Florida Bar Journal

What Every Business Lawyer Needs To Know About Captive Insurance and Why It Matters in Today’s Hardening Insurance Market

Not entirely distinct from the well-publicized homeowners insurance crisis that Florida is currently experiencing, Florida businesses are experiencing their own insurance nightmare. This insurance plight has brought with it rising premium rates and reduced coverage, exposing businesses to losses and thinner profit margins.^[1] Policy enthusiasts can debate the underlying cause of these rate increases, but the fact remains that it is becoming harder for businesses to protect themselves from fortuitous, sometimes catastrophic losses.

There is a solution, however, that most Florida businesses and their legal counsel have never heard of: captive insurance. Historically, the captive insurance industry has not done a very good job of marketing itself outside of the insurance sector. However, in today’s ever-hardening commercial insurance market, captive insurance companies can become life-savers for middle-market businesses. Lawyers who represent such businesses, regardless of the industry, need to understand why and how captives can help their clients.

Captive Insurance Companies

So, what is a captive insurance company (or a captive)? Florida law defines a captive insurance company as, “a domestic insurer established under this part. A captive insurance company includes a pure captive insurance company, special purpose captive insurance company, or industrial insured captive insurance company formed and licensed under this part.”^[2]

While technically correct, this merely identifies that such insurance company is organized under that specific legislative chapter and the three types of captives that are permitted under Florida law (by way of contrast, other states provide several other types of captive structures in addition to the three types allowed in Florida).

Looking beyond the bare-bones definition, a captive is an insurance company owned by a corporate affiliate or subsidiary that insures the risks of its parent and/or related entities.^[3] Generally speaking, since there may be jurisdictional constraints, captives may be used to insure against: 1) commercial property/casualty risks (e.g., business interruption, professional liability, product liability, cyber risk, directors and officers, loss of key contracts, loss of key person, workplace violence, etc.); 2) provide medical stop loss; and 3) reinsure against workers’ compensation and commercial auto liability losses.^[4] Captives, however, cannot be used for personal property lines like personal auto and homeowners liability. The rationale is simple, captives are intended to help business only. While prevalent among large, publicly-traded corporations, when it comes to smaller and middle-market businesses, captives are some of the most under-utilized risk management tools available, even in today’s toughening insurance market. In Florida, they are largely absent because of Florida’s restrictive legislation and higher premium tax rates.^[5]

Captives Provide Several Important Benefits

Why does this matter? It matters because a properly-run captive insurer can provide several, congressionally-intended and state-legislated benefits to non-fortune 1000 businesses including, but not limited to:

1) Plug in the gaps in the commercial insurance market where coverage is either unavailable or simply too expensive;

2) Improve the claims process;

3) Directly access the reinsurance market;

4) Premiums paid to a captive, as with a commercial carrier, are deductible as an ordinary business expense (and the insured business is paying those premiums to an insurance company that it owns);^[6]

5) Captives that comply with the requirements of, and make the election under, §831(b) of the Tax Code pay federal tax at the long-term capital gains rate on their premium income rather than the ordinary, corporate income tax rate which may result in a tax savings; and

6) Underwriting profits in a mature captive can be invested in a variety of ways, pursuant to state regulations, bolstering the corporate bottom line.

During the past few years, publications such as Forbes,^[7] The New York Times,[8] and The Wall Street Journal^[9] have praised the benefits of captive ownership as “nearly all Fortune 500 Companies” have a captive and approximately “90% of Fortune 1000 Companies” have one.^[10] In late 2023, the ratings agency, AM Best, noted that “with the continued growth in captive surplus and dividends, captives have saved their organizations an estimated $9.4 billion over the past five years in comparison to the traditional [insurance] market.”^[11]

Federal and State Regulations

Other than federal tax considerations, captives are largely regulated at the state level. However, not all states have passed legislation that permit captive formation or usage. As referenced earlier, Florida does have captive legislation in place (F.S. Ch. 628, Part V). But, in the author’s opinion, such legislation is not as well-developed as other states. For example, it fails to provide for critically important types of captives like protected cell captives and limited liability series captives which, because of their lower capitalization requirements, make forming and using a captive more accessible to middle market businesses. Florida’s captive application is also unduly burdensome compared to other states. For example: 1) other states’ captive applications are typically under 15 to 20 pages long — not including the business plan and feasibility study — compared to Florida’s 74-page application; further, 2) Florida requires two Florida residents to be incorporators, compared to just one required by more competitive states; 3) at $1,500, the application fee is two to three times more expensive than most other states; and 4) it requires fingerprints for all officers/directors of the captive, unlike other states, that just require a biographical affidavit.

Moreover, the Florida Office of Insurance Regulation does not have a captive-specific division that is active and growth-oriented (and out recruiting business owners to the state) the way other states like Vermont, Delaware, Tennessee, North Carolina, Arizona, Utah, and Hawaii.^[12] As a result, Florida, with its historically business-friendly environment, is missing out on a revenue stream by: 1) not having an active captive regulatory system (because states derive premium taxes and annual report dues from being a captive domicile); 2) not having legislation that enables a wider variety of captive insurance types; and 3) not encouraging business owners to establish their captives in this state.

Nonetheless, Florida businesses can still benefit from captive ownership even if their captives are domiciled out of state because they can have their Florida-based risks ceded to their captive insurer from a carrier admitted in Florida. This would be known as a “fronted” captive insurance program. Alternatively, and as permitted under the concept of “self-procurement,” a Florida business owner could leave the state and self-procure his or her out-of-state captive to provide direct insurance to his or her Florida-based business under the precedent found in State Board of Insurance v. Todd Shipyards Corp., 370 U.S. 451 (1962), which held that insureds have a constitutional right to go out of state and procure coverage with any insurer of their choice, though the state where the insured business operates and incurs its risks may assess a tax on the transaction and require it to be reported (the self-procurement tax).

Critically, though, and at the most elementary level, a captive insurer is just like any other insurance company that is in the business of earning premiums in exchange for indemnifying other entities against fortuitous loss.^[13] While captives are not subject to the same regulations as commercial carriers,^[14] they still must abide by various capitalization and filing requirements, and certain insurance industry standards.^[15] Moreover, because of the federal tax benefits associated with captive insurers and notwithstanding Congress’ clear intent to encourage businesses to use captives, the Internal Revenue Service (IRS), for decades, has scrutinized captives as a means to evade taxes. This is regardless of whether the captive is: 1) a large captive that is taxed under §831(a) of the Tax Code (where there is no limit on the amount of premium income the captive can earn each year), or 2) a small or micro-captive that cannot earn more than $2.65 million in annual premium and elects to be taxed under §831(b) of the Tax Code (wherein Congress incentivized smaller businesses by making the captive’s premium income subject only to being taxed at the long-term capital gains rate).^[16] Thus, because of this IRS scrutiny, for a business to seriously consider establishing a captive, it must be prepared to abide by the operational norms to which standard insurance companies adhere.

Scrutiny

One of the IRS’ recurrent attacks on captives is that they do not provide real insurance. To be considered real insurance, the U.S. Supreme Court mandates that: 1) the risk must be transferred to another entity (to the captive) and off the books of the insured; and, 2) that risk must also be distributed and diversified among a sufficiently large number of unrelated, independent risks.^[17] This diversification or distribution of the risk mitigates an insurer’s solvency concerns so that no single loss would jeopardize the totality of the premiums paid to the captive to cover such losses.

Achieving adequate risk diversification and distribution can be the most challenging hurdle for any captive owner to overcome. Whether the risk is distributed enough, and how such is evaluated, depends upon whether the captive is taxed under §§831(a) or 831(b) of the Tax Code.

