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    Over the last month, international tax planning and captive insurance -- two areas of law and tax planning typically shrouded in mystery -- have come to the forefront of the news cycle.  Unfortunately, both areas are typically poorly reported on not because of journalistic negligence or incompetence but due to the sheer complexity of the topics at hand.  Tax law is typically only taught in detail at the graduate legal level and captive insurance is not taught at all.  Moreover, the legal issues involved with captive insurance span a very broad swath of law including contracts, business entities, estate planning, tax planning, and insurance – three of which (estate planning, tax law and insurance) are in and of themselves legal specialties.  The purpose of this article is to provide the reader with a basic explanation and outline of captive insurance – what it is, how it came about and the current state of the law.  In addition, at the end I’ll talk a bit about the recent New York regulatory situation.  I’d be remiss at this point if I didn’t engage in a bit of self-promotion by stating that if you’d like to learn more you can purchase my book U.S. Captive Insurance Law or visit my website.  At minimum, it will cure you of your insomnia.

    A captive insurance company is an insurance company owned by the insured.  The case law defines a captive as a “wholly-owned insurance subsidiary.”  While it may seem like insurance is always available, it can actually be harder to get than you’d think.  For example, if you own property in an area prone to being hit by hurricanes you’ve probably discovered that insurance coverage is very expensive.  Here are two additional real-world examples: due to the large amount of tort litigation in the 1970s, product liability coverage was impossible to get and in the mid-1980s, Congress amended the risk retention act allowing doctors to form risk retention groups because medical malpractice coverage had become extremely expensive.  Both of these industries are obviously important to the US economy, but their inability to procure insurance threatened their economic viability.  
    Even though companies started using captives for legitimate business reasons, the IRS had their doubts about this concept due to a very important technical legal reason: they were concerned that for tax purposes the captive was a “reserve.”  The key difference between a reserve and an insurance company is payments to a reserve are not deductible while insurance premiums are.  This key tax issue obviously meant there was a great deal of money riding on the legal outcome of captive litigation, which can be chronologically divided into four periods: the reserve cases from the early 20th century, the early captive cases in the 1950s, the initial IRS victories from the late 1970s to the Humana case in 1987 and the IRS losses from Humana to the UPS case in the early 2002.  By the time of the UPS case, the writing was essentially on the wall that courts would accept certain types of captive structures.  At this point the IRS issued two Revenue Rulings which are essentially statements from the Treasury Department outlining how they will treat commonly occurring transactions.  In these rulings the IRS provided two legal safe harbors for captive insurance, essentially stating, “if you’re going to do this, here’s how you should do it.”
    While captives are typically associated with offshore tax planning, they are now an “onshore” phenomena: over 30 states have a captive insurance statute allowing for the formation of a captive in their jurisdiction.  While Colorado passed a statute in the early 1970s, Vermont’s statute passed in the late 1970s has become the de facto US model code or industry standard.  Some of the bigger captive jurisdictions are Vermont, Delaware and Utah.    
    So, let’s sum up so far.  Captives started in the 1950s because of deficiencies in the insurance market.  While the IRS challenged these structures for legitimate legal reasons, they were arguing against a historical tide.  Now, when properly structured and run, a captive insurance company is a valuable risk management tool used by over 5,000 US companies.
    Now let’s turn to the more recent events to see what’s going on.  The following excerpt is from Bloomberg:

Carriers in New York had $48 billion in “shadow insurance,” according to the report from Benjamin Lawsky, superintendent of the New York State Department of Financial Services. Lawsky has been investigating since July transactions that life insurers conduct with subsidiaries, known as captives.

Insurers use the captives to decrease the amount of capital they’re required to hold, Lawsky said in the report. The department said 17 New York-based firms use such transactions, without identifying them. The captives, which are typically based in other jurisdictions, are sometimes capitalized with letters of credit or intra-company guarantees, which can leave the parent responsible for claims if losses mount.

    In essence, this is a question about capital and capital requirements.  According to the Third Edition of Barron’s Dictionary of Finance, capital is the “difference between the company’s asset and liabilities.”  This value protects the interests of the company’s policy holders in the event it develops financial problems.”  Ideally, capital should be in cash or a cash equivalent for fast access in the event it’s needed.  But while all US states allow a captive to use a letter of credit for capital, the real issue is the reserves backing the LOCs.  Under Basil II, the US requirement is 10% while for an offshore bank it’s between 1%-3%.  It is the difference in the reserve requirements among issuing institutions that has New York concerned.  And if a captive is backed by a personal or corporate guarantee you’ve potentially got bigger problems.
    So let’s play this out in a catastrophic situation.  Large US insurer has shifted some liabilities to a “web” of offshore captives.  While these captives are capitalized with letters of credit, the capital backing those letters is less stringent.  As a result, in the event a wave of liabilities hits the company, the possibility of capital being depleted increases.  This is the nightmare scenario concerning the New York authorities.
The issue here is not the use of a captive insurance company; it’s the capitalization of the captive that is concerning the regulators.  Captives are now an accepted and often used risk management tool.  However, this case does highlight the need (as with any financial tool) to use them correctly.  And it also shows that once again, New York state and its various institutions appears to be the real regulator of US markets while the FRB and SEC sit on the sidelines.
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Comment Preferences

