Insurers also are forcing buyers to retain more risk themselves. Basically, if an insurance policy carried a $10,000 self-insured retention (similar to a deductible on car insurance), this will jump to about $25,000 when the policy renews. If there was no self-insured retention, as is the case with many workers’ compensation policies, there definitely will be one upon renewal.

To cope with the higher premiums and elevated levels of retained corporate risk, many businesses are turning to alternatives, chiefly “captive” insurance companies—that is, insurance companies owned by the organizations they insure. The insured pays its captive a premium to absorb the risk of loss and puts capital in reserve to cover any losses.

The advantage of a captive is not only generally lower costs, but it offers its corporate owner a way to gain greater control over its risk exposures by providing a financial incentive to reduce loss—that is, if losses are reduced the captive will make a profit for its owner—the insured.

“That was our intent when we formed a captive last year,” says Francis Galligan, CFO of the Roman Catholic Diocese of Brooklyn, New York. Galligan oversees the business affairs of 220 parishes and several cemeteries and hospitals. Before forming the captive, the diocese’s policy called for it to absorb the first $100,000 in potential property losses and the first $250,000 in potential liability losses, paying these losses out of cash flow. Galligan now insures the retained risk through the captive, which buys reinsurance to transfer the higher-level risk. “This is a very sophisticated way of managing our retained risk,” he says.

CAPTIVATING BUSINESS

Although the exact number is not known, it’s estimated that more than 4,500 captives are licensed to do business in the various offshore and domestic domiciles that permit their incorporation, including Bermuda, the Cayman Islands, Barbados and the states of Vermont and Hawaii. Insurance executives predict that number will increase 15% this year.

By retaining more of their own risk and running it through a wholly owned captive, the captive’s owners also get to keep the investment income earned on the money reserved for future losses, explains Michael R. Mead, chairman of the Captive Insurance Companies Association (CICA), a trade group.

According to Mead, the Big Five accounting firms all own captive insurance companies, which are members of CICA. “They’ve had captives for at least the last six years, and in years past these captives even reinsured each other,” he says. However, he adds that those reinsurance agreements have since ceased, given attractive terms and conditions for spreading loss through the conventional reinsurance market. Reinsurers are companies that, among other things, insure risks of insurance companies and captives.

Mead adds that it is likely that some midsize accounting firms also have formed captives, and he expects the recent insurance price increases will prompt many others to follow suit this year.

Yet another advantage of captives is the possibility of a tax deduction for the premium paid by the insured, as well as a deduction for the loss reserves. “Companies are figuring that with all this retained risk now on their books, they might as well put it into a captive and reap a tax benefit,” says Guy Ragosta, managing director at insurance broker Willis Inc. in New York.

Mead agrees. “If an insurer raises your risk retention from $50,000 to $150,000, you cannot get a tax deduction for that retention by sticking money in a fund somewhere,” he explains. “But if you call it a payment of a premium to a captive insurance company, and the captive is structured appropriately, you can get that deduction.”

While premiums paid by a corporation to a commercial insurer have always been tax deductible, premiums paid to a captive were subject to challenges by the IRS, which questioned the lack of risk shifting to a third party since the captive, in effect, was owned by the company it insured. The IRS first formally addressed captive taxation in 1977 in revenue ruling 77-316, in which the service articulated the “economic family” doctrine, which disallowed premium and loss reserve deductibility to captives. The IRS took the position that if a company’s risks are insured within the same “economic family,” the premiums involved cannot be deducted because there is no risk shifting to an unrelated third party.

“The IRS’s view was that a company forming a captive had not really transferred any risk outside its own economic family and that any loss incurred by the captive was a loss incurred by the parent, thus this could not be construed as a valid insurance arrangement,” says Joseph Jordan, CPA, a partner in the insurance tax practice of KPMG LLP in New York. Consequently, the premium paid to this captive was nothing more than a self-insurance fund, which the IRS rejects as a tax deduction.

In 1986, Humana Inc., a Louisville, Kentucky-based health care company, appealed the economic family doctrine. Humana argued that its holding company structure, consisting of several wholly owned subsidiaries (one of which was its captive), represented separate corporations that should be treated separately for tax purposes despite their common ownership. Humana drew from the long-standing tax maxim that every legal entity has a separate and independent existence.

