Non-Profit Health Care System Captives: Is Your Captive an "Insurance Company" and Do You Want It to Be?

13 March 2007 Publication
Authors: Kevin G. Fitzgerald

FOCUS on the Insurance Industry

1A captive insurance company is, for larger organizations, one of many “alternative risk transfer” vehicles.2 It can provide a variety of benefits if structured and operated properly. The basic premise for a single parent captive is that it is a form of self–insurance. Thus, it is certainly not for everyone. Only those organizations that have the requisite financial where-with-all as well as the skill to manage a self–insurance program should consider the use of such a captive.

The strategic reasons behind the use of a captive include: better financial management, improved claims management, more effective loss prevention and risk management, and customized insurance programs. Before establishing a captive, an organization should conduct a thorough review of the fundamental underpinnings of a captive. The factors to be considered include: predictable and controllable losses, available and cost effective reinsurance, effective risk control, adequate capitalization, a long-term commitment, and a method to exit the captive structure when desired.

One of the potential advantages to utilizing a captive insurance company over a traditional self-insurance program is the possibility to accelerate certain tax deductions. In a typical selfinsurance program, money that is set aside, or “reserved,” for a future claim payment is not deductible until the loss is paid.3 This is true even for known claims that have already been incurred. On the other hand, premiums paid for “insurance” are deductible when paid. Section 1.162-1(a) of the Income Tax Regulations provides that certain insurance premiums are included as deductible “ordinary and necessary” business expenses.4 However, the terms “insurance” and “insurance contract” are not defined by the Internal Revenue Code, but rather have been defined by the U.S. Supreme Court to include the presence of both risk shifting and risk distribution.5 Over the years, the IRS has had different ideas of what constitutes risk shifting and risk distribution.

Under the definition set forth by the Supreme Court in 1941, risk shifting and risk distribution are the primary requirements for insurance.6 Beginning in 1977, the IRS adopted the “economic family” theory, under which a parent corporation and its subsidiaries do not shift risk or distribute risk to an affiliated captive if the ultimate burden of loss is retained by the same economic family that may suffer a loss.7 As a consequence, the IRS concluded that “when there is no economic shift or distribution of the risk ‘insured,’ the contract is not one of insurance, and the premiums therefore are not deductible under section 1.162-1(a) of the regulations.”8 The premium payments were not treated as payments for insurance, but rather as capital contributions under Section 118. Moreover, the related captive insurer was not treated as an insurance company if its primary and predominant business activity was insuring or reinsuring the risks of related parties. In sum, the IRS maintained the position that there can be no risk shifting or risk distribution unless the economic burden of loss is transferred outside the economic family.9 The IRS’s economic family theory was never adopted by the courts,10 and the IRS finally abandoned it on June 5, 2001.11

On December 11, 2002, the IRS issued three new revenue rulings on the qualification of captives as insurance companies for federal tax purposes: Revenue Rulings 2002-89, 2002-90, and 2002-91.12 The rulings focus on risk shifting and risk distribution under parent-subsidiary, brother-sister arrangements, and group captive insurer arrangements.

  • Revenue Ruling 2002-89 addressed the deductibility of premiums in the parent-subsidiary captive arrangement by describing two scenarios. In one scenario the parent's premium is 90 percent of total premium and the parent's risk is 90 percent of total risk. Because the vast majority of the risk falls on the parent, this is not deemed insurance. In the second scenario, both the risk and the premium of the parent is less than 50 percent of the total risk, with the remainder of the risk coming from unaffiliated insureds. Here, because the parent risk and premium is less than 50 percent of total risk, it is insurance.13
  • Revenue Ruling 2002-90 addresses the deductibility of premiums in the brother-sister affiliate captive arrangement. The IRS approved insurance company status where the risk insured of any one affiliate is no more than 5 to 15 percent of the total risk insured by the captive.14
  • Revenue Ruling 2002-91 addresses the group captive arrangement. The ruling described a situation in which a relatively small group of unrelated businesses formed a captive to compensate for the unavailability of commercially available coverage. None of the group members had greater than 15-percent voting control of the captive or more than a 15-percent capital interest in the captive. No member’s risk exceeded 15 percent of the total risk insured by the captive. The ruling also states that none of the owner/insureds was subject to additional premium assessments if losses exceed premium, no member was entitled to a refund if losses are less than premium, and premiums paid by any insured were available to cover losses of other insureds.15

Under the Internal Revenue Code, a corporation qualifies as an “insurance company” for a particular year if more than half of the corporation’s business during that year consists of activities that, for federal tax purposes, constitute “insurance” (which, for this purpose, also includes reinsurance).16 Thus, with the abandonment of the economic family theory and the guidance set forth in the new Revenue Rulings, as well as existing case law, the issue of what constitutes “insurance” for tax purposes has probably never been clearer.

Accordingly, most “for-profit” organizations with captive insurance companies work diligently to structure their captive insurance arrangements to satisfy the requirements outlined above in order for the transaction to constitute “insurance” and for the captive to be an “insurance company” under the Internal Revenue Code. For some, the tax advantages of the accelerated deductibility of losses may make the difference between the captive being an economically viable model or not.

But while having a captive meet the requirements for an “insurance company” can have tax advantages (i.e., the accelerated deductibility in the form of “premium” for an ultimate loss payment), there are tax costs associated with such a structure as well. These “costs” can include state premium taxes (owed by the captive insurance company, or more likely a licensed “fronting” company utilized as part of the captive program) and/or independent procurement taxes owed by the insured on the premium paid to the captive. For example, in California an “insured” that independently procures insurance is responsible for a “Nonadmitted Insurance Tax” of 3 percent of gross premium;17 in Florida, this “independent procurement tax” is at a rate of 5.3 percent.18 In addition to the state taxes, if the captive is established “off shore” in a jurisdiction without a tax treaty with the United States, and has chosen not to make a Section 953(d) election,19 then the premium paid to the captive is also subject to a Federal Excise tax of 1 percent for reinsurance premium and 4 percent for direct insurance premium.20 Thus, if the “insured” is headquartered in California and independently procures insurance from its off shore subsidiary, the insurance premium is taxed at 7 percent, and if in Florida, 9.3 percent.

If the captive is part of an organization that is not-for-profit, the tax costs associated with the captive being an insurance company (i.e., the 7 percent to 9 percent “sales tax”) can greatly exceed any tax benefit (since there may very well be no tax benefit for a non-profit). In such a situation, it may be advantageous to establish the captive insurance program in such a way that it fails to meet the definitions for insurance under the Internal Revenue Code so that the captive is not an insurance company. Since the IRS no longer follows the economic family theory, the analysis of whether the captive insurance program satisfies the requirements of insurance must be based on the more recent revenue rulings and case law. Factors that can be utilized to take the captive program out of the insurance realm for tax purposes include: (1) using a thinly capitalized captive, (2) putting in place a parental guarantee behind the captive, (3) including no unaffiliated risk in the program,21 and (4) using an insurance policy form that is 100-percent assessable (meaning there is no risk transfer).

One such non-profit health care system took this approach and others, following this lead, are restructuring their captive insurance arrangements in a manner to minimize the tax costs.22 So back to the title, is your captive an insurance company, and do you want it to be?


1 The author would like to thank Jamshed J. Patel and Ben S. Thomas for their assistance in preparing this article.

2 Other alternative risk transfer options include self–insurance, high deductible programs, retrospectively rated programs, along with a variety of “captive” programs, such as group captives, rent-a-captives (including segregated portfolio companies), and risk retention groups. The discussion in this article will focus on single parent captives, the most common type of captive insurance company.

3 26 C.F.R. § 1.461-1 (2006).

4 26 C.F.R. § 1.162-1 (2006).

5 Helvering v. Le Gierse, 312 U.S. 531 (1941).

6 Id.

7 Rev. Rule 77-316, 1977-2 C.B. 53.

8 Id.

9 Id.

10 See, e.g., Humana, Inc. v. Comm’r, 881 F.2d 247 (6th Cir. 1989).

11 Rev. Rul. 2001-31, 2001-1 C.B. 1348.

12 Rev. Rul. 2002-89, 2002-2 C.B. 984; Rev. Rul. 2002-90, 2002-2 C.B. 985; Rev. Rul. 2002-91, 2002-2 C.B. 991.

13 Rev. Rul. 2002-89, 2002-2 C.B. 984.

14 Rev. Rul. 2002-90, 2002-2 C.B. 985.

15 Rev. Rul. 2002-91, 2002-2 C.B. 991.

16 I.R.C. §§ 831(c), 816(a) (2006).

17 Section 13210, Cal. Rev. & T. Code (2006).

18 Fla. Stat. § 626.938(3) (2006).

19 A 953(d) election is an election made by the off shore captive to be taxed as a US taxpayer. There are many situations in which this can be an advantageous election.

20 I.R.C. § 4371 (2006).

21 The addition of unaffiliated risk is something quite commonly done to ensure that a captive satisfies the requirements of being an insurance company.

22 I.R.S. Priv. Ltr. Rul. 2005-18-010 (May 6, 2005).


This article is a part of the FOCUS on the Insurance Industry Spring 2007 Newsletter.

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