Captive insurance: How Congress can help fix high property insurance costs

By Matthew Queen

Everything is downstream from reinsurance. Reinsurance is expensive and nearly every single line of insurance is in a hard market as a consequence. This means that the property insurance crisis in Florida and the Gulf Coast is only a small part of a larger phenomenon.

The world’s insurance markets are expensive and there is no obvious catalyst to ease the prices in the foreseeable future. Consumers and brokers possess limited options to reduce the cost of insurance. The single best way to lower the cost of insurance is to purchase less of it. That means that consumers are retaining more risk.

Captive insurance is formalized risk retention. Businesses identify risks that they want to self-insure, develop rates with the help of an actuary, and secure an insurance license from a state department of insurance. The process takes a few weeks and incurs considerable cost in the startup. However, any assets not paid out as claims are retained as surplus. In other words, if the premiums are greater than the claims, then the business owner stands to earn a profit through the use of a captive insurance company.

Self-insured programs mean that commercial carriers provide less coverage for the insured. This radically reduces the cost of commercial insurance while setting up the business owner for a windfall in the event that risk management controls the cost of claims. Moreover, rates for the captive insurance program are not necessarily dependent on the cost of reinsurance. The rates within the captive are generally stable over time.

Unfortunately, the IRS disfavors small captive insurance companies. If a captive writes less than $2.65 million in premium, then the captive owner is permitted to make the 831(b) election. The 831(b) election is a century-old law within the Internal Revenue Code permitting small insurance companies an exclusion from paying federal income taxes. For small and mid-market businesses, this can create large tax benefits. The business is permitted to deduct premiums from gross revenues as a deduction and then any premiums retained in the captive post claims are not taxable as income to the corporation.

While this benefit has been reviewed by Congress countless times over the course of the past 100 years, the IRS regards the election with skepticism. While there have been abuses of the 831(b) election in the past, the IRS prosecuted the bad actors into oblivion. Regardless, the IRS dislikes the election and drafted proposed legislation to effectively remove the 831(b) election from the Internal Revenue Code.

In April, the IRS posted proposed regulations with the effect of turning the 831(b) transaction into a “listed transaction.” A listed transaction is a transaction identified by the IRS as abusive. In other words, the IRS wants to categorically consider any small or mid-market business making the 831(b) election as akin to operating a tax shelter. This is despite the following:

Commercial property insurance in Florida is increasing in double-digit percentages for all insureds in Florida.

Commercial property coverage in California is more expensive than ever before mostly due to wildfires and other hazards.

Reinsurance markets are hard in Bermuda, London and all of the U.S. markets, which means that all lines of property/casualty insurance are historically expensive

The best solution to lower the cost of insurance is to pay for less commercial insurance and retain more risk. Ironically, the IRS is doing everything it can to ensure that taxpayers continue to pay more for their insurance policies than necessary.

Congress can fix this. There is no authority for an executive agency to remove a whole law from the Internal Revenue Code. Congress can amend the 831(b) election to preclude the listed transaction. Simple amendments include permitting the 831(b) election for any captive insurance company that pays claims during a policy year or amend the election to directly state that risk distribution occurs if a certain amount of premium is received from third parties. Regardless of how Congress chooses to resolve the issue, the IRS is acting beyond its congressional authority by attempting to revoke a whole law it finds unwieldy and difficult to govern.

Matthew Queen is the owner of The Queen Firm, in Rome, Ga., a law firm providing captive insurance consulting services. Contact him at [email protected].