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Three Ways the Captive Industry is Responding to Tax Reform


At this time last year captive managers and advisors were closely monitoring the development of the most comprehensive tax reform we’ve seen in over 30 years.  It was anticipated that tax rates would drop to a significantly lower rate, but the question of how much remained. What other changes would there be and how would they affect captive programs? On December 22, 2017, after months of anticipation and multiple versions of the bill working through the House and Senate, the Tax Cuts and Jobs Act (TCJA) was passed and the captive industry began assessing the impact. Since then, countless articles, whitepapers, webinars, and seminars have been dedicated to picking apart the new tax code changes and determining exactly what they mean and how they may affect captive owners. In contrast, there has been little coverage of how the captive industry has responded.

Focus Shifting Back to Risk

The most significant change was the new marginal corporate tax rate of 21% (in addition to state taxes), which was a substantial decrease from the top rate of 35%. With the drop in marginal tax rates, the economic benefit of the accelerated tax deductions that are afforded to captives drops proportionally. While captive formations should never be based solely on tax benefits, there was concern that the reduction in this benefit would cause a significant drop in captive formations.

However, so far in 2018 there are no indications that this is the case. In fact, there has been a noticeable shift in focus from tax benefits back to risk management; prospective captive owners are focusing on how a captive can lower the economic cost of risk by assuming coverages that are overpriced or unavailable on the commercial market. This is not only better from the IRS’s viewpoint, it’s also better for the health and longevity of an organization’s captive.

Captives as a Profit Center

As mentioned, with a lower tax rate, some organizations found that the economics of insuring certain coverages in a captive no longer made sense. There simply would not be enough premium to generate the savings necessary to offset the frictional costs of owning a captive. Less premium in a captive means less capital and surplus would be generated. That surplus could be used to fund additional risks or risk related endeavors, provide investment income, or transfer funds back to the parent.

With this fact evident, interest by current and prospective captive owners in exploring the value of utilizing a captive as a profit center by insuring third-party risks has received more attention.  Since income is now taxed at the lower federal rate, captives are able to retain more of their underwriting profits on business such as employee benefits, mainly voluntary benefits like critical illness, hospital indemnity, accident, and legal insurance. These types of voluntary benefits are typically 100% employee paid and tend to have much lower risk and loss ratios than other lines of coverage. By reinsuring these benefits to a captive, an organization is able to offer its employees improved benefit plans at the same or lower costs while recovering a large portion of the profits that would normally go to the fronting carrier.

Similarly, there has been an increase in activity by captive owners exploring the value of reinsuring extended warranties. Like the voluntary benefits mentioned above, these tend to be a very profitable line of third-party business. Most organizations utilize a third-party insurer who pays a commission for each warranty sold or offers a profit share arrangement. However, captives are now looking to participate in these risks. Through a quota share arrangement, the captive is able to reinsure a portion of the warranty coverage and earn some of the profits (if any) that would normally go to the insurers, thus building up valuable surplus within the captive.

Response to Base Erosion Anti-Abuse Tax (BEAT)

Next to the lower marginal tax rate, the BEAT tax was another major change brought forth by TCJA that caused concern for many captive owners. In short, the BEAT imposes an alternative minimum tax but applies only to corporations with average annual gross receipts in excess of US$500 million and whose “Base Erosion Percentage” is greater than 3% (or 2% in certain situations where the group has a bank or registered securities dealer).  If applicable, it is effectively a tax on any amount paid or accrued by a corporation to a foreign related party for which a deduction is allowable. This includes, among many other types of payments, premium payments made by US taxpayers to their non-US captive insurers, loss payments made by US captive insurers to their non-US insureds, or reinsurance premiums made to non-US reinsurers. These payments are subject to being added back into the tax base for calculation of the BEAT, even though they are also subject to the federal insurance excise tax. There will be an initial 5% phase-in rate for the 2018 tax year, then the 10% will apply through 2025, after which it will rise to 12.5% (but with rates 1% higher for groups with a bank or securities dealer).

Many captive owners are assessing their exposure to the BEAT and considering whether a re-domestication of their foreign captives may be necessary. The state of Vermont has responded with a new alternative. Less than a year after the TCJA was passed, Vermont regulators passed legislation that established the Affiliated Reinsurance Company (ARC), a new type of captive. While no ARCs have been licensed yet, the new captive type is intended to be an alternative for US companies that have been reinsuring to an offshore affiliate and may now be subject to the BEAT.  An ARC will be permitted to reinsure the risks of a ceding insurer that is its parent or affiliate, as well as cede assumed risks to other reinsurers. The facility would also provide the ability to avoid the 1% to 4% excise tax on premiums paid to foreign insurers.

While the full effects of the TCJA are yet to be seen and IRS guidance is expected later this year [1], we are already seeing captives demonstrate their versatility and ability to continually respond to market and regulatory changes. Captives can provide solutions outside of traditional risk programs and the past year has shown how organizations are utilizing them as tool chests at the core of their risk management programs.


[1] To date, the IRS has only issued a draft BEAT reporting form (Form 8991), but it is expected that proposed regulations may be issued later this year which may, among other things, provide certain anti-avoidance rules that will need to be monitored.


Marsh is one of the Marsh & McLennan Companies, together with Guy Carpenter, Mercer, and Oliver Wyman.

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