The following is Part III of a six-part series of blog postings regarding whether a captive insurance subsidiary or one owned by the owners or affiliates of a company may represent an effective risk management tool that also provides economic benefits. Although there are various types of captive insurance, this posting and the three to follow will focus primarily on single parent/pure captives and how they might provide economic benefits for you or your company. Part I and Part II of the blog series are here.
This posting turns its attention to two basic elements of insurance – risk transfer and risk distribution.
PART III: RISK TRANSFER AND RISK DISTRIBUTION
The Supreme Court has identified two criteria for an arrangement to be treated as insurance for federal income tax purposes. Accordingly, these must be present for a company to deduct premiums for insurance and, under Section 831(b) of the Internal Revenue Code for a captive insurance company to exclude up to $1.2 million in premiums received. These are:
- risk transfer; and
- risk distribution.
Risk transfer is the insured’s transfer of its liability risk to another person or entity, and risk distribution is the insurer’s spreading its liability risk among a number of insureds.
Risk transfer is an easy concept. By purchasing liability insurance from a third party, the company is transferring to the third party its risk of liability for an insurable loss it would otherwise have to pay itself. Risk distribution is a somewhat more complicated concept and the IRS has issued two Revenue Rulings that provide guidance on how the risk distribution requirement may be satisfied. In short, risk distribution may be satisfied if either:
- the company that is to be the single member of the captive insurance company also owns 100% of twelve or more subsidiaries (“brother-sister affiliates”) to which the captive insurance company will provide the insurance with no one brother-sister affiliate accounting for less than 5 percent or more than 15% of the risk; or
- more than 50% of the captive insurance company’s risk exposure is derived from insuring third parties.
With respect to the first bullet above, many experienced captive insurance practitioners believe the IRS would accept eight brother-sister affiliates to demonstrate sufficient risk distribution.
When the pure captive is owned by a parent company, it is sometimes referred to as a “single parent captive” and it insures the risks of the parent and the other operating subsidiaries of the parent (i.e., the “brother-sister affiliates”). The single parent captive may also insure companies not affiliated by ownership or control of the parent but which otherwise have a business relationship with the parent or the affiliates of the captive insurance company.