  •  Question? (1+ / 0-)
    Recommended by:
    cotterperson

    A lot of what I see as problems when it comes to insurance, and this is going to sound simple, is that these companies are trying to maintain profitability while also attempting to insure, house, health, stocks, bonds, whatever. Wouldn't removing the need for profit from the equation make having insurance, getting your claim expedited and the rest of the process fairer for the insured? and does an insurance company need to be for profit in order to succeed?

    I sing praises in the church of nonsense, but in my heart I'm still an atheist, demanding sense of all things.

    by jbou on Thu Jun 13, 2013 at 12:28:21 PM PDT

    •  In some cases, yes (3+ / 0-)
      Recommended by:
      tardis10, cotterperson, cynndara

      Profit and health care put the patient and the insurance company in diametrically opposed positions.  While this is true in other insurance, there is an added dimension: in health care the patient may die.  That seems to be lost on many people.

      As for other insurance, I would argue that profit motive should remain.

      "You think you can intimidate me? Screw you. Choose your Weapon." Eliot Spitzer

      by bonddad on Thu Jun 13, 2013 at 12:32:56 PM PDT

      [ Parent ]

      •  follow up question (2+ / 0-)
        Recommended by:
        Horace Boothroyd III, cynndara

        Why should the profit motive remain? I don't see how profit matters in the delivery of insurance. and I think it hurts the overall process, because the company is looking out for their bottom line before they're looking out for the good of the insured. When my house burnt the Red Cross put me up in a motel, the fire department made sure the fire was out, and the police secured my house and told me they would send a patrol car by at night to make sure it was not being broken into. All of those services were paid for with tax money(basically, not for profit security and fire insurance). Why couldn't we add insurance to the things we do collectively like fire fighting and policing?

        I sing praises in the church of nonsense, but in my heart I'm still an atheist, demanding sense of all things.

        by jbou on Thu Jun 13, 2013 at 12:41:18 PM PDT

        [ Parent ]

        •  Without the profit motive (0+ / 0-)

          The question would be who would provide any insurance?  And the answer is no one -- or the government.  And while I don't have a problem with the government handling catastrophic issues, I don't think it'd be done well in P&C or life.

          "You think you can intimidate me? Screw you. Choose your Weapon." Eliot Spitzer

          by bonddad on Thu Jun 13, 2013 at 12:52:45 PM PDT

          [ Parent ]

          •  why wouldn't it be done well? (1+ / 0-)
            Recommended by:
            cynndara

            The government handles a massive insurance and retirement bureaucracy quite well already. Adding a tax and using that tax to cover death benefits along with an added optional tax for life insurance. I don't see the need for profit in the insurance delivery system. I think the whole thing would be better as a not for profit system, but I am open to hearing why the insurance companies are better equipped to handle this then say the government that operates at even bigger scale than any insurance company and could offer better rates and a better chance of the insured getting a fair shake come claim time.

            I sing praises in the church of nonsense, but in my heart I'm still an atheist, demanding sense of all things.

            by jbou on Thu Jun 13, 2013 at 01:00:06 PM PDT

            [ Parent ]

            •  Just my opinion. Feel free to disagree. (1+ / 0-)
              Recommended by:
              cotterperson

              "You think you can intimidate me? Screw you. Choose your Weapon." Eliot Spitzer

              by bonddad on Thu Jun 13, 2013 at 01:02:27 PM PDT

              [ Parent ]

            •  i'll give this one a shot. (4+ / 0-)
              Recommended by:
              jbou, cynndara, joanbrooker, Oh Mary Oh

              Generally the government, as you say, can provide certain types of "social insurance" on a non-profit basis fairly well, and as a progressive, I would like to see that expand to health insurance.  So no argument there.

              But the reason they do that well is because generally, these are socially equitable types of insurance, i.e. they insure situations and scenarios that almost everyone is equally exposed to, and whereby the Insured, i.e. you or me don't have much agency in the level of exposure we create.  

              For example in health insurance, certain people may create disproportionate risks by smoking, eating unhealthily or generally engaging in dangerous lifestyle choices but in general these risks are so well-distributed among the populace that such coverage can be provided for, and financed relatively equitably without alienating other people.   You don't try to take my medicare because I smoke, I don't try to take your medicare because you eat too much fried food, etc...etc...  and don't stare at us health-boy, just as much a chance you get plowed over by a truck on your jog!!!

              Now let's consider property and liability insurance, and let me ask this in a few ways:

              Part 1:

              1.  Do you want your tax dollars to pay for the damage caused to someone's house full of faberge eggs and ming vases, Ferraris and Bugattis?

