Strategic Risk Solutions’s (SRS) most recent webinar, Captives for Tax Exempt Organisations, honed in on exactly why a tax exempt, or not-for-profit organisation, would decide on owning a captive insurance company.
Strategic Risk Solutions’s (SRS) most recent webinar, Captives for Tax Exempt Organisations, honed in on exactly why a tax exempt, or not-for-profit organisation, would decide on owning a captive insurance company.
The panel, moderated by Wayne Cowan, director of SRS in the Cayman Islands, included Tom Jones, partner at McDermott Will & Emery LLP, and Michael Hawkins, director or risk management at Fletcher Allen Health Care.
Jones kicked of the discussion by outlining exactly why a tax-exempt, not-for-profit organisation, such as a charity, would want to form a captive. He explained that the establishment of a captive can firstly help to stabilise and reduce the cost of risk, including claims payouts and legal defence costs.
The use of a captive also provides the organisation with customised terms of coverage and control over investment funds. But for Jones, a tax advisor, an important objective is to leverage off the parent company’s tax-exempt status by avoiding or minimising ‘unrelated business taxable income’.
Jones said: “If a charity or not for profit enters into a business activity there is a particular Internal Revenue Service (IRS) code sections that essentially mean they are treats it as a taxable businesses, and insurance is by nature a taxable business.”
Jones explained that if a captive is only covering the risk of its tax-exempt parent and its employees then the domestic captive can obtain an IRS ‘determination letter’ granting it IRC 501 (c)(3) tax-exempt status as a charitable entity.
The captive does this by filing an IRS form 1023 with a description of its intended activities. Jones said that the 1023 form cannot include non-employed physicians or third parties if they constitute a substantial portion of the business.
Jones explained: “Thus, limited scope of captive activities if formed onshore, covering more than 10 percent unrelated parties, can cause all income of the domestic captive to become fully taxable applying the current 35 percent tax rate.”
“If the percentage of unrelated business becomes substantial, ie, if the captive exceeds that percentage of premiums in an onshore captive, then that captive loses its tax exemptions and becomes completely taxable,” added Jones.
He noted that “substantial” is not actually defined in the code or regulations, but most tax advisers say in the 10 percent is the highest you should go with unrelated premiums.
So if a captive knows that it is only going to do related business, then the onshore captive structure would work well.
An offshore charitably owned captive is typically set up as a stock company because it will not go to the IRS for a tax exemption, according to Jones.
He said: “Offshore captives are not tax-exempt—so they can include non-employed physicians and unrelated policyholders up to 50 percent on premiums … But unlike onshore captives, covering unrelated parties will generate some minor taxes but it does not taint the entire captive.”
He cautioned, however, the offshore captive must not engage in business in the US. So, all captive meetings must be held, and all contracts signed, outside of the US.
This, Jones said, is the principle reason that most captives owned by tax-exempt hospitals are domiciled offshore. The big takeaway from the offshore option is that “offshore captives are able to write up to 50 percent unrelated business without becoming fully taxable”.
For Jones, the non-insurance status for tax-exempt owners of offshore captives has many advantages. In his words: “Captives owned by tax exempt organisations do not want to be classified as insurance companies for federal tax purposes.”
Advantages of non-insurance company status, according to Jones, include the avoidance of both federal excise tax and state direct placement taxes on premiums for related party business. Captives can also avoid the attribution of any unrelated business taxable income to its tax-exempt parent as there is no “insurance income” as defined for tax purposes.
“The majority of the offshore hospital captives are not insurance companies from a tax perspective, people always ask how this is possible as they issue policies, collect premiums etc. But the key thing to remember is that the tax law looks at the substance not the form of transactions … Most captives owned by tax exempt organsiations don’t have sufficient risk distribution under IRS definitions to be treated as insurance companies.”
To understand the workings of a not-for-profit organisations offshore captive, Fletcher Allen Health Care’s Michael Hawkins explained the premise of his company’s Bermuda-based captive, VMC Indemnity Company (VMCIC).
VMCIC, incorporated in Bermuda in June 1993, is a wholly owned subsidiary of Fletcher Allen Health Care—a university hospital and medical center based in Burlington, Vermont.
“VMCIC provides claims made coverage for our employees in the hospital. It covers professional liability and general liability of everyone employed by Fletcher Allen health care. The policy limits for the captive policy are $5 million per occurrence and $2 million per occurrence for the commercial general liability,” said Hawkins.
Hawkins explained that a key incentive for developing a captive insurance company was the removal of the proverbial middleman.
“[Forming a captive was] a good way to manage our own destiny in terms of risk and being in control of our professional and general liability, which is what keeps hospital administrators awake at night.”
Another benefit of the captive that Hawkins highlighted includes Fletcher Allen Health Care’s increased level of control, and closer focus on internal review.
According to Hawkins, Fletcher Allen extends this level of control via in-house claims management, policy wording development, and its direct access to reinsurance capacity.
Fletcher Allen focuses on internal review through biannual claims review and a loss scorecard that compares actuarially projected losses to actual claims.
“The captive is [also] a good way for us to benchmark against our peers to see where we stand with regards to the severity and frequency of claims,” added Hawkins.
Hawkins concluded that the captive has been very successful in its 20 years of existence.
“[Ultimately] it has been a way for the hospital to take control; it has also been a good way to engage the medical staff, who understand that it is their insurance company and that there is a direct benefit to them if it is successful in managing its claims.”
