proposed premium set.

• Proper reserving for reported claims, and incurred but not reported (IBNR) losses to be supported by an annual actuarial review.

• Fulfilment of US tax obligations and adherence to US tax filing deadlines.

• Ensuring management of the captive is performed outside the US.

The essence of this guidance is that insurance reasons must be first and foremost in the use of the 831(b) captive, and the taxation aspect is considered purely from the perspective of the beneficial tax elections available once the insurance reasons have been satisfied. If the priorities were vice versa, and insurance is shoehorned in an attempt to fit a tax solution, the unintended consequences could be costly.

The role of the captive’s insurance manager is vital to ensure the establishment of consistent protocols, one of the statutory duties being under Section 2 of the Cayman Islands Monetary Authority Guidance Notes relating to the conduct of insurance managers “to ensure that all insurance arrangements are in place and for the subsequent coordination of these”.

An additional skill required of the insurance manager is the close working with other service providers appointed, in particular the tax attorney to uphold a consistent policy of board meetings held and decisions made outside the US, and meeting with the Cayman regulator to discuss the captive, all of which supports the captive as a bona fide insurance company able to satisfy any statutory review.

It is hoped that the investigation of the IRS will reveal very few uses of the 831(b) for improper purposes, thus confirming that the 831(b) captive does have a rightful place, and that as a result more 831(b)s will be seen in the established domiciles.

James Rawcliffe is vice president, captives at Sagicor Insurance Managers. He can be contacted at: