It is frustrating that captive programs established by large, well-known companies, such as Carnation, Humana, UPS, U-Haul, Mobil Oil, and Gulf Oil, were not only challenged by the US Treasury but also found in some cases to be invalid by the Tax Court. All were run by sophisticated professionals and supported by knowledgeable third-party advisers. Some used fronting insurers who, as part of the underwriting process, did their own analysis before committing to the program. Regulators in various locales approved and supervised all the programs. And, prior to the micro-captive cases, all demonstrated a sufficient business purpose to comply with the subjective factor of the economic substance doctrine.
Yet in Revenue Ruling 77-316, the Treasury announced that any captive program—be it direct, fronted, or reinsured—was invalid because the parent and captive were part of the same "economic family," which reduced the captive to an accounting reserve for the group. Courts initially sided with the Internal Revenue Service (IRS), loosely basing their decisions on a combination of anti-avoidance law and technical accounting theories. The tide turned for taxpayers in the early 1990s, a situation that continued for the remainder of the decade. The IRS rescinded the economic family argument in 2002 but brought two new captive challenges in Rent-A-Center, Inc. v. Comm'r, 142 T.C. 1 (2014), and Securitas Holdings, Inc. v. Comm'r, No. 21206–10, 2014 Tax Ct. Memo LEXIS 225 (U.S. T.C. Oct. 29, 2014). Both were losses, but the recent string of micro-captive cases could bring new energy to the IRS's longstanding dislike of captives.
This result is deeply unsatisfying from a public policy perspective. The fact that companies that can demonstrate a legitimate nontax business purpose in forming a captive do not have the same degree of tax certainty as those using traditional funding is an abject regulatory failure. This is especially true during hard insurance markets, such as those currently occurring in the commercial trucking or property markets. Considering the size of the insurance expense for some companies—and the overall benefit they bring to the country as a whole—a higher degree of policy certainty is needed.
Despite the lack of clarity, the captive insurance market is clearly moving forward as companies are adopting captives at strong rates. "Captives now represent nearly 25 percent of the overall commercial insurance market, having diverted hundreds of billions of dollars in premiums from traditional channels in the last decade." 1 In fact, some are now arguing that captives should no longer be considered "alternative" but a traditional risk finance mechanism. 2 But how did we get there?
This article provides an overview of the current state of the captive insurance law. It begins with an explanation of the classical definition of insurance first developed in the early 20th century by insurance academics, which comprises the basic framework used by courts to understand and define insurance. This is followed by an examination of the two primary reasons that companies form captives and an analysis of works of the original captive consultants who formed the first captives. These works show that companies have been utilizing alternative risk transfer techniques for over half a century. Despite this, the Treasury long argued these structures were nothing more than reserve accounts, as will be explained in the section of this article titled "Primary Arguments Against Self-Insurance," which ends with a discussion of Revenue Ruling 77-316.
This background information leads into a discussion of the three Harper factors: insurance risk, risk shifting and risk distribution, and insurance in its commonly accepted sense to determine the current status of the law. See "Captives: The Harper Test." The conclusion notes the currently unstable position of the tax law in this crucial economic area. See "Micro-Captives and Claims Handling."
The Classical Definition of Insurance
Several early texts contain the first attempts to formally define insurance. Some authors wrote for academics, 3 others synthesized case law for lawyers, 4 while others targeted insurance practitioners. 5 There is a remarkable uniformity among these works in defining insurance's basic contours. Synthesizing these writings, insurance requires the following.
- An understanding of uncertainty
- An entrepreneur's and society's need to mitigate the same
- Near mathematical certainty of risk prediction and reduction through the assembly of a sufficiently large pool of risk
- A specialized risk taker
- A pooling of risk (usually homogenous in nature)
Their combined efforts of these original authors contain the key elements of what we will call the classical definition of insurance.
Most began their analysis by delineating the difference between uncertainty and probability. 6 The Oxford Dictionary defines certainty as "an event that is definitely going to take place." 7 This characteristic promotes planning, which in turn fosters socially beneficial activity. If a company is "certain" that a counterparty will sign a contract, the first company can begin making capital improvements. If an economic sector is confident of an increase in government appropriations, it is more likely to hire additional workers.
The prefix "un" "denotes reversal." 8 Uncertainty has negative economic implications. Returning to the above examples, if a counterparty will not sign a contract, there is no incentive to purchase new capital; if stimulus is not forthcoming, new hiring is unnecessary. Anxiety about the future decreases overall risk appetite.
