Expert Commentary

Captive Insurance Companies: Beware of New Treasury Proposal

On September 27, 2007, the Department of the Treasury issued proposed regulations to provide guidance in regard to the tax treatment of transactions between and among members of a group, including members who are insurance companies, i.e., captives. These proposals are significant and far-reaching.

October 2007

I will attempt to address them briefly in non-accounting, non-tax language. You should look into this if you have a captive or are considering one.


Some background may be in order. First, as a disclaimer, I am neither a tax professional nor an attorney. I am merely a captive consultant who frequently sits in meetings with such folks and listens to their views. Without question, you should seek your own counsel for advice on this new proposal.

Over time, the Internal Revenue Service (IRS) has sought to disallow tax deductions for premiums paid by a member of a group to another member of the group on grounds that have been referred to as the "economic family theory." In other words, the view of the IRS was that such transactions had no risk transfer and inadequate risk distribution; therefore, they should not be deductible for tax purposes.

The probable landmark case on this issue is known as the Humana decision. The court found that premiums paid in a related party group to a brother/sister, as opposed to a parent/child, were indeed deductible. With no prodding, in June 2000, the IRS announced that it would abandon the economic family theory of disallowing deductions. The formation of new captives exploded.

Proposed Change

When regulations are to be changed, the process is that the Department of Treasury announces the proposed changes, seeks public comment, holds hearings, and then puts them into effect, sometimes with changes and modifications derived from the public feedback. At the end of this article, I will tell you how to comment if you so desire.

The main point of the new proposal in regard to captives is to once again return to disallowing deductions for members of the same group in which one member is an insurance entity insuring the other members, i.e., a captive. The exact proposal involves the treatment of the accounting as to whether or not the premium payment will be considered a single entity for the combined group or on a separate entity basis for individual members. The code sections are to switch from § 1.1502-13(e)(2)(ii)(A) and (B) to the matching and acceleration rules of § 1.1502-13, if that helps you at all. If premiums paid by the combined group are in excess of 5 percent of the captive's revenues, it is deemed self-insurance, and no deduction for reserves is allowed.

In effect, the IRS is saying that such transactions are in fact self-insurance. With self-insurance, you cannot deduct funds set aside for reserves for future losses through the use of a premium. This challenges the entire foundation of captives; however, it may only affect certain types of captives.

Over the years since the Humana decision and the voluntary abandonment of the economic family doctrine, the world of captives has moved far beyond single-parent captives. This new proposal would seem to me to essentially affect large companies with domestic captives or offshore captives which have elected to be taxed as a U.S. entity under Section 953 D. It would also seem to affect certain specific captives in which the insuring member of the group is a related party, such as is the case with warranty coverage. While this encompasses a very large number of captives used by the Fortune 1000 and similar firms, it should not affect group captives, association captives, nonprofits, Non-Controlled Foreign Corporations, or risk retention groups.

The world of captives today has grown beyond the typical structure being addressed by Treasury. While these proposals, if put in place as written, will certainly negatively impact many, many captives, it will not impact all captives.

Industry and Association Response

Again, I urge you to seek professional guidance on this matter as it could have very serious consequences for you and your business. Several industry groups are discussing responses, including the Captive Insurance Companies Association, Vermont Captive Insurance Association, Nevada Captive Insurance Association, and Arizona Captive Insurance Association. And there will be others. I have learned that the Director of Insurance in South Carolina has written to every member of his state's Congressional delegation to mount resistance.

If you wish to read the proposal, it was published in the Federal Register on Friday, September 28, Volume 72, Number 188, page 55139.

If you wish to get involved directly, write to: CC:PA:LPD:PR (REG-107592-00), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, D.C., 20044. You may e-mail through the Federal eRulemaking Portal at (IRS REG-107952-00).

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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