An Introduction to Captive Insurance

F. Hale Stewart, JD, LLM, CTEP, CWM, CAMAuthor of the book U.S. Captive Insurance LawCaptiveinsuranceinfo.com832-330-4101

Who Should Form A Captive? A company that has an above-average

risk profile. A company or individual with the

financial resources to contribute to the captive.

Finally, a company should have a good combination of income and risk

◦ Ideally, a company should have $3 million in gross revenue

◦ But a company that has $1-$3 million may have enough risk to warrant looking at a captive.

◦ Please call if you have questions

What Companies Are More Likely to Benefit From a CaptiveDoctors and other professionalsManufacturersCommercial real estateConstruction companies Transportation companiesShipping Companies

What Are the Benefits of Forming A Captive?

Custom Insurance Policies The Beech Case Using Individual loss experience in determining

insurance ratesBroader Insurance Coverage

Third party insurer insures standard risk The captive underwrites specialty risk

Asset protection Estate Planning Tax arbitrage

What Are the Steps to Forming a Captive?After a company decides to form a captive, the next step is to perform a feasibility study, which has three objectives. It provides a blueprint for the entire captive program.

Second, it aids in compliance. Third, the study can aid in selling important decision-makers within the organization on the plan.

What Are the Steps to Forming a Captive?

The jurisdiction where the captive is being formed must determine if forming the captive is in the jurisdiction’s best interest. To do that, they will consider◦ (i) The character, reputation, financial

standing and purposes of the incorporators;◦ (ii) The character, reputation, financial

responsibility, insurance experience and business qualifications of the officers and directors; and

◦ (iii) Such other aspects as the commissioner shall deem advisable.

What Are the Steps in Forming a Captive, con’tNext, the applicant must make a formal application to open an insurance company. The application must typically contain the following information (A) The amount and description of its assets relative to

the risks to be assumed; (B) The adequacy of the expertise, experience, and

character of the person or persons who will manage it; (C) The overall soundness of its plan of operation; (D) The adequacy of the loss-prevention programs of its

parent, member organizations, or industrial insureds, as applicable; and

(E) Other factors considered relevant by the commissioner in ascertaining whether the proposed captive insurance company will be able to meet its policy obligations

Finally, there is the issue of original capital and surplus.

Running the Captive

Domicile managerLegal counselAuditActuarial ServicesInvestment manager

Shutting Down the CaptiveIn most states, one of the following seven

reasons will allow a state regulator to shut down a captive:◦ 1. Insolvency or impairment of capital and surplus.◦ 2. Refusal or failure to submit an annual report … or

any other report or statement required by law or by lawful order of the director.

◦ 3. Failure to comply with the provisions of its own articles of incorporation, bylaws or other organizational document.

◦ 4. Failure to submit to an examination or any legal obligation related to the examination.

◦ 5. Refusal or failure to pay the cost of an examination.◦ 6. Use of methods that, although not otherwise

specifically prohibited by law, render its operation hazardous or its condition unsound with respect to the public or to its policyholders.

◦ 7. Failure otherwise to comply with the captive statute.

The IRS Fought Captive Insurance For Nearly 30 Years

They used three argumentsThe Economic Family Nexus of ContractsAssignment of Income

No Court Accepted Any of the IRS’ arguments

Safe Harbor Guidance, Part I

Under Harper, a captive must comply with a three prong test:(1) whether the arrangement involves the existence of “insurance risk”;

(2) whether there was both risk shifting and risk distribution; and

(3) whether the arrangement was for “insurance” in its commonly accepted sense. The duck test – does the company “walk and talk” like an insurance company?

Safe Harbor Guidance, Part II

The IRS has issued several Revenue Rulings that provide further safe harbor guidance

A captive must derive at least 50% of its insurance revenue from a non-parent.

Or, a captive must have at least 12 subsidiaries in order to have sufficient risk distribution.

Private Letter Rulings, or, the Ultimate Safe Harbor

A Private Letter Ruling (or PLR) is "issued for a fee upon a taxpayer's request and describes how the IRS will treat a proposed transaction for tax purposes." 

Private Letter Rulings create certainty – we know how the IRS will view a specific transaction