Mitigating the negative implications of uncertainty is a prime purpose of insurance. For example, a property owner with $1 million in total real estate assets, but without insurance, faces a total loss exposure of $1 million. But a property policy with a $100,000 premium allows them to take on more risk. A manufacturer with $10 million in gross revenue but no workers compensation coverage could potentially lose its entire revenue. But a workers compensation policy purchased for $250,000 lowers the company's risk.
The original authors cited by this article also placed great emphasis on the importance of basic probability and the supposed certainty provided by the mathematics of large pools of risk. Willett believed the standard margin of error could be strictly applied to a large pool of risk 9 while Riegel 10 and Hardy 11 were proponents of the infallibility of the law of large numbers as it relates to insurance.
Insurance requires a specialized risk taker: This individual or person should possess superior knowledge enabling them to profit from the transaction. The profit structure for this venture should include an "insurance" provision that paid claims and was hopefully large enough to absorb all losses, and the insurance provision was in addition to the standard profit margin included in most transactions.
Finally, the risk must be pooled in sufficient quantity such that predicted losses nearly equal actual losses. 12 The large number of risks allowed the insured to acquire sufficient capital to pay claims and more accurately predict losses. In fact, the greatest risk facing any insurer was the inability to obtain critical statistical mass. Willett went so far as to argue that each specific risk should ultimately be underwritten by a single insurer.
Primary Reasons for Captive Formation and the Rise of Specialized Captive Consultants
There are two cost-related reasons why a company will form a captive insurance company. The first is rising claims costs that force insurers to increase rates at the company, industry, or macroeconomic level. This occurred in several captive cases. The company in Ocean Drilling & Exploration Co. v. U.S., 988 F.2d 1135, 1139 (Fed. Cir. 1993), could only obtain coverage through Lloyd's and, even then, was forced to pay substantially higher rates due to losses. Crawford Fitting paid $850,000 for its first $1 million in coverage. 13 Humana almost went without coverage due to the cost. 14
The entire US economy experienced a liability insurance crisis in the 1980s, with various lines of coverage rising between 50 to 500 percent. 15 The problem became so pronounced that Time magazine ran a cover story on March 24, 1986, titled, "Sorry America, Your Insurance Has Been Cancelled." The coastal US property market has been experiencing the same issue since approximately 2015 due to the increased severity and frequency of extreme weather events.
The second reason why a company will form a captive insurance company is if the insured determines that self-insurance is cheaper, a point requiring an understanding of insurance pricing. To determine a premium, an insurer will analyze the losses of similar businesses to arrive at an average industry loss, which is then incorporated into a base premium charged to the entire class. An underwriter may be able to alter the price via a manual rating adjustment, but even then, some companies will be overcharged for coverage—sometimes significantly so. 16 A captive allows the insured to use its individual loss history to calculate a premium, giving the company a cheaper insurance rate. 17
Due to the opaque nature of the insurance business, companies in either situation turn to professionals to form and manage captives. Three early texts spotlight this development. Robert Goshay's Self-Insurance and Risk Retention Plans is the earliest. 18 It contains an explanation of the previously mentioned pricing issues, some expense advantages offered by captives, an analysis of the law of large numbers fallacies when applied to insurance pooling, and an overview of a survey conducted of then in existence self-insurance plans and programs.
Donald MacDonald's Corporate Risk Control 19 is written from the risk manager perspective as most of the text explains how to use certain coverages effectively. However, chapter five also explains some of the shortcomings of the law of large numbers.
P.A. Bawcutt's unambiguously titled Captive Insurance Companies 20 is the most on-point of the texts and contains what may be the first standard laundry list of parent company requirements.
Taken together, these books show that captive consulting started more than 50 years ago and has been an accepted method of risk financing. 21
Primary Arguments Against Self-Insurance
While there was no statutory prohibition regarding captive formation, there was a theoretical argument against the idea. Some insurance authors argued that no matter the "bookkeeping or funding arrangement" 22 used, self-insurance was impossible because the insured remained the risk-bearing party; there was no risk shifting. This theoretical argument dovetailed with a series of cases in which the insured established various self-funding mechanisms to fund a known loss.
The following hypothetical explains the basic accounting problems with self-funding. After analyzing its workers compensation losses for the last 5 years, Acme Corp. determines that 80 percent of its claims are less than $100,000. The company purchases a workers compensation policy with a $100,000 deductible and then contributes sufficient funds to a dedicated account for the next year's projected deductible payments. Is this contribution deductible for tax purposes?
