Magazine article Risk Management

The IRS and Captives

Magazine article Risk Management

The IRS and Captives

Article excerpt

In "practical risk Management," David Warren and Ros McIntosh list seven advantages to creating and using a captive insurance company. They include the ability to obtain broader coverage than through the conventional market, lower costs, the prospect of earning investment income, an improved cash flow, ability to move funds through international markets, the chance to develop profitable new lines of insurance, and improved loss control.

Notably absent, however, is the ability to deduct premiums paid to captives from corporate income for tax purposes. It's an interesting omission in light of recent tax rulings and court decisions that would appear to indicate that the IRS has "beaten a slow, grudging retreat" on the deductibility of premiums paid to a captive, in the words of Mark Rosenberg, vice president of federal affairs at the Insurance Information Institute (III).

For risk managers, this issue creates some problems. For one, even if the statement is true that the IRS is moving to disallow deductions to captives, there is always the temptation to create a captive for tax benefits that might lure the non-risk professional into surprisingly costly insurance business arrangements. Whether or not captives create favorable tax advantages, U.S. corporations continue to move into the captive market. As a result, risk managers must educate corporate leaders as to why and how captives are formed -- and also to steer them away from the potential short-term benefit of tax savings and toward the long-term benefits of true risk management.

In effect, according to most feasibility studies on captive formation, seldom do tax breaks rate very high as an advantage. Ronald J. Lamb, risk manager for Digital Equipment Corp., explains that, "Tax breaks did not at all figure into our decision to insure through captives. "For our insurance products, we pay full taxes on premiums," he says. "It was always our intention to do that."

"A company shouldn't create a captive because of taxes, but rather because buying insurance in the traditional market has been excessively expensive or unavailable," says Gary Salt, president of Risk Management Consulting Associates located in Fairlawn, New Jersey. "By going into a captive situation, a company will obtain more reasonable rates, and perhaps for better coverage. If done properly, it can work to the benefit of all involved."

The Issue of Pricing

ACCORDING TO James A. Robertson, director of insurance litigation and risk management services at Coopers & Lybrand, stability in pricing is probably one of the most important issues in captive formation. "Not only stability in the market, but stability in pricing," he adds. "Managers in businesses have difficulty understanding why the price of insurance in the open market should fluctuate as much as it does. Captives have been very successful and very stable for their owners. And they continue to be formed -- probably at the rate of 150-300 new captives a year."

"Allowing tax considerations to dictate the operation or formation of the captive can be disastrous," noted Jon Harkavy, vice president and general counsel of Vermont Insurance Management. "In the 1970s and early 1980s, numerous single parent captives began writing third-party business, in the hopes that by writing outside business the captive would be viewed as a bona fide insurance company, thus allowing the parent a tax deduction for premiums paid to its captive. During this period many captives unwittingly wrote the poorest outside risks imaginable -- asbestos, EIL and DES, just to name a few -- causing heavy losses and many captive insolvencies. These captives, and others like them, failed because the risk manager got away from the risks he or she knew best."

Mr. Harkavy characterizes this "outside business" criteria as being part of a socially and economically useless cat-and-mouse game between the IRS and commercial insureds. …

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