Dentons’ Charles (Chaz) Lavelle, Ross Cohen and Bailey Roese discuss requirements in the US and the
variance between other domiciles, captive formation types and more

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 US, 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. American corporate law often varies from non-American 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 limited liability for its owners: the creditors of the corporation can seek repayment only from the corporate assets, 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 judgments against the owners. Today, many US jurisdictions permit the captive to be an 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 (“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, entering 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, exclusions, premiums, 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, any limitations on indemnification and scope of services. Furthermore, 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 (or 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 nontax 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 and 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 currently deduct the discounted present value of insurance reserves.

A small insurance company is taxed under section 831(b) of the US Internal Revenue Code (IRC) only on its investment income and not on its insurance income; such a company’s annual premium must not exceed $2.8m, indexed for inflation.

Premiums are the greater 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 “Dirty Dozen” transactions).

On 10 April 2023, the agency issued proposed regulations regarding captives that elect section 831(b). Under the proposed regulations, nearly all small captive insurance companies would be considered a listed transaction in the eyes of the IRS, subject to strict reporting requirements and high penalties for failure to comply.

The captive industry responded with more than 100 comments, which the IRS has an obligation to consider.

As of 1 April this year, the proposed regulations still have not been finalised. 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), 2018 and 2022 (Reserve Mechanical case) and 2024 (Keating, Swift, and Patel cases).

These are the only seven small captive court opinions, but others are forthcoming. Through dedicated audit teams, settlement programmes, and now the proposed regulations, the IRS has been extremely aggressive in attempting to eliminate all abusive arrangements.

Securities law

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