September 2010, Vol 2

Message From An Actuary
Tim Luedtke, FSA, CFA

This edition of The Actuarial View discusses the unique issues facing business owners considering insuring employee benefits with their captive insurance company. Recent additions to Delaware's captive insurance law have made owning a captive both easier and more attractive for business owners interested in insuring their self-insured and fully insured employee benefit programs.

While a captive insurance owner is likely well familiar with the state insurance requirements associated with owning a captive, they may be less familiar with the other issues of owning a captive.

When implementing a captive insurance company, a captive owner generally engages a captive manager whose primary responsibilities include insuring that the captive meets minimum capitalization requirements, establishing and receiving approval for its business plan, engaging an actuary, completing a feasibility study, determining what services to perform in-house or finding out-sourced service providers, enlisting a fronting company or reinsurers, and meeting with regulators to have their plan approved. On an on-going basis the captive must be continuously monitored to assure that the risks are appropriately managed with reinsurance and the company is appropriately capitalized.

If you'd like to learn more or would like to assess the feasibility of having your own captive, please reach out to us. We'd be happy to help.


Tim Luedtke, FSA, MAAA, CFA
Principal & Consulting Actuary

Diane Luedtke, FSA
Principal & Consulting Actuary

Are You Considering Insuring Employee Benefits With Your Captive? Have You Thought About . . .

Tim Luedtke, FSA, CFA

Insuring employee benefit risks through a captive insurance company may raise federal tax and prohibited transaction issues under the Employees Retirement Income Security Act (ERISA):

Federal Tax Issues - Captive sponsors who pay taxes strive to structure captive insurance programs in such a way as to receive current period tax deductions for premiums paid to their captive. Court rulings and recent revenue rulings outline several key provisions for receiving a tax deduction for premiums paid to a captive insurance company.

Key questions include:

a) Is the transaction a sham? To meet this test the transaction must provide a non-tax business purpose.

b) Does the transaction meet traditional insurance standards? Elements considered for determining whether insurance standards are met include whether there are an insurable risk that is shifted from one party to another and whether there exists an insurer having sufficient risk distribution.

Revenue Ruling 2005-40 stated "risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer, such that a loss by the insured does not affect the insured because the loss is offset by a payment from the insurer." Further, the revenue ruling stated "risk distribution incorporates the statistical phenomenon known as the law of large numbers". The revenue ruling is consistent with the findings of the United States Supreme Court in Helvering vs. Le Gierse (1941).

Theories on both "risk shifting" and "risk distribution" continue to develop with numerous revenue rulings and court decisions impacting application to a specific situation. As such, it is important that a qualified tax advisor be engaged to assess the specifics of any particular situation. Over time, some safe-harbors have developed. It is generally accepted that a captive that accepts a threshold level of unrelated third-party business (sometimes viewed to be as little as 29%) will provide support for sufficient "risk distribution" and that captives that are "brother-sister" organizations are supportive of "risk shifting".

While premium deductibility is important, such deductibility is only important because insurance companies are subject to different accounting and tax rules which enable them to deduct claim reserves for anticipated losses. Given the captive and the insured party are generally part of the same consolidated tax return, the deductibility of insurance premiums would be negated by the income generated by the insurance premiums received in the captive except for the deductibility of such reserves.

ERISA Concerns - Under ERISA, transactions involving plan assets among parties in interest are generally prohibited without an applicable exemption. Employer-owned captives are considered a party in interest with respect to the employer's employee benefit plan. The prohibition is designed to protect plan assets against self-dealing that could conflict with the interests of plan participants. Available exemptions include:

    1. Statutory Exemption - Although a transaction involving plan assets of an employee benefit plan would be prohibited, the prohibition does not apply where benefit premiums account for less than 5% of affiliated insurance companies' aggregate premiums.
    2. Class Exemption - The Department of Labor (DOL) automatically provides a class exemption for any prohibited transaction if certain criteria are met as outlined in PTE 79-41. Generally, the PTE 79-41 criteria that is most difficult to meet is that at least 50% of the captive's premiums must come from unrelated business.
    3. Individual Exemption - An exemption provided specifically to a plan sponsor for their specified transaction.

For years, plan sponsors sought individual exemptions to permit the use of captives for employee benefit plans. A watershed event occurred with the Department of Labor's exemption approval given to Columbia Energy Corporation in 2000. PTE 2000-48 permitted Columbia Energy to reinsure its long-term disability plan with its captive, Columbia Insurance Corporation LTD. Subsequent to this approval, the DOL approved Archer Daniels Midland Company's use of their captive to provide life insurance benefits (PTE 2003-07) and approved SCA's use of their captive for accidental death and dismemberment, long-term disability, and life insurance (PTE 2004-12).

These early approvals gave rise to an expedited process (ExPro) for new individual exemption requests by other captive owners. Under the ExPro process, the DOL will fast-track approval for any request where there are at least two substantially similar approvals within the prior eighteen month period. The accelerated process can provide an exemption within 75-90 days of an application. To achieve such approval the DOL outlined several criteria which must be met including:

  • Captive (or a branch thereof) is licensed and authorized in the United States or a U.S. territory
  • no sales commissions are paid
  • at least one year of audited financials for the captive must exist
  • there must be an independent third-party fiduciary
  • plan cannot pay more than adequate consideration for insurance
  • insured with a fronting company rated 'A' or better by A.M. Best
  • plan participants must receive enhanced benefits
  • premiums computed within industry standards and comparable to other insurers

Since installing the ExPro process for individual captive exemptions, nearly twenty prohibited transaction exemptions have been granted. Most have been for life insurance and long-term disability benefits. A recent approval that was granted to Coca-Cola is interesting in that the approval (PTE 2010-11) allowed Coca-Cola to fund retiree health benefits and pay premiums with assets contained in an existing VEBA. A key challenge for Coca-Cola was to prove that its proposal was substantially similar to previous ExPro approved situations and initially was denied by the DOL.

Benefit plan designs, too, are evolving with several newer approaches perhaps further simplifying the use of a captive and increasing the potential for a complete retirement, health care, and long-term care security solution. We encourage captive sponsors that are employers to reach out to us to learn about these rEvolutionary opportunities.

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