Magazine article Risk Management

The Consolidated Captive

Magazine article Risk Management

The Consolidated Captive

Article excerpt

IN A LANDMARK DECISION IN JANUARY 1991, the U.S. Tax Court, ruling on a series of captive cases, upheld the deductibility of premiums paid by three parent companies to their insurance subsidiaries. The decision effectively overrules Revenue Ruling 88-72, which states that corporations cannot deduct premiums paid to wholly owned subsidiaries regardless of how many non-related premiums are written by the insurance subsidiary. Overall, this is a very favorable ruling for captive owners.

Much has already been written about the impact of this decision regarding the expansion of the captive marketplace or the combination of captives. One effect that has not been explored in light of this decision is the parent-subsidiary group that either files or could file a consolidated tax return.

Current tax law allows a non-insurance parent company to consolidate with its wholly owned insurance subsidiary. The consolidation creates the benefit of offsetting underwriting loss with taxable income of a non-insurance entity. This benefit, along with the new tax ruling regarding captives, adds a new dimension to the cost determination of retaining loss exposure in a consolidated group. It is this type of consolidated parent-subsidiary relationship, and the related risk management decisions, that merits closer attention.

The risk manager of a consolidated group with captives has three basic options regarding the management of pure loss: retention in the parent company (self-insurance); insurance provided by its captive subsidiary; and insurance provided by an outside, non-owned insurance company. These options are by no means mutually exclusive. Experience has shown that companies with sufficient size to possess a captive insurance subsidiary utilize a mixture of retention and insurance.

The intent here is not to discuss a method for selecting a retention level, or decide whether to retain or insure an exposure based solely on the tax consequences of the alternative actions. The decision to retain a risk or to form a captive is a result of an analysis of pure loss, coverage cost and availability, and the financial resources of the entity. However, the tax expense or benefit will have a significant impact on the cost of the action selected. The tax implication on these alternatives to insure, self-insure or utilize a captive has to be analyzed in light of the new tax ruling.

Pre-Tax Costs

OVER THE LONG-TERM, insurance placed with a non-owned, external carrier would be the most costly option on a pre-tax consolidated basis. This is due to the profit built into the insurance plan that would accrue to the external carrier and therefore leave the consolidated group.

The consolidated cost of retention in the parent company and the cost of insurance placed with its captive would be relatively the same. The profit built into the captive's insurance charge to the parent would inure to the benefit of the consolidated group and have no impact on consolidated income. In combining the results of the parent company and its captive insurance subsidiary, the premium charged by the captive is "zeroed out" in consolidation. That is, the captive's premium income is offset by the parent's insurance expense. Therefore, there is no consolidated impact of premiums.

The cost difference between retention and the placement with a captive is a function of the self-insurance funding requirements of the parent company and the surplus requirements of the captive. Since the profit element of insurance would stay within the consolidated group on a pre-tax basis, retention or placement with a captive would generally be a less costly alternative than an external insurance program.

Before reviewing the after-tax outcomes of the risk management alternatives, it is important to consider the parameters necessary to deduct the parent-related premium. One of the conditions of deductibility is that the premiums are negotiated at arm's length. …

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