Charles J. (Chaz) Lavelle, Ross D. Cohen and Bailey Roese, partners at Dentons Bingham Greenebaum LLP, explain the legal requirements attached to creating and operating a captive insurance company

The creation of a captive touches on five different legal practice areas: corporate, contract, insurance regulatory, tax and securities.

Each of these run on parallel tracks, but each must be accounted for to ensure the creation and operation of a valid captive insurance company.

Corporate law

Legal compliance considerations for captives often first arise in the area of corporate law, when the entity is being formed.

Historically, captive insurance companies were for-profit corporations. From a legal perspective, all corporations must have governing documents. In the United States, the principal governing documents for corporations are typically the articles of incorporation and the bylaws.

Similarly-purposed documents with different names are used in jurisdictions outside the US.

US corporate law often varies from non-US corporate law. For instance, US states’ laws generally do not allow a director to provide a proxy, while it is permitted in some non-US jurisdictions.

Many captive domiciles require that at least one board of directors meeting – usually the annual meeting – be held in the domicile. Moreover, most domiciles also require a resident director – a director of the captive who resides in the domicile.

One fundamental characteristic of a corporation is that it offers quite limited liability for its owners: the creditors of the corporation can only seek repayment from the corporate assets and not the assets of the owners.

The US court decisions are well-developed on the rare instances when creditors can ‘pierce the corporate veil’ and obtain judgements against the owners. Today, many US jurisdictions permit the captive to be a limited liability company (LLC), a non-profit corporation or other organisation.

An LLC’s limitation on liability has been less often tested in the courts, although LLCs are generally formed with the expectation that the limitation on liability will be comparable to that of a corporation.

A captive may also be organised as a division of another entity. A cell company is a corporation with divisions (called cells), each of which have limited liability. Accordingly, if properly organised and managed, the creditors of one cell cannot demand payment from the assets of other cells.

To date, this concept has not been significantly tested in the courts. Some jurisdictions permit a cell to be incorporated, which would presumably provide more certainty of its treatment.

Similar to cell companies, a series LLC is an LLC which has separate divisions, each having limited liability. The divisions are called series and their ability to provide limited liability on a series-by-series basis has not been tested in the courts. Not all states have enacted statutes authorising series LLCs.

Contract law

Every corporation enters into numerous contracts regardless of the corporation’s business. Captives are no different and enter into insurance policies and reinsurance contracts, among others.

These insuring and reinsuring contracts are the heart of the captive’s business and should be reviewed in great detail by the principals, corporate officers or professionals who advise the principals or officers.

It is advisable to seek the commercial insurance broker’s assistance in coordinating the commercial and captive insurance coverages.

The scope of the insurance, the exclusions, premiums, the measure of damages, time constraints on filing claims, obligations to arbitrate, pricing, and so on, are several of the myriad critical aspects in these insuring and reinsuring documents.

If a pool or other reinsurance arrangement is involved, among the items of particular concern are whether the funds are withheld until claims are paid, the termination of the arrangement, and the ability to withdraw funds.

In addition, captives will often contract for services for captive management, actuarial analysis, tax return preparation, claims management, financial auditing and investment advice, among others. Again, each engagement contract should be reviewed carefully.

Among the provisions of most interest are pricing, term, termination provisions and any limitations on indemnification and scope of services. Further, claims documents and procedures are important aspects of the captive’s operation.

Insurance regulatory law Insurance is a heavily regulated industry, so there are many regulatory obligations imposed on captives, including obtaining and retaining/renewing a certificate of authority to conduct insurance in a domicile.

There are requirements for capitalisation. For example, there is often a minimum capitalisation requirement.

The regulatory body of a particular domicile may require that this be provided in cash or may permit a letter of credit or surplus note, using forms provided by the regulator.

A surplus note is a loan, which is subordinated to the claims of its insureds, meaning the surplus note cannot be repaid until payment of each claim has been assured.

Surplus notes may be further subordinated. Typically, state insurance regulators must approve distributions of the captive’s assets and, sometimes, loans to the captive’s affiliates.

Tax law

To be valid for tax purposes, an insurance arrangement should be done for good non-tax business purposes, involve an insurance risk which is shifted and distributed, and be insurance in its commonly-accepted sense.

The captive should be organised, operated and regulated as an insurance company, have adequate capitalisation, valid and binding policies, good claims arrangements, as well as reasonable premiums.

Under US tax law, every captive insurance company is taxed as a C corporation, regardless of the form of entity (for instance, an LLC is generally taxed as a ‘pass through’ entity by default, but not if it is an insurance company).

This is often a surprise to those who are unfamiliar with captive insurance taxation. If there is a good arrangement for tax purposes, premiums are generally deductible by the insured and taxable to the insurance company.

The primary tax difference between self-insurance and insurance is that with self-insurance a claim is generally deductible only when paid, whereas an insurance company – including a captive – can deduct the discounted present value of insurance reserves.

A small insurance company is taxed under section 831(b) of the Internal Revenue Code (IRC) only on its investment income and not on its insurance income; such a company’s annual premium must not exceed $2.65 million, indexed for inflation. Premiums are the lesser of direct premiums or net written premiums.

Section 501(c)(15) of the IRC provides for complete income tax exemption for the smallest of captives. For several years, the US Internal Revenue Service (IRS) has been auditing many small captive insurance companies very intensely.

Beginning in 2015, and for most years thereafter, the IRS has warned taxpayers that a captive should not be used abusively (the so-called ‘Dirty Dozen’ transactions). On 1 November 2016, the IRS issued Notice 2016-66 which labelled most small captive arrangements as “transactions of interest”.

This required captives, their insureds and any pass-through owners of the insureds to file Form 8886, and many service providers to file Form 8918.

There are continuing obligations to file these forms, depending on the facts. The validity of such notice is being contested in the courts and participants should consult their tax advisors for the then-current status.

Beyond the audit stage, the IRS has also challenged numerous small captives in the courts. It has been successful in 2017 (Avrahami case), 2019 (Syzygy case), 2021 (Caylor Land & Development case), and 2018 and 2022 (Reserve Mechanical case); these are the only four small captive court opinions, but others are forthcoming.

The IRS has announced it has deployed 12 additional audit teams to conduct thousands of small captive audits, and has extended two settlement programmes in an attempt to eliminate all abusive arrangements.

Securities law

In a single-parent captive, there are generally no US securities law issues. There may, however, be federal and state securities law disclosure obligations imposed on captive managers and others involved in group captives, cell companies or series LLC captives.