Captive Insurance Taxation – the basics
A captive insurance company is essentially a form of self-insurance. In its simplest form, an operating company sets up a subsidiary, which is the captive insurance company, and moves risk off the parent company’s book onto the subsidiary’s books by paying premiums to the captive insurance company. The captive insurance company acts as the insurance company for the parent and invests the premium dollars so that they grow and are available to pay claims when they arise.
In recent years, the use of captives, both domestic and foreign, has increased dramatically. Use of captives opens numerous issues which have ramifications for federal income tax purposes.
The main issue for captives is whether the captive insurance company is a valid insurance entity from an IRS standpoint.
This is an important factor in determining whether or not the insurance premiums that are paid to the captive insurance company are deductible by the insured and whether or not the captive insurance company is able to take advantage of the unique tax treatment available to insurance companies (i.e., deductibility of reserves).
In order for the captive to be treated as a true insurance entity for income tax purposes, the elements of risk-shifting and risk distribution must be present.
Risk-shifting is defined as the transfer of the impact of a potential loss from the insured to the insurer. If the insured has truly shifted the risk, then a loss incurred on the risk does not affect the insured. Instead, the insurer bears the loss in its payment of proceeds to the insured.
Risk-distribution is the spreading of the risk of loss to others beyond the insured (typically through reinsurance). Therefore, if the insured suffers a loss, the cost of the loss is distributed to all parties who have paid a premium to the insurer. The more parties which insure their risks and pay insurance premiums to the insurer, the more distribution of risk there is.
There are a number of revenue rulings and tax court cases that discuss these two factors at length.
At the very least, I would recommend you read Revenue Rulings 2005-40, 2002-89, 90 and 2002-91.
If you have any questions or would like more information, please contact:
Joanne Shaver, CPA