I addressed this issue (life insurance in captives) in a recent post on my tax law blog. Here is the post in its entirety.
The topic of life insurance and captive insurance companies is fairly controversial. Some practitioners have no problem recommending that a captive invest in life insurance as part of their investment portfolio, while others recommend against it. I fall into the latter camp for the following reasons:
1.) The vast majority of time when a captive invests its investment assets into life insurance products, it does so because that has been the strategy since the beginning of the sales process. That is, a salesperson went to a prospect and said, "I've got a great idea; we can form a captive insurance company and have the company invest in life insurance as part of their investment portfolio." The problem with this approach is it runs against the basic legal function of a captive insurance company -- to underwrite risk. If the sales process completely avoids this central tenant -- or, if underwriting risk is not the primary reason for forming the captive -- the transaction runs counter to the primary legally defensible reason for forming a captive.
The entire history of anti-avoidance law is filled with cases where the sales literature, methodology, and presentations used demonstrated an intent counter to a standard business transaction. For further reading on the topic, I would recommend the entire series of equipment leasing cases from the 1980s, the COLI cases from the 2000s or the new codification of the economic substance doctrine by the IRS.
2.) The 831(b) captive is already a tax-advantaged vehicle; it is taxed on its investment portfolio rather than its gross earnings. Why would a company that has a tax advantage invest in a tax advantaged product? It's a situation directly similar to a person with $30,000 in annual income investing in a municipal bond; it's a complete mismatch between the investor's investment profile and the investment.
3.) Before I was a lawyer, I was a bond broker. Insurance companies made up about half of my clients. In all the time I dealt with the investment side of insurance companies I never once saw them invest in life insurance. Why? Because the actuarial department of insurance companies spend a fair amount of time aligning the duration of the expected liabilities and the duration of the investment portfolio (for more on this idea -- at least from the fixed income side -- read Frank Fabozzi's Fixed Income Mathematics). Life insurance just doesn't serve in this capacity. But another way, the duration of the average life insurance policy is far longer than the average expected P and C claim.
Why is this important? Because the third prong of the three prong Harper test states the court will recognize a captive so long as the transaction "was for “insurance” in its commonly accepted sense." I call this test the "duck test;" the captive must walk and talk like an insurance company. Because other insurance companies don't invest in life insurance, captives shouldn't either.
All that being said, there are two places where life insurance can play a part in the captive process.
1.) Buy-sell agreements: these are especially appropriate when the captive is inter-twined with an estate plan. The parents and the children create and sign a buy-sell agreement funded with life insurance at some point in the captive's life cycle. This strategy can also be employed when the captive has multiple owners. Buy-sell agreements are standard business plans that will not draw any unwarranted scrutiny.
2.) A highly liquid loan to an ILIT: once a captive has been in existence for a number of years it will have the ability to make loans thanks to excess cash. One of these loans could be a callable loan to an irrevocable life insurance trust that is part of an overall estate plan. The loan must conform to transfer pricing rules and regulations.
As I ran out of room, let me add that reasonable minds can differ on this topic. But given what I see as a situation that will draw increased scrutiny from the IRS (which I believe applies to captives in general), why risk it?
Let me begin by commending Hale for recognizing that this is an issue upon which reasonable minds can and do differ. Unlike Jay (who is not a tax attorney), Hale avoids overly-broad, useless and inflammatory labels like " tax scam", "shills", "shelter", etc., and he doesn't imply that those who disagree with him are going to jail. So, Hale is someone with whom one can have a reasoned and productive debate. I'm grateful for that.
With that in mind, I do want to challenge a few of his comments and conclusions above. First is his contention that incorporating life insