Tax Evasion Issues Hound Captives
It’s inaccurate and unfair to characterize captive insurance companies as “primarily engaged in tax evasion,” as one international group did, said Dennis Harwick, president of the Captive Insurance Cos. Association (CICA) at the group’s international conference in Scottsdale, Ariz. on March 9-11.
Even as the Internal Revenue Service and some state and federal regulators increase their scrutiny of captive financial arrangements, Harwick noted that “captives are not a hidden device. They are not an offshore secret bank account. … They are visible, regulated companies.”
Two of the main issues drawing attention are the improper use of IRS section 831(b) – which allows underwriting profits of captives with at least $1.2 million in premiums to be tax free – and the use of captives by commercial insurers for reinsurance.
“There’s nothing inherently wrong with using 831(b) but it has to be a real insurance product,” Harwick said.
For some companies, that is not the case, said Thomas F.X. Hodson, president of the Connecticut Captive Insurance Association. He “absolutely agrees” that some captives are being formed for tax evasion, often at the suggestion of “wealth managers.”
“If risk management is not your first priority in organizing a captive program, don’t organize a captive program,” he said. If tax issues are the primary reason, “it is the wrong reason and you will get in trouble.”
Suspect captives – reputedly said by an IRS auditor – are those seeking to protect against the risk of tsunamis in Nebraska, said Daniel Kusaila, director of the insurance tax group at Saslow Lufkin & Buggy, a CPA and consulting firm.
He said his firm has received calls from companies interested in setting up a captive and it “turned them away” when they were unable to define the risks they wanted the captive for.
Nevertheless, a lot of information continues to be disseminated on the tax advantages of captives, instead of focusing on the risk financing objectives, he said.
Matthew Takamine, managing director at Beecher Carlson in Honolulu, said that most times, tax implications are “almost an after thought. … It’s never a good idea to design a program to take advantage of the tax law. That’s just asking for the IRS to audit your program. The insurance aspect always comes first.”
Another main issue drawing some regulatory attention, said Sanford Saito, captive insurance examiner for the State of Hawaii Insurance Division, is the use of captives for reinsurance by commercial insurers. That’s an area being looked at by the National Association of Insurance Commissioners, the New York State Attorney General, and others.
“They will start taking a look at it and looking at the quality of the assets backing the risk,” he said. “If the risk is ceded to a captive, what is the captive expected to put up as collateral … ? How is the credit for reinsurance being supported?”
The difficulty comes in trying to set up broad guidelines for captive use, many of the conference attendees noted.
“Each [captive] is different and each one has its own purpose,” Saito said. “That’s what the basic purpose of a captive is.”
Harwick noted that long-time observers have said “the sky is falling and this will be the end of captives” off and on for many years, but captives remain a viable vehicle.
“It’s an industry that is characterized by innovation and flexibility,” he said, noting that CICA is carefully reviewing any proposed regulatory changes and “obviously we object” to some.
The attempt to “pigeon hole” captives under one set of regulations is based on a misunderstanding of the vehicle, he said, which is “to address the needs that are unique to your business or hard to place in the commercial insurance market.”
Even with the increased scrutiny, interest in the use of captives is apparently growing. Nearly 600 people attended the conference this year. It was an all time high.
Advice for Employers as Congress Considers Fate of Backstop
“As insurers evaluate their business in light of the uncertainty, some have limited their underwriting of workers’ compensation for companies with high concentrations of employees in major cities,” states a new report. “Because insurers cannot exclude terrorism-related losses and employers are required to buy it, the options available to buyers have been reduced and rate increases have accelerated.”
The statement is included in an update on the impending expiration of the Terrorism Risk Insurance Act. The risk management research briefing was produced by Marsh, as workers’ comp practitioners ponder the impact of the expiration of the government’s financial backstop program.
TRIA was implemented after the 9/11 attacks to cap insurance losses from a large-scale terrorist event. It has been extended twice, but the latest version, the Terrorism Risk Insurance Program Reauthorization Act of 2007, is due to sunset on Dec. 31.
Three separate bills before Congress would extend TRIA for five to 10 years. Organizations such as NCCI, the National Association of Insurance Commissioners, and industry trade associations have been speaking to members of Congress in support of the legislation.
According to NCCI, each bill has bipartisan support. However, the administration has not clarified its position on TRIA.
“Insurers in 2014 are underwriting workers’ compensation policies that contemplate coverage without the potential financial protections of TRIPRA, presenting challenges for some workers’ compensation buyers,” the Marsh briefing explains. “Most insurers are less willing to underwrite the risks of employers in certain high-profile industries, with large employee concentrations, or in certain major cities. Such employers are likely to experience higher rates and premiums as the uncertainty over TRIPRA continues.”
Other insurers are attaching endorsements to policies while still others are setting policy expiration dates to coincide with the expiration of TRIPRA, according to Marsh. The idea is to put the onus of the uncertainty of the program onto insurance buyers.
Marsh suggests starting the renewal process as early as 120 days or more to better manage the situation. “The importance of providing a differentiated view of an organization’s terrorism risk profile to insurers cannot be overemphasized,” the report says. “To achieve this, employers should work with their advisors to develop communication strategies and presentation tactics around all key risk exposures, including modeling and risk analytics in support of their renewal objectives.”
Employers are advised to prepare detailed information for underwriters on their exposures and operations, including loss trends, safety programs, and risk management practices. Insurers have “significantly increased questions focused on the risks associated with a potential terrorist event,” the briefing says. It suggests employers facing aggregation issues have the following information available:
- Employee marital/dependency status.
- Employee telecommuting/hospitality practices and impact on concentration.
- Physical security of the building, including guards, surveillance cameras, parking areas, and HVAC protections.
- How access to the building is controlled.
- Construction of the building and location of the offices.
- Management policies around workplace violence, weapons, and employment screening.
- Employee security procedures.
- Emergency response/crisis management plan and procedures.
- Fire/life safety program.
- Security staff.
Employers that have multiple shifts or operate in campus settings are advised to provide additional information to better reflect their actual exposure to catastrophic losses at a given time. Such information would include the total number of employees and the number working during peak shifts, the actual buildings where the employees are located, and the percentage of the workforce in the field or telecommuting rather than in the office.