The answer is "No." Per 26 Treas. Reg. §1.446-(a)(c)(i), under the cash method of accounting, an expense can only be deducted for the "taxable year in which [it is] made." The company can only deduct payments made. Per 26 Treas. Reg. §1.446-(a)(c)(ii), under the accrual method of accounting, the company cannot deduct an expense until "the amount of the liability can be determined with reasonable accuracy." Here, the company can only deduct a payment that can be reasonably calculated.
Several early tax controversy cases support the above analysis. The petitioner in Oppenheimer v. Commissioner, 16 B.T.A. 993 (1929), was an attorney who was sued for $30,000 by a former client. The lawyer deposited $30,000 in a separate bank account in anticipation of losing the case and deducted that amount from his gross income. The court noted that, "Reserves, however, are not allowable deductions from gross income unless specifically provided for by statute." Id at 995.
The company in Pan-American Hide Co. v. Commissioner, 1 B.T.A. 1249 (1925), deposited $3,300/year into an account to self-fund its fidelity exposure. The amount of the deposit was derived from quotes from insurance brokers for similar coverage. Each year, the taxpayer deducted the amount of the contribution. After 3 years, the company paid a claim for slightly more than $9,900, but the claim was disallowed. The court first noted the taxpayer was attempting to take "income from one pocket" and place it into "another pocket as a reserve." Id at 1926. (This phrasing would be used by the Tax Court in later captive insurance decisions.)
The taxpayer also argued there was nothing conceptually different between paying money for insurance coverage into an account and paying an insurance premium. The court noted this was a matter of legislative grace; the former was allowed by statute, while the latter was not.
The business in Ostheimer v. Commissioner, 1 B.T.A. 18 (1924), leased restaurant furniture. The lease required the business to return the chattels in a condition similar to that in which they received them. To pay for potential repairs, the taxpayer contributed funds to a reserve account, which he deducted from his gross income. Since the taxpayer used the accrual method of accounting, and no expense had been incurred, the court disallowed the deductions.
In Consolidated Asphalt v. Commissioner, 1 B.T.A. 79 (1924), the company built roads for the City of New York. Its contract required the company to fix work for a specified amount of time after completion. The company deposited and deducted some of the contract proceeds in an account to fund these expenditures. The court disallowed this deduction, reasoning that since the taxpayer used the cash basis of accounting, it could not deduct the contributions but only the payments it made.
In Spring Canyon Coal Co. v. Commissioner, 13 B.T.A. 189 (1928), aff'd Spring Canyon Coal Co. v. Commissioner, 43 F.2d 78 (10th Cir. 1930), a Utah mining company established a separate trust to pay workers compensation claims. A third-party managed the trust. He calculated a monthly premium based on payroll and the rate charged by the state-sponsored insurance fund. The company paid premium tax on contributions. The fund payment contributions were disallowed as an expense. The court ruled that the company could not deduct payments until claims were paid.
In Consumers Oil Corp. of Trenton, N.J. v. United States, 188 F. Supp. 796 (D.N.J. 1960), the taxpayer leased land subject to flooding and could not procure insurance. The company instead deposited $15,559.58 and $17,817.84 into a trust account managed by three of its officers and directors and deducted the same from its income. On audit, the Treasury determined the contributions weren't insurance.
The court sided with the Treasury, basing its decision on two facts. First, the account was nothing more than a "voluntary segregation of funds"—reasoning that harkens back to the concept of an account reserve. Second, the court expressed concern that the funds remained under the control of the taxpayer, but it did not elaborate. The obvious inference is that an insurance transaction requires a truly independent third party not controlled by the insured.
The following observations should place these cases into a broader perspective.
- All transactions had a legitimate business purpose: to fund a future contingency. 23
- In several circumstances, the taxpayer referenced relevant insurance rates to determine the amount of contributions.
- Some transactions paid claims.
- In one transaction (Spring Canyon Coal), a state agency issued a certificate of authority.
- The Treasury did not allege any transaction was a tax shelter.
These cases are still good law.
Conclusion
The unsettled nature of captive insurance law is an abject failure of public policy. This is especially true when this transaction's importance is considered, along with the current challenging nature of several key insurance markets. Insureds who can demonstrate a clear need for coverage should have the same level of certainty for their transaction as coverage purchased from a third-party insurer.
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