              2.  Do you want your tax dollars going to defend an oil company from a million dollar environmental lawsuit and then pay their settlement?

              3.  How about tax dollars going to defend a pedophile against the accusations of 25 victims?

              Part 2:

              Do you understand the obscene amount of money capitlizing the private insurance industry writ large?  Can you contemplate how much additional taxes we would have to pay - particularly given corporate / rich asshole lobbying - to sustain an insurance scheme of the size created by the private market?

              Can you imagine the competence, speed and intelligence levels of people who would work at government cheese wages to adjust claims or manage that portfolio of dollars?  Insurance administration requires pretty well-trained professionals with specialized knowledge (pats self on back), it pays well because while it can be interesting, it's certainly not the type of job one does simply for the love of the game.... well except my boss but he's nuts.  

              Part 3:

              There is an inherent temptation to corruption to large social insurance funds already, whether it's Bush raiding social security to pay for the war, or even on "our" side, both Cuomo Jr & Sr. raiding the NY State Insurance Fund to pay for pet projects/balance the books.  This is a situation that must be fixed for these programs as is, and must be vehemently monitored if we ever get to single payer.

              So in summation:

              1.  No common equitable social need which produces the cohesion to support massive single payer property or casualty insurance.  These are places where it is perfectly fair to have people accept or not, transfer or not their risk of loss based on the types of things they wish to own, and activities they choose to engage in..

              2.  This is a case, and such cases do exist, where the profit motive - when well regulated, or at least relatively well-regulated results in a superior product than the government can provide.  

              3.  Pooling risk by pooling premiums would create a Scrooge McDuck sized pile of gold which would simply be too tempting to be wasted, used to stuff holes in budgets, etc...

              One solution for the conscientious insurance buyer is to seek coverage from mutual insurers (they are the ones with mutual in their names).  Mutual insurers are almost non-profits, in that they are not at all non-profits but their policy holders are share holders, and excess reserves or underwriting profits may be returned to policy holders in the form of dividends or reinvested in the company.

              •  thank you (0+ / 0-)

                I knew some of that, but didn't take into account corporate insurance against accidents.

                I sing praises in the church of nonsense, but in my heart I'm still an atheist, demanding sense of all things.

                by jbou on Thu Jun 13, 2013 at 02:47:45 PM PDT

                [ Parent ]

  •  Great to see you here again, bonddad (6+ / 0-)

    I have always appreciated your clear and useful explanations of arcane financial matters.

    Hope you can get an Op-Ed into the NYTimes or WSJ on this -- more people need to understand this stuff.

  •  Long time no see n/t (1+ / 0-)
    Recommended by:
    cotterperson

    The only trouble with retirement is...I never get a day off!

    by Mr Robert on Thu Jun 13, 2013 at 12:46:08 PM PDT

  •  Another question or 2 (4+ / 0-)

    Could the IRS, in your opinion, rule that in order to get the favorable treatment of captives, you need to meet the capital reserve requirements of the home jurisdiction, regardless of where the assets are held (or "held," since location of virtual assets is pretty fictional anyway)?

    And what's with an insurance company setting up a captive re-insurance company, which seems to violate the concept of reinsurance? That seems quite different from a group of OB-Gyns setting up an insurance company.

    •  Sort of (3+ / 0-)
      Recommended by:
      joanbrooker, cotterperson, Oh Mary Oh

      The IRS looks at captives from a liquidity stand-point.  That is, is the captive able to pay its potential obligations in a few standard actuarial scenarios.

      Regarding your second question, I'm pretty sure this is off-balance sheet manipulation.  I can't prove that; it's just a gut feeling.

      "You think you can intimidate me? Screw you. Choose your Weapon." Eliot Spitzer

      by bonddad on Thu Jun 13, 2013 at 12:59:41 PM PDT

      [ Parent ]

  •  You specialize in offshore tax law, too, right? (0+ / 0-)

    Re: "Under Basil II, the US requirement is 10% while for an offshore bank it’s between 1%-3%."

    "I always thought if you worked hard enough and tried hard enough, things would work out. I was wrong." --Katharine Graham

    by bobswern on Thu Jun 13, 2013 at 12:54:39 PM PDT

  •  Bonddad is back! Woohoo! (3+ / 0-)
    Recommended by:
    joanbrooker, cotterperson, vicki

    Hope you stick around!

  •  Your 2nd diary since 2010 (1+ / 0-)
    Recommended by:
    Oh Mary Oh

    Welcome back. I hope you'll stick around.

    I owe you.

    ::

    "If Clint can shuffle back on stage, so can I." ~~billmon

    by vicki on Thu Jun 13, 2013 at 04:04:05 PM PDT

  •  Hi Bonddad nice to see you here (1+ / 0-)
    Recommended by:
    Oh Mary Oh

    Now to read the diary.

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