Using Protected And Incorporated Cells To Provide Captive Insurance: Benefits And Considerations

This article will unpack for the potential captive owner what benefits protected and incorporated cell transactions can offer while highlighting key considerations to take into account when evaluating entry into a potential captive arrangement.

What Is Captive Insurance?

A captive insurance company is, in its simplest terms, an insurance company that is owned and controlled by its insureds. Captive insurance can be an invaluable risk management tool to obtain coverage against risks that are currently being self-insured, to supplement existing coverage, and to obtain better control over the claims process. Historically captive insurance has been utilised by large corporations as the start-up, maintenance, and regulatory costs made them inaccessible to smaller potential insureds. More recently, so-called “micro-captive arrangements” have reduced the barriers to entry, and protected cell and incorporated cell companies have become a popular structure to facilitate such arrangements.

What Are Protected Cell And Incorporated Cell Companies?

A protected cell company is a corporate structure with a single-core and an unlimited number of protected cells.  The structure is often described as akin to a hub and spokes.  The protected cells are not distinct legal entities; they do not separately incorporate with the domicile but instead constitute separate entries on the core’s books.  The main benefit of this model is that the assets and liabilities of the cells are segregated and protected from claims by creditors of other cells within the structure.

An incorporated cell company is similar to a protected cell company but with more protection and more corporate formalities. Unlike a protected cell, each incorporated cell will be a separate legal entity with its own board of directors (although some jurisdictions require common boards between the core and its cells).  Each incorporated cell will also need to register separately with the domicile and obtain its own articles of incorporation.  Notably, incorporated cells can contract with each other and can sue and be sued in their own name.

How Protected Cell And Incorporated Cell Companies Help Facilitate Micro-Captive Arrangements            

As mentioned above, protected cell and incorporated cell companies have become popular vehicles for micro-captive transactions. In general, the core entity will act as a centralised insurance company that will either issue policies itself or facilitate the reinsurance of coverage from large commercial insurers.  Each participating insured will form its own protected cell (or more than one protected cell) with the assistance of the core.  The cell model allows cell owners to leverage the infrastructure and relationships with the regulator that the core has already built.  In many jurisdictions, the cell will not even need to obtain its own insurance license but will instead operate under the insurance license issued to the core. The regulatory approval process will also generally be more streamlined as the core is responsible for regulatory compliance on behalf of itself and each cell it forms.  In addition, the core will often provide or contract out for captive management services to ensure that administration of the captives are uniform across the arrangement.

Such captive insurance arrangements can substantially reduce administrative and start-up costs of forming a captive and can make captive insurance more accessible to small and mid-sized insureds. Furthermore, many protected cell and incorporated cell arrangements will include additional reinsurance and risk sharing among the cells in order to obtain increased risk distribution beyond what the insured could achieve on their own. As additional cells are formed, the insurance pool will become increasingly robust.  More generally, the hub and spokes model allows for individual insured ownership of the protected or incorporated cell while participating in a uniform insurance program run through the core.

The IRS’s Concern With Micro-Captive Arrangements

While captive insurance can be an invaluable risk management tool and protected and incorporated cell structures can help make captive insurance more accessible to small and mid-sized insureds, the IRS has expressed concern that these transactions may be abusive which has unfortunately been reflected in increased enforcement action.

On November 1, 2016, the IRS issued Notice 2016-66 which identified certain Section 831(b) Micro-Captive Transactions as “transactions of interest” that need to be disclosed to the Service on a Form 8886.  In addition, the IRS placed what it describes as “abusive micro-captive insurance tax shelters” on its list of “Dirty Dozen” tax scams in each year between 2015 and 2019.  More recently, emboldened by a series of wins in the United States Tax Court, the IRS announced the formation of 12 new examination teams dedicated to micro-captive transactions with the goal of opening audits of thousands of taxpayers.

