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IRS takes a closer look at captive insurance setup


INDIANAPOLIS — Historically a heavily regulated industry, U.S. insurers are facing more scrutiny ranging from an increasingly inquisitive Internal Revenue Service at home to more assertive regulators abroad.

As the use of captive insurers has become more popular, the industry is drawing a closer look from treasury and tax officials, said Brian Kilbane, St. Louis-based senior manager at tax advisory and consulting firm Dixon Hughes Goodman L.L.P.

The IRS is increasingly focused on the issues of risk shifting and risk distribution when assessing the tax status of captive insurance companies, Mr. Kilbane said. Companies that focus on accruing the tax benefits of establishing a captive without demonstrating that a risk has been transferred run the risk of “adverse outcomes” from the IRS, he said.

“If you are a captive, you must prove that the risk transferred for a reasonable premium. Rates have to be actuarially determined. You just can't set arbitrary premiums to max out tax deductions,” Mr. Kilbane said, during a panel discussion held at this month's Insurance Accounting & Systems Association Inc.'s 2014 Educational Conference and Business Show.

Fellow panelist Douglas Stein, Atlanta-based partner with Strategic Law L.L.C., said a common mistake many companies make when establishing a captive is structuring it in such a way that there is little chance the captive can lose money.

“By definition, insurance requires risk of loss, so if there's no chance of loss it's not really insurance,” he said. “There's nothing better-looking to regulators than a captive that's had a claim.”

Captives increasingly must pass a “smell test” with regulators, Mr. Stein said. He cited the example of a farmer in Iowa that ran afoul of regulators after he established a captive. In addition to standard coverages, the farmer paid hefty premiums to the captive for kidnapping insurance despite the fact that he didn't hold a passport and had never left Iowa.

“How likely is that person to be kidnapped?” Mr. Stein asked. “That's a good example of an insurance transaction that won't pass regulatory muster.”

Moreover, Mr. Kilbane said a January ruling by the U.S. Tax Court saying that subsidiaries of Rent-A-Center Inc. are entitled to deduct premiums paid to the company's captive insurer from federal taxes, should provide only limited reassurance to captive owners.

In the case, the IRS accused the rental company of using “sham transactions” and questioned whether a real risk transfer was taking place between the company's subsidiaries and its Bermuda-based captive. While the court ultimately ruled in the company's favor, the IRS still may appeal the ruling, and not all captive owners may be willing to fight a protracted legal battle as Rent-A-Center did, he said.

“The IRS has said not to construe the recent ruling as a safe harbor,” Mr. Kilbane said. “The IRS will look at specific facts of each case and rule accordingly.”

On the world stage, James Morris, Baltimore-based senior manager and director at advisory firm ParenteBeard L.L.C., said all insurers, regardless of size or line of business, are operating in an evolving regulatory environment.

Mr. Morris said that while the Dodd-Frank Wall Street Reform and Consumer Protection Act left the state-based system of insurance regulation untouched, the United States is not entirely removed from the influence of international regulatory bodies such as the International Association of Insurance Supervisors and the Financial Stability Board of the G-20.

Given the FSB's stated goal of addressing “too big to fail” financial institutions, insurers need to be leery of bank-centric rules being applied to the insurance industry, Mr. Morris said, noting that the Basel, Switzerland-based FSB designated nine global insurers “systemically important.''

“The FSB is really starting to flex their muscles,” he said.