Burlington, VT (July 26, 2013) — A ruling last month by a United States district court in Texas flashed a yellow caution signal to certain segments of the captive insurance community. For example, some mini-captives, which may be organized specifically to meet the requirements of section 831(b) of the Internal Revenue Code, may need to recheck their captive’s priorities to ensure legitimate business purposes support their creation.

Last month, the court ruled that premiums paid into a captive insurance company and then used to purchase offshore Business Protection Policies (BPPs) did not have a legitimate business purpose, and were instead simply an estate planning strategy. Those who have established mini-captives without the proper foundation supporting legitimate insurance purposes may therefore need to reorder their priorities.

At JLT Towner we believe that captives qualifying to be taxed under IRC Sec. 831(b), when structured and maintained properly, give smaller companies an opportunity to take advantage of insurance benefits large companies have long enjoyed. The court ruling doesn’t change these advantages, nor does it specifically target mini-captives. However, it is a first sign that the Internal Revenue Service is looking very seriously at captives designed primarily for estate planning, and not insurance, purposes. 

Why a mini-captive
In both form and substance, there is almost no difference between a mini-captive organized pursuant to 831(b) and any other insurance company, except a mini-captive insurer underwrites no more than $1.2 million in annual premium. In such cases, the captive may not be subject to income taxation on its underwriting income, only on its investment income. 

The purpose of the statute is to promote the dedication of capital to insurance ventures, with the ultimate intent of having the insurer grow well past $1.2 million in premiums so that it eventually will be taxed in parity with other insurers.

“Small captives with a valid business purpose and a solid insurance program shouldn’t have to worry too much about this ruling,” says Thomas P. Stokes, Managing Principal and U.S. Consulting Practice Leader of JLT Towner. “Owners of poorly assembled or pre-packaged IRC Sec. 831(b)s, however, may want to reexamine the way their captives are set up.”

Stokes urges mini-captive owners to revisit the underlying business rationale for establishing their captives. He says that while estate planning is a structuring opportunity, it simply cannot be the driving reason for having a captive. The key, he says, is to make sure the strategy and execution of these captives meet established captive industry standards.

Insurance comes first
“First, the captive has to be about insurance,” says Stokes. “Ask, ‘Is there a valid business purpose for the captive?’ Next, make sure the amount of premium the captive generates is actuarially sound and that the captive can afford the capital necessary to support risk. Only if there is enough critical mass to justify a robust insurance program should structural planning occur.”

Ultimately, a captive that is set up and maintained as a true insurance vehicle and elects to be taxed on its investment income under IRC Sec. 831(b) should survive scrutiny. We do work with these companies under the right circumstances, and are happy to review your existing program to make suggestions.

For more information about how best to address your company’s risks, please contact us to learn how JLT Towner and our global partner, JLT Insurance Management, can assist you with your unique captive management and risk financing efforts.

JLT Towner is an independent, full-service captive insurance management and captive consulting company with a multi-domicile reach. A partner of Hanover Stone Partners, LLC, JLT Towner is dedicated to providing alternative risk solutions to meet diverse needs.