Some notes on Captive Insurance
As insurance premiums mount, we review the concept of captive insurance.
Requirement for captives:
According to journal of accountancy article
For the premium payment to the captive to be deductible as an insurance expense, the captive must be able to prove that it is a valid insurance company (payments for self-insurance generally are not deductible (L.A. Thompson Scenic Railway Co., 9 B.T.A. 1203 (1928)). Besides obtaining an insurance license from a state or a foreign jurisdiction, the captive must provide insurance to the operating company or its affiliates. Insurance was defined for tax purposes in Helvering v. LeGierse, 312 U.S. 531 (1941), which stated that insurance must include elements of risk shifting and risk distribution.
To meet the risk-shifting requirement, the operating company must show that it has transferred specific risks to the insurance company in exchange for a reasonable premium. In Kidde, 40 Fed. Cl. 42 (1997), the Court of Federal Claims described the risk-distribution concept as follows:
Risk distribution occurs when particular risks are combined in a pool with other, independently insured risks. By increasing the total number of independent, randomly occurring risks that a corporation faces (i.e., by placing risks in a larger pool), the corporation benefits from the mathematical concept of the law of large numbers in that the ratio of actual to expected losses tends to approach one.
Thus, the captive must be accepting risks from multiple separate entities to satisfy this requirement.
The IRS has issued a number of revenue rulings that provide guidance to captives to ensure compliance with these factors (see, e.g., Rev. Rul. 2002-89). In addition, in Rev. Proc. 2002-75 the IRS stated that it would begin to issue private letter rulings on specific companies’ risk distribution and risk shifting and whether the captives are true insurance companies.
There is one additional requirement for the captive to be considered an insurance company for federal purposes. More than 50% of its total revenue must be from the issuance of insurance or annuity policies (Sec. 816(a)). In the early years of a captive’s existence, this requirement should not present a problem, but in later years, assuming the captive and its investment program succeed, this would need close monitoring to assure compliance.
Bermuda or Other Jurisdiction:
captives can be setup in the States. Licensing requirements depend on the State where insurance is sold. Alternatively, Bermuda and Cayman are possible jurisdiction for captives.
Hong Kong has regulations for captive insurance
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