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WASHINGTON-The Clinton administration is renewing and stepping up its attack on captive insurance companies, with twin proposals aimed at curbing captive tax breaks.
Tucked into the massive proposed federal budget for 1998 is a provision-revamped and significantly expanded from a 1995 proposal-that would throw premium deductions for most captive owners into doubt.
The budget package, sent to Congress last week, also would revamp how the federal government pays health maintenance organizations for providing coverage to retired workers and would provide subsidies for COBRA health care premiums paid by lower-income workers who lose their jobs, as well (see story, page 21).
Like the 1995 proposal, the latest captive provision would bar a "large" captive shareholder or owner from deducting premiums paid to the captive if more than 50% of the captive's net written premiums were attributable to the insurance or reinsurance of large shareholders' risks.
While large shareholders are not defined, captive experts-based on what the administration earlier proposed-believe large shareholders would be parties that own at least 10% of a captive.
To comply with the new test, most captives would have to increase significantly the amount of third-party business they do in order for owners to continue to be able to deduct premiums paid into their insurance subsidiaries. That would be difficult for most captives to do.
The new 50% test would be a significantly higher standard for tax deductibility than those that courts have held. Several courts in the early 1990s ruled that a captive owner could take a tax deduction for premiums paid to its captive even if as little as 30% of the captive's premiums came from unrelated third-party business.
Going far beyond the 1995 proposal, the latest captive provision also says captives that generate more than 50% of their net written premiums from large shareholders no longer would be considered insurance companies for tax purposes.
That would mean captives could not take tax deductions for reserves established to pay for future losses. As a result, many captives' taxable income would increase, leaving less money to pay for reserves. That, in turn, could threaten some captives' solvency and affect all of a captive's shareholders, not just large ones, captive experts say.
"If I was a regulator, I would be very concerned," said Jon Harkavy, vp and general counsel of USA Risk Services Inc., a captive administrator in Arlington, Va., and president of The Coalition of Alternative Risk Funding Mechanisms, an industry group.
The Clinton administration, in its brief description of the twin captive proposals, did not explain why it believes tax rules affecting captives should be changed.
But captive experts say the Internal Revenue Service's longstanding belief that captives are no more than tax dodges are behind the proposals.
"I believe this is the result of IRS animus against captives. The IRS, to the extent it can, will try to create as many problems to discourage captives as it can," Mr. Harkavy said.
"This is an extension of the IRS' longstanding perception that self-insurance reserves are qualitatively different than reserves established by a commercial insurance company," said Tom Jones, a partner with the law firm of McDermott, Will & Emery in Chicago.
The captive industry, though, is gearing up to fight the proposals. Mr. Harkavy says CARFM soon will meet to develop a strategy to lobby against the proposals.
"If I could think of one issue worthy of the alternative insurance market to coalesce around to protect its existence, this would be it," he said.
"This should be the beginning of a significant lobbying effort on the part of insureds and group-owned captives to maintain the competitive position of alternative risk financing vehicles," according to Robert Dumont, a partner with Baker & McKenzie in New York.
While it is too soon to predict how successful the captive industry will be in resisting the proposals, Mr. Jones notes that tough lobbying last year led Congress to water down legislation that would have imposed new taxes on group offshore captives owned by tax-exempt organizations.
Under the original proposal, tax-exempt shareholders of virtually all offshore captives would have been hit with taxes on captive earnings. That proposal, though, in the wake of a vigorous lobbying campaign by hospitals, later was pared back to exclude tax-exempt hospitals and universities (BI, Aug. 26, 1996).
"What passed was much more lenient that what was proposed," Mr. Jones said.
But last year's success should not mean captive owners can afford to let their guard down, Mr. Jones and others say.
"I'm always scared to death that something like this could become law. That is because companies with captives have not always been particularly effective in protecting their turf," Mr. Harkavy said.