The IRS’s main concern is simple. Under Section 831(b) of the Internal Revenue Code, an insurance company can elect to be taxed only on its investment income if its annual net written premium does not exceed US$2.3 million.[i]  Under this alternative taxation regime, the insurance company does not pay tax on premiums received. On the other side of the ledger, insureds can generally deduct premiums paid to an insurance company as ordinary and necessary business expenses under Section 162(a) of the Internal Revenue Code.  Because the insured, or a related party to the insured, will generally own the captive insurance company, the IRS views these transactions as a potentially abusive mechanism to shelter income.

If individuals or corporations are considering participating in micro-captive transactions through the formation of protected or incorporated cells, they should be careful and intentional in the arrangements that they choose to form a captive with. Doing proper due diligence and consulting qualified legal advisors will place the potential participant in the best position to obtain the risk mitigation benefits of a captive arrangement while reducing the chances of incurring an IRS audit.

Important Considerations

A potential insured will never have certainty that the IRS will not challenge the micro-captive arrangement they choose to participate in, but there are important considerations to keep in mind that can bring more comfort that the structure will withstand scrutiny.  The fundamental question at issue will be whether the captive insurance arrangement is considered insurance for federal tax purposes. The IRS has never identified micro-captive arrangements that it views as “legitimate” and that could be used as a model, but between case law and IRS guidance there are a number of characteristics that are particularly salient.

Courts have stated that insurance arrangements must involve actual insurance risks, risk shifting and risk distribution, and must conform to commonly accepted notions of what insurance is. In Revenue Ruling 2008-8, the IRS found that the same principles apply to determine whether protected cell structures qualify as insurance as apply to an arrangement with any other insurer.  When evaluating protected cell and incorporated cell structures it would be prudent to keep in mind the following:

Number of Risk Exposures/Insureds: Courts are looking for robust risk pools that provide substantial risk distribution. Many protected cell and incorporated cell structures will execute reinsurance and retrocession agreements between cells to bolster the risk pool.  Potential participants should inquire how many other insureds are participating in the pool and what type and volume of risk exposures are being insured. The larger the pool, the more likely a court is to rule that there is sufficient risk distribution.

Loss Ratio: Courts will sometimes interpret a lack of claims as evidence that risk has not actually been shifted to the captive arrangement and may rule that the transaction looks like a circular flow of funds that lacks economic substance.  Notice 2016-16 notes that a loss ratio of less than 70 per cent may be suspicious. Many captive insurance arrangements will not have a loss ratio that high, and no court has required one, but when evaluating captive insurance arrangements it would be prudent to inquire about the claims history of the pool and preference structures with an active claims process.

Actuarially Determined Premiums: It is important that insurance premiums are set by reputable actuaries pursuant to a valid actuarial model. In some of the court cases that have analysed micro-captive structures, there was evidence that the insured sought higher premiums or premiums set to the 831(b) limit so that they could increase the deduction they claimed on their tax return.  Potential participants should inquire about the actuary that performs premium pricing and do research to confirm that they have a suitable reputation within the industry.

Sufficient Liquidity: Many captive insurance structures will permit the investment of some portion of the funds held in the captive. Courts look sceptically on structures where captive owners are overly invested in illiquid or risky assets such as life insurance or derivatives or if substantial related party loans are being taken out of the captive.  Potential participants should inquire about the investment policy of the captives and make sure that particularly the amounts that satisfy the domicile’s capitalisation and reserve requirements are only held in liquid investments such as cash.

These factors are far from exhaustive, but their due consideration can bring additional comfort to the potential participant that they are making the right decision when forming a protected or incorporated cell as part of a captive insurance arrangement.

Footnotes:

[i] As well as other, more technical requirements, beyond the scope of this article.

Benjamin Z. Eisenstat
Mr. Eisenstat is an Associate in the Washington, D.C. office of Caplin & Drysdale. He assists individuals and corporations in all matters relating to coming into compliance with their U.S. tax obligations, as well as both civil and criminal defense before the IRS.