U.S. Tax Court Validates Another Captive Insurance Arrangement

Captive Insurance ArrangementNovember 10, 2014 (Houston, TX) - Captive insurance planning is a complex area with many tax, legal, insurance and financial requirements that, if not satisfied, undermine the entire arrangement. The facts and circumstances of the arrangement, including the operations of the insurer, are critical.

Designing, implementing and managing a captive insurance company that satisfies all requirements is best left to competent professionals with the necessary background and  experience. The October 29, 2014 holding in Securitas Holdings, Inc. & Subsidiaries v. Commissioner of Internal Revenue1 highlights some of the important issues that must be addressed in any captive insurance arrangement.  In this high profile loss by the Internal Revenue Service, the U.S. Tax Court held that the captive insurance arrangement employed by Securitas Holdings, Inc. and its subsidiaries was a valid insurance arrangement for federal income tax purposes.

Valid Captive Insurance Arrangement

To be valid, all insurance arrangements must (1) cover insurable risks, (2) satisfy the requirement of risk shifting, (3) have sufficient risk distribution, and (4) be insurance in the commonly accepted sense. In Securitas, the Internal Revenue Service argued that the arrangement between the Securitas' operating subsidiaries and their affiliated captive insurance company was not insurance for federal income tax purposes because the arrangement lacked risk shifting and risk distribution, and was not insurance in the commonly accepted sense.2

The IRS stipulated that the risks underwritten in Securitas' captive insurance program were insurance risks; therefore, this prong was not at issue in the case. In early cases, the IRS took the position that risk did not shift from one party to another when the parties are related. After numerous losses in court, the IRS stated that it would no longer automatically consider there to be a lack of risk shifting between related parties but instead would examine the individual facts and circumstances of each captive insurance arrangement.3

One issue that the IRS has challenged vigorously is the presence of a parental guarantee; that is, a guarantee issued on behalf of a captive insurance company by its parent. The IRS argues that the parental guarantee invalidates risk shifting between the captive insurance company and the insured. However, the courts have disagreed on this point and ruled that the mere presence of a parental guarantee is not fatal.4 In Securitas, the tax court stated that the captive was not undercapitalized and did not contain any other flaws that would undermine the shifting of risk from the operating subsidiaries to the insurance company, such that the parental guarantee would be a fatal blow.

Another significant issue that the IRS frequently raises is whether sufficient risk distribution is present in the captive insurance arrangement. Lately, the IRS has focused on the number of insureds and the concentration of risk within each one. The IRS had provided a safe harbor where a captive insurer wrote insurance to 12 brother-sister subsidiaries, each with no less than 5% and no more than 15% of the total risk underwritten by any one subsidiary.5 The IRS took this approach in its attempt to invalidate the captive insurance arrangement in Securitas.

The IRS claimed that there was a lack of risk distribution due to the majority of premiums being attributable to a single subsidiary. Securitas argued that it had a vast number of employees, vehicles and services offered by numerous subsidiaries that were insured by its captive insurer. As such, sufficient risk distribution was present based on the large pool of statistically independent risk exposures.

Securitas claimed that this did not change when the multiple subsidiaries were merged into one; all of the independent risk exposures remained. The Court agreed with this reasoning and found that by insuring the numerous risk exposures, risk distribution was achieved. The final requirement is that the captive insurance program involves insurance in the commonly accepted sense. In addressing this requirement, courts have typically looked to whether or not the captive was organized and licensed as an insurance company by an appropriate domicile, whether the policies were binding, premiums reasonable, and the amounts due parties (premiums to the captive and loss claims to the insureds) were actually paid.

In analyzing each of these points, the tax court found that given all the facts and circumstances, the Securitas captive insurance arrangement constituted insurance in the commonly accepted sense

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1TC Memo 2014-225 (2014). 2 Helvering v. Le Gierse, 312 U.S. 531 (1941); Harper Group v. Commissioner, 96 T.C. 45 (1991), aff'd, 979 F.2d 1341 (9th Cir. 1992); AMERCO v. Commissioner, 96 T.C. 18 (1991), aff'd, 979 F.2d 162 (9th Cir. 1992). 3Rev. Rul. 2001-31, 2001-26 I.R.B. 1348 (6/25/2001). 4 Rent-A-Center v. Commissioner, 142 TC 1 (2014). 5 Rev. Rul. 2005-40, 2005-27 I.R.B. 4 (7/5/2005).


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