Summarily, in the world of captives, risk distribution does not occur if a captive insures only one policyholder; or if a captive insurer (which is wholly-owned by a parent) insures various disregarded entities owned by that same parent.^[18] Fortunately, within the past several years, Congress, the IRS, and federal courts have provided guidance on how to achieve this important threshold.

On January 1, 2017, the Protecting Americans Against Tax Hikes Act (the PATH Act) went into effect, which, for §831(b) captives, established two bright-line tests for risk distribution:

1) The 80/20 test which mandates that no single captive can accept more than 20% of its risk and associated net written premium (or, if greater, direct written premium) from any single policyholder, wherein a “policyholder” applies to affiliated companies that share 50% or greater common, family ownership;^[19] or

2) The ownership or specified holder test that requires that ownership of the insured businesses and assets must mirror (within a 2% de minimis margin) ownership of the captive.^[20] A specified holder is a person “who holds (directly or indirectly) an interest in such insurance company and who is a spouse or lineal descendant (child, grandchild, great-grandchild) of an individual who holds an interest (directly or indirectly) in the specified assets with respect to such insurance company” that are defined as the “trades or businesses, rights, or assets with respect to which the net written premiums (or direct written premiums) of such insurance company are paid.”^[21]

These tests prevent captives from being misused as tax avoidance tools in the wealth transfer aspects of estate planning, but they do not apply to large captives taxed under §831(a) of the Tax Code that earn $2.65 million in annual premiums. Larger captives have other safe harbors to which they must adhere. These safe harbors are largely found in various IRS revenue rulings and federal court cases.

One notable example is Harper Group et al. v. Commissioner, 96 T.C. 45 (1992), where the Tax Court held that an insured parent that paid premiums to its subsidiary captive achieved minimum risk distribution because 30% of the captive’s premiums were paid from unrelated businesses. Ten years later, the IRS determined in Rev. Rul. 2002-89 that a captive that received 50% of its income from unrelated, non-parent premiums achieved adequate risk diversification and the premiums were deductible as an ordinary business expense. Likewise, in Rev. Rul. 2002-90, the IRS stated that premiums paid by 12 subsidiaries owned by the same parent were also deductible as their captive insurer achieved adequate risk distribution as no single subsidiary, each of which respected various corporate formalities and conducted themselves as distinct entities, paid more than 15% of the captive’s gross written premiums. Similarly, in a group captive setting (where multiple, unrelated businesses in the same industry co-own a captive to insure homogenous risks), the IRS declared in Rev. Rul. 2002-91 that 31 unrelated insured entities, each with less than 15% of the total risk insured (and associated premiums), provided the requisite risk distribution.

In addition to risk transfer and risk distribution, the captive — irrespective of its size — must also follow certain insurance industry standards, such as: 1) adherence to corporate formalities (i.e., annual meetings, corporate binders, bank accounts, etc.); 2) sufficient capitalization which is established by state statute and feasibility studies prepared by an actuary; 3) whether the captive operates like a traditional insurance company inclusive of insurance applications, underwriting processes, and timely issuance of real insurance policies; and 4) its regulation and adherence to claims protocols and the ability to promptly pay valid claims.^[22]

Whether a captive conducts itself pursuant to industry standards is determined by state regulatory authority since Congress “has delegated to the states to have exclusive authority, subject to exception, the right to regulate insurance.”^[23] With this in mind, business owners seeking to establish a captive would be well-advised to select a domicile that has an active and engaged captive regulatory commission since the IRS may evaluate whether the state is lax in its oversight as a method of discrediting whether a captive is legitimate. Because of the IRS’ scrutiny of a captive’s regulatory environment, and given Florida’s own limited captive regulatory program, the author cannot recommend that Florida businesses domicile captives in this state (unless the legislation is improved and the state becomes more active in its oversight of captives). They can, however, and as mentioned previously, establish an out-of-state captive, use a fronting relationship^[24] to provide the direct insurance for Florida-based risks, and then use their captives to indemnify the risks of the fronting carrier.

Ultimately, captives that fail to meet basic operational standards will likely fall under examination by the IRS which can lead to not only the disallowance of the deductibility of the insurance premiums, but late fees and tax penalties incurred by both the insured and the captive. In fact, the IRS has recently won several notable cases where captives and/or the policies themselves were deemed illegitimate. Important factors outlined in those rulings included: 1) a circular flow of funds among related insureds; 2) cookie-cutter premium allocation within a risk pool; 3) lack of risk distribution; 4) paying a premium that was five times more expensive than the commercial market for less coverage; 5) inadequate capitalization; 6) not having a real insurable risk (e.g., insuring hurricanes in Montana); and/or 7) not timely issuing policies.^[25]

Practical Implementation

So how does a business owner, inexperienced in the world of insurance operations, actually run a captive? Unless the business has the bandwidth to hire its own back-office support that includes actuaries, underwriters, and claims specialists, it should hire an experienced, reputable captive manager that stresses the importance of the captive being used for risk management, not tax avoidance.

In most every state that has an active captive marketplace, the regulators maintain and/or publish a list of captive managers approved to manage captives in that state. These regulators also maintain lists of approved CPAs and actuaries, know who the knowledgeable attorneys are, and have relationships with the financial advisors experienced in managing captive investments.

Captive managers typically charge setup fees and then earn an annual management fee based on a percentage of the captive’s annual premium income, or they will charge a flat, annual rate. Approved captive managers will have on staff or on retainer actuaries and underwriters who will identify insurable risks and ensure that the premiums are commercially reasonable and determined through an arm’s length analysis. The captive manager will also have claims specialists in place to ensure the timely and objective processing of any claims. Managers will work closely with the state regulators to ensure annual filing compliance. Managers will work with experienced accountants and other professionals to have the captive’s tax returns prepared and audited annually; and they will, critically, help each captive achieve the risk distribution that is needed. It does this by either management of a risk pool, which is regularly used in the commercial insurance world, where each captive has the requisite minimum risk distributed to unrelated captives via reinsurance, or by way of a direct, written subscription consortium akin to how international insurance syndicates underwrite their risks.

Because of the capitalization requirements for establishing a captive, which, in Florida, are higher than most states, ^[26] owning a captive may be unattainable to certain small businesses that do not have a minimum level of gross revenues. Depending upon the captive manager’s comfort level based on an analysis of the organization’s cashflow, the underlying business should have minimum gross revenues between $10 and $20 million. Nevertheless, those small businesses where owning a captive outright may be out of reach may still find it worth their while to speak with a reputable captive manager or other knowledgeable advisor that can discuss participation in an association or group captive where some of the setup costs are shared, deferred, and/or otherwise baked into the annual operating expenses.

Given that captive insurers provide tailored insurance programs unique to each business, and given the fact that they can be used in virtually every industry (including not-for-profits and state bodies), every business lawyer that develops a basic knowledge of how they can work could provide a valuable solution to his or her clients struggling to protect themselves against losses. Moreover, since Florida wishes to maintain its reputation as a business-friendly state, and since it is exposed to losing business by not updating its captive legislation, the author respectfully requests that elected representatives further develop the state’s captive insurance laws to complement its active solicitation of business to this state.

Conclusion

For the moment, Florida business lawyers could certainly aid their clients in identifying where their risks are under-insured or uninsured and suggest to their clients the possibility of establishing a captive to ultimately insure those Florida-based risks where commercial insurance is hard to come by. Reputable captive managers will work with a client’s legal, tax, and financial advisors, along with the regulators, to determine whether a captive insurance company is appropriate and the best way to structure it. In due course, considering Congress’ long-standing efforts to encourage the use of captives and the majority of states seeking to capitalize on their inherent value, business lawyers throughout Florida could help their clients enormously by evaluating whether captive insurance could provide their over-exposed, middle market clients with the same kind of protection that this country’s largest corporations already enjoy.

This column is submitted on behalf of the Business Law Section, Mark Stein, chair, and Daniel Etlinger, editor.