Filed Under:Risk, Captives

831(b) Captives: ‘Small’ Option Is Increasingly Big Idea for Midsize Cos.

Tax, other advantages are driving growth of this alternative- risk-transfer vehicle, but abuses could trigger IRS crackdown

The Section 831(b) or “small” P&C captive is becoming a big idea for midsize companies looking for cost-effective ways to transfer risk.

Captive experts say an 831(b) offers midsize companies an introduction to alternative risk transfer and its benefits, providing this class of insurance buyers a valuable cost-saving tool long utilized by Fortune 1000 companies.

Steve Kinion, director of Delaware’s Bureau of Captive and Financial Insurance Products, refers to this series of self-insurance units as “captives with training wheels.”

As more captive managers, accountants, actuaries and attorneys become familiar with the 831(b) concept, the level of interest in it among midsize companies is growing—and is expected to increase.

Indeed, 2011 marked a particularly strong year of growth in 831(b) captives.

Clete Thompson, vice president of marketing and business development at Houston-based Capstone Associated Services Ltd., a captive consulting firm, estimates that around 200 such facilities were formed last year, accounting for a significant percentage of all new captive formations.

FACTORS IN POPULARITY

Section 831(b) has been in the tax code for decades. So why is it suddenly becoming so popular now?

One reason is the vastly diminished availability of Section 501(c)(15) status to small P&C insurers, says Thompson.

At one time, that section of the IRS code exempted small P&C insurers from underwriting and investment income taxes. But the 2003 tax reform so limited 501(c)(15) eligibility that the provision effectively was invalidated for most insurers.

Another reason is simply more risk managers, tax attorneys and accountants are becoming aware of the advantages.

Karl Huish, senior vice president at Arthur J. Gallagher & Co. subsidiary Artex Risk Solutions Inc., likens Section 831(b) to Section 401(k) of the tax code, which authorized the now-ubiquitous employee-retirement savings plan.

That retirement plan, he notes, did not gain popularity until the 1970s—long after the tax code allowed it—because employers did not understand that it could be applied far more broadly than to top executives.

A third reason—and part of the explanation as to why more businesses are aware of the option—is that captive managers and related service providers are looking to grow by aggressively promoting the 831(b) option.

Tax attorney Chaz Lavelle, a partner at Bingham Greenebaum Doll LLP in Louisville, Ky., says the saturation of captives among Fortune 1000 companies has meant the sector has had to turn to smaller companies for new business.

And finally, the economic upheaval that began in 2008 stopped many companies from forming 831(b)-eligible captives, creating pent-up demand for them now that the economy has begun to turn, says Martin Everleigh, chairman of Cayman-based Atlas Insurance Management.

DOMINANT DOMICILES

The most popular U.S. domiciles for 831(b)-eligible captives are Utah, Delaware and Vermont, where more than 500 such facilities are domiciled.

Regulators say they do not classify licensed captives by their tax-code status, but they can determine by annual-premium volume whether a facility is 831(b)-eligible.

Combining 94 traditional captives and 174 series-business units that are eligible for 831(b) status, Delaware had 268 such facilities at year-end 2011, according to Kinion.

In Utah, 178 of 239 licensed captives at year’s-end 2011 appeared eligible for 831(b) status, according to Ross C. Elliott, the captive insurance director at the Utah Insurance Department.

Among Vermont’s 590 licensed and active captives at year-end 2011, 156 reported less than $1 million of premium volume, including some that reported none, according to David Provost, Vermont’s deputy commissioner of captive insurance.

Offshore, Anguilla, Bermuda, Cayman and Nevis rank as popular domiciles for 831(b)-eligible captives.

Experts have no firm count on the total number of 831(b)-eligible captives, but they offer anecdotal estimates. Huish of Artex believes there are between 1,000 and 2,000 such facilities worldwide.

Artex helped more than 60 clients establish such facilities in 2011—its best year for such formations, he notes.

PROsPECTIVE FORMATIONS FACE TAX, DISTRIBUTION CHALLENGES

Technically, a captive owner does not “form” an 831(b) captive. Rather, any P&C insurer that has written no more than $1.2 million of either annual-net or direct-written premium can simply elect tax- advantaged treatment under Section 831(b) of the Internal Revenue Code.

The insurer would then not be taxed on its underwriting profit; it would be taxed only on its investment income.

That tax treatment, however, is not completely favorable to small insurers, says tax attorney Lavelle. If the insurer reports an underwriting loss, for example, it still would be taxed on its investment income without any offset for that loss, he says.

In addition, the insurer cannot carry forward an underwriting loss to future tax years. 

Then there is the issue of risk distribution.

Even if a midsize company intends to underwrite legitimate insurable risk, only 10-15 percent of them have enough business units to meet the IRS’ safe-harbor rule on risk distribution, says Huish. (The safe harbor is a dozen business units, although fewer could conceivably pass muster with the IRS, according to Lavelle.)

For most midsize companies, that means their captives would have to write significant third-party risk either directly or by participating in a risk-pooling (or reinsurance) arrangement with unrelated businesses for the IRS to consider their captives true insurers eligible to elect 831(b) status.

ABUSE BY THE WEALTHY RISKS IRS SCRUTINY; WILL IT SPOIL 831(B) USE FOR EVERYBODY?

While state regulators generally welcome the increasing captive business in their jurisdictions being driven by growing interest in the 831(b) option, Kinion, Ross and Provost all say they proceed with caution when prospective captive owners approach them with plans of setting up small captives.

The problem, according to these regulators—as well as several captive managers—is that many prospective 831(b) owners are simply wealthy individuals who intend to utilize midsize captives to help protect their assets.

Regulators and captive managers say they try to turn away such individuals because they believe they would not insure true risk or meet IRS risk-distribution rules.

But some must be getting through, because numerous estate-planning professionals openly advertise on their Web sites their ability to help wealthy clients.

One such site writes: “There is a great deal of opportunity for estate-planning as part of an 831(b) captive strategy. Ownership of the captive can be established inexpensively for younger generations, and underwriting profits from the captive insurance company can accrue to those younger generations.”

The use of 831(b)-eligible captives for estate planning—and the risk-distribution challenges that midsize companies face—have soured London-based captive consultant Hugh Rosenbaum on the 831(b) concept.

Rosenbaum, owner of Hughro Ltd. and a retired principal at Towers Watson, applauds regulators and captive managers for turning away estate-planning business.

Still, the formation of those types of captives eventually could trigger an IRS response that severely limits the usefulness of Section 831(b) for even legitimate alternative-risk-transfer purposes, he says.

The risk-distribution issue that compels many 831(b)-eligible captives to assume third-party risk also troubles Rosenbaum. He says that practice goes against the original underlying concept of captive insurance: covering one’s own risk in a more cost-effective manner than purchasing commercial insurance.

“The original captive principles are being debased,” says Rosenbaum. “It’s a bit theoretical,” he acknowledges. “But someone has to say it.”  

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