Although the Tax Court disagreed, subsequent appeals affirmed the principle. The IRS remained mum on the subject until June 4, 2001, when it finally provided regulatory recognition of the court rulings. In revenue ruling 2001-31, the IRS officially abandoned its 24-year-old economic family theory for denying premium and loss reserve deductions to captives. “Accordingly, the IRS will no longer invoke the economic family theory with respect to captive insurance transactions,” the service stated.

Richard Safranek, a principal at Deloitte & Touche in Washington, D.C., says the IRS ruling “came at the perfect time. Companies now have an extreme need to cover risks they previously had transferred to insurance companies,” he explains. “If they have a holding company structure, or can effect one, I feel quite comfortable telling them a captive will achieve significant tax-deductible benefits.”

Still, some observers warn that the IRS hasn’t opened the door fully to captive tax deductions. “From a tax perspective, a company that enters into a captive arrangement must have a specific business reason beyond tax for forming the entity, otherwise the IRS will take notice,” says Karey Deardon, CPA, a former senior manager at PricewaterhouseCoopers LLP in New York.

Jordan agrees: “The ruling is not a ‘free pass.’ A captive will remain in tax jeopardy if it is undercapitalized, operates in an underregulated jurisdiction or obviously is set up primarily for tax reasons. If you don’t have a substantial business purpose for the entity, the IRS may object. That’s why it is critical to document the business reasons motivating the decision to form the captive.”

CAPTIVE CONSIDERATIONS

Forming a captive requires substantial funds—for reserves, for establishing a corporate entity and infrastructure, for preparing and executing regulatory filings and for administering claims. Most companies also will want to undertake a captive feasibility study, which alone can cost more than $100,000. Such studies are conducted by insurance brokerages, captive management firms and accounting firms.

Large and midsize corporations therefore are the usual candidates to form a captive, although small companies can participate, too, as the so-called leased captives.

“We couldn’t afford to form our own captive given the expense of a feasibility study,” says Michael Shelton, CFO of Directory Distributing Associates Inc., a St. Louis distributor of telephone books, with $50 million in annual revenue. “It was just too complicated.” Instead, the company joined Mutual Indemnity Bermuda Ltd., a Hamilton, Bermuda-based leased captive representing the insurance interests of more than 150 small and midsize companies.

With a leased captive, also called a rent-a-captive, several businesses lease risk transfer capacity from an existing captive. As with a regular captive, the rent-a-captive participants keep their individual underwriting profits and investment income. In some leased captives, the participants share in each other’s risks; in others, each participant is segregated for risk-sharing purposes.

Shelton says he gets the traditional benefits of a captive through a rent-a-captive—without the headaches. “We’re funding the first $250,000 of our workers’ compensation risks though Mutual, which then buys reinsurance on top of that,” he says. “Since joining the program in 1994, I estimate we’ve saved about $1.2 million a year by not buying (conventional) workers’ comp insurance.” He expects larger savings next year.

The tax issues with respect to premiums paid a rent-a-captive are not as clear as they are with single-parent captives, warns Deardon of PricewaterhouseCoopers, with much depending on the facts of each scenario.

“Neither the Internal Revenue Code nor the Treasury regulations say how such payments should be treated, and neither the IRS nor the courts have issued any specific guidance. Thus, no bright line test has been provided.”

Deardon advises taxpayers to rely on existing judicial principles specific to insurance to determine whether such payments qualify for U.S. federal income tax deductibility. “If such payments meet the earmarks of insurance—the presence of insurance risk shifting and risk distribution—the payments (to a rent-a-captive) may qualify as deductible insurance payments for U.S. federal income tax purposes,” he says.

WATCHING FOR HAZARDS

While there are sound business reasons other than favorable tax issues to form a captive, captives have some drawbacks. Chief among them is that the corporation is, in effect, setting up an insurance company to cover its own risk of loss. Just as insurance companies can misread a potential risk, so might a captive. “The effects of inadequate loss control, insufficient funding and an incomplete understanding of the exposure to loss can prove hazardous,” says trade association head Mead.

Key to avoiding these traps is hiring experienced risk managers and insurance professionals and buying reinsurance from high-rated, secure reinsurers to transfer catastrophic losses. Some companies also use third-party claims administration companies to handle their claims and assess loss trends.

As the insurance market seeks to recover from the effects of September 11, many companies are finding that a formalized captive structure may not only save them money, but may also provide a sound business alternative.