Last Wednesday US news website The Daily Beast described captive insurance companies as tax shelters in an inaccurate headline aimed at US democratic candidate Bernie Sanders.
“The One Corporate Tax ‘Shelter’ Bernie Supported Was In His Backyard”, the headline on the politics and pop culture focused site reads.
The article went on to report a number of untrue, partially true or misinformed statements about captive insurance and Vermont’s captive insurance industry.
The premise of the article is that Sanders, who is currently one of the frontrunners to be the democratic candidate for President, opposes tax shelters and wants to increase corporate tax, but has supported the Vermont captive industry, which is a tax shelter.
Dan Towle, President of the Captive Insurance Companies Association (CICA), said that because captives are so misunderstood by the mainstream media that “salacious headlines” about the industry are common.
“Unfortunately, more often than not, captive insurance is universally misunderstood throughout the world,” Towle said. “I think part of this is designed ignorance by the mainstream media as it is easier to create salacious headlines when you refer to captives as ‘tax shelters.’ This is further exacerbated by online news aggregators that simply grab headlines and expose them to a much wider audience.”
Ian Davis, director of financial services at Vermont’s Department of Economic Development, works on promoting the captive industry.
“As this article makes abundantly clear, one of the biggest misconceptions is the idea that captives are somehow a tax ‘shelter.’ The tax ‘shelter’ is simply that captives are taxed as insurance companies,” he said.
“Vermont licenses captive insurers based on their needs for managing and financing risk. We expect all companies to follow the tax code. At no point was there mention of the fact that some of the biggest users of captives are not-for-profit organisations such as hospitals and educational institutions, who are already tax exempt.”
831(b) and the IRS
The crux of the article, and calling captives a tax shelter, is linked the Internal Revenue Service’s (IRS) recent focus on captives who have taken an 831(b) election, trying to link this to the entire industry.
Captives with less than $2.3 million in net premiums written, also known as micro-captives, can make an 831(b) tax election. This figure was originally set at $1.2 million, then raised in 2017.
The 831(b) election allows captives to pay taxes only on their investment income, not on their underwriting income.
Jason Flaxbeard, alternative risk finance leader at risk management broker Beecher Carlson is a well-known commenter on the captive industry and has been following the 831(b) news for some time.
“Initially the 831(b) was designed to help companies in start-up mode, to allow them to grow in a way that they would build surplus in the early years of their growth,” Flaxbeard explained.
This election is legal for genuine insurance micro-companies.
In 2016 the IRS issued Notice 2016-66, which stated that they believed that certain micro-captive transactions have the potential to be used for tax avoidance and evasion. In 2018 it named 831(b) as part of its “Dirty Dozen” schemes which can be used to avoid taxes.
“What happened was a lot of tax planners went, whew hang on this looks pretty tasty, I like anything that has a 0% tax rate on it,” Flaxbeard said. “But insurance industry understood this fairly well and most of the operators inside the industry want to do things right.
“We’re trying to build a long-term platform. We’re trying to help our clients retain their risk. We want them to have all the stuff that captives were set up for, access to reinsurance, take money out of the insurance market where it’s overpriced, demonstrate that I’ve got coverage for specific events.
“Tax was never at the top of anybody who’s in the industry’s list of reasons to have a captive. It was the other parties that started looking at pieces of the tax code.”
In fact the captive industry is so committed to doing things right that cases like that of captive manager CIC Services, who recently sued one of their own clients for fraud, occur.
CIC Services recently filed a suit against a former client, SRM Group, who had made the 831(b) tax election. SRM Group were not domiciled in Vermont.
The captive manager discovered that SRM Group and its owner, Suresh Prabhu, were misrepresented their intentions in forming captive insurance companies, and only formed the captive for tax avoidance purposes.
CIC Services is now suing Mr Prabhu and SRM Group for breach of contract and fraud.
“If you have no genuine insurance motivation for your captive insurance company, then CIC Services is not the place for you,” Sean King, general counsel for CIC Services said.
Vermont’s captive industry
David Provost, deputy commissioner at the State of Vermont, said that there aren’t even many micro-insurance captives in Vermont by his calculations.
“Our best estimate is that less than 5% of Vermont captives make the 831(b) election,” Provost said. “We determined this by sorting companies that wrote less than $1.2 million in premium (the limit at the time) and reviewing their audited financial statements.
“We can’t provide an exact count of Vermont captives making the 831(b) election because we simply don’t track companies based on their taxes – it’s not a regulatory concern.”
Heather McClure, the chief risk officer at OU Medicine, a captive that is domiciled in Vermont, knows better than most about how tax is not a factor in creating a captive. OU Medicine is a non-profit, so does not need a tax-reduction strategy.
“Tax has nothing whatsoever to do with it,” McClure said. “So many captives exist in non-profit entities anyway, like mine. I mean, we have no tax benefit at all because we’re not taxable anyway.
“And to equate all captives with the 831(b) captives is also grossly misinformed. The 831(b) industry, that’s an IRS regulation that they tightly control, and has nothing to do with the thousands of pure captives and RRGs that exist outside of 831(b) structure.”
The article also claimed that the Vermont captive insurance industry has “significant political muscle”, pointing to one meeting that Sanders had with Vermont Captive Insurance Association (VCIA) members when he was a senator.
“The article failed to understand the clear delineation that exists in Vermont between the marketing and business development functions, the role of the regulator, and the legislative advocacy efforts led by the trade association. While we all work in support of Vermont’s captive insurance industry, each are separate and distinct from the other,” Davis said.
Vermont is the largest captive domicile in the US, with 1,159 captives licenced and 559 active captives as of 31 December 2019.
“Fictitious or exaggerated risks”
In one of the most misinformed statements, the piece also quoted Adam Looney, a Brookings Institute economist that claimed that captive insurance companies were writing policies for “fictitious or exaggerated risks”.
While a small number of companies are being investigated by the IRS for creating micro-captive insurance companies specifically as a way avoid tax, as Flaxbeard pointed out, it was not the insurance industry itself that was forming captives for this purpose.
“The IRS is doing what it does to anyone who evades tax, they’re checking,” Flaxbeard said. “It’s perfectly normal, it’s standard operating issue for the IRS and I applaud them for doing it. None of us in the industry want bad actors. None of us want this to be an industry that is known for evading tax.”
As a captive owner McClure firmly disagreed with Looney’s statement, and said that not only was it untrue, but that her captive had done a lot of good for the community.
“Our captive has saved lives, I will put it that way,” McClure said firmly. “Our captive saves patient’s lives because of the way we’re able to fund patient safety and risk mitigation efforts. The money that we keep rather than send out to the commercial insurance industry is money that is put towards patient care.
“In my world, I know that our captive structure has saved lives. It has caused less injury to patients, less brain damaged babies, it has improved patient care in a way that we never could if we did not finance our risk using our captive model. So I’m particularly offended by this.”
Ultimately, the piece demonstrated that more education is required for the general public on the captive industry, as the damaging myths in the article still permeate.
“These are myths, this old antiquated thinking by someone who does not know the industry well,” McClure said.
“Whatever you think about Bernie Sanders, and I have no political opinion about Bernie Sanders at all, but whatever you think about him, this is just clearly a gross misuse of information. It’s falsehood and it’s for a pure political gain.”