Hurricanes create captive opportunity
As I write this article, Hurricane Matthew is bearing down on the east coast of Florida and will soon be engulfing the coasts of Georgia and the Carolinas. Several of the hurricane tracking models have shown that this particular hurricane has the potential to boomerang back around and hit Florida for a second time as a tropical storm.
It’s been over a decade since the last major hurricane hit Florida with destructive winds and storm surge. Back in 2004/05 six hurricanes hit Florida, ranging from category 2 to category 4 in intensity. With these high intensity storms comes the unfortunate circumstance of loss of life. Everyone watching the news hopes and prays that everyone in the path of the storm stays safe. The other obvious circumstance is property damage which is unfortunate but can be planned for and mitigated to a degree for large commercial multi-property owners and property management companies.
As time moves on, as was the case from 2006 to yesterday, property rates and deductibles have decreased with deductibles going from 5 percent in some locations down to 2 percent due to the lack of hurricane activity in the Southeastern region of the US. One of the key components to property coverage is “wind”. If Hurricane Matthew wreaks as much damage as predicted, these lower rates and deductibles are probably going back up, potentially all the way back up to 5 percent for the deductible.
“This accumulation of funds to pay eventual claims can be used in a couple of ways during periods of low hurricane activity.”
For the commercial property owners who sustain damage, funds from their working capital are used to pay for the damage up to their deductible limit. These are funds that could have been earmarked for additional acquisitions of property or renovations on existing property or a number of other uses. Another issue could be, will the funds be there to pay for the damage in a timely fashion or will it take some time to liquidate other investments to secure funds to make repairs, creating delays and expanding down time for the property.
One solution to funding for property damage caused by hurricanes is a captive insurance company. If formed properly and with the right circumstances, it can be treated as a real insurance company for tax purposes affording the captive some beneficial IRS rules and elections to assist companies to save for a stormy day.
Take for example a commercial property owner with multiple locations who formed a captive in 2006 when rates and deductibles were elevated due to the hurricane activity of 2004/05. Although the captive may have paid some minor damage claims over the years 2006 to today, the captive would have collected premiums for the past 10 years and earned interest income on those funds which would now be able to more than pay the deductible for the property owner without affecting the cash flow or working capital needs of the property owner.
If the captive is formed properly and can be considered a real insurance company for tax purposes, the premium paid into the captive is tax-deductible to the parent company. Furthermore, if the premiums for the coverage the captive is assuming are less than a threshold amount, the captive can make a tax election under code section 831(b) to be taxed as a “small insurance company”, which makes the underwriting income of the captive tax-exempt—only its net investment income is taxed.
The threshold amount is currently $1,200,000 but is increasing to $2,200,000 effective from January 1, 2017 due to the Protecting Americans from Tax Hikes Act of 2015 passed by Congress and signed into law by President Obama on December 18, 2015. Qualifying as a real insurance company is the key here and to do that we test for risk-shifting and risk distribution with guidance from Revenue Ruling 2002-90.
It’s simply guidance given the subsequent tax court cases where the taxpayer has prevailed even though their particular facts and circumstances have deviated from the safe harbour guidelines described in the revenue ruling. In brief for the purposes of this article, the shifting of risk from one entity to another separate entity must be evident and the insured entities covered by the captive must be distributed among many entities to satisfy the “law of large numbers”.
Revenue Ruling 2002-90 defines “many entities” as more than 12, with no one entity comprising more than 15 percent of the total risk and no one entity comprising less than 5 percent of the risk (as mentioned earlier, there is tax case law where the taxpayer has prevailed while moving away from these safe harbour guidelines).
Let’s look at a hypothetical example to see what the benefit would be for a commercial property owner to have formed a captive which qualifies for insurance company tax treatment if it had formed a captive in 2006 to mitigate its wind risk. Let’s assume that the property owner had actuarially determined premiums and expenses that created net income of $1,000,000 a year. The parent company would have made annual deductions for the premiums paid into the captive and the captive would have accumulated this amount each year, amassing approximately $10,000,000 by 2016 to pay any losses.
Of course the captive would have paid tax on its net investment income through the years. This accumulation of funds to pay eventual claims can be used in a couple of ways during periods of low hurricane activity as we saw from 2006 to yesterday. If the amount on hand exceeds the actual deductible amount of the parent company, the parent could look to voluntarily increase its deductible to take more of the risk which should lower its property premiums to third parties, reducing its insurance spend.
Conversely, the parent company could dividend excess funds back to itself. This dividend out of the captive would be taxed at the dividend rate at the parent level or member level if the parent is a pass-through entity.
Things to consider when making the small insurance company election are the pitfalls with such an election. The election is irrevocable—once you’ve made the election you must file as a small insurance company unless the captive’s premium volume exceeds the threshold premium limitation. Expenses and losses are non-deductible for tax purposes and any net operating loss generated during any year that the captive is considered a small insurance company is disallowed for deduction.
Put another way, if the expenses of running the captive and the losses paid out of the captive exceed the premiums collected and investment income creating a net loss for the year, the captive is still required to pay tax on the net investment income. If we revisit our example from earlier, the captive and its parent have enjoyed the full benefits of the tax election from year 2006 to 2015 but when Hurricane Matthew hits and damages several of the parent’s buildings causing $2,000,000 in damage, for example, this loss will create a $1,000,000 net loss for the captive for this year. However, it will still be required to pay the federal income tax on the net investment income and this loss will not be able to be taken on this tax return or any others as a net operating loss.
I believe these types of captive arrangements truly follow the intended use of the 831(b) election. They are formed to fund a risk management need which is of a low frequency and high severity nature to help smooth the results of commercial property owners. They are a great tool to segregate your risk management function and loss funding in the event of a catastrophic loss.
Like crop insurance, for which the 831(b) election was created by Congress back in the late 1980s, wind storm is a tough risk to insure given its unpredictability and its devastating effects when it does happen. Since this type of loss is created by Mother Nature, we can only hope to prepare and limit the financial effects of such an event—we can never prevent it.
Jeffrey S. Kenneson, is senior vice president, business development at R & Q Captive Management. He can be contacted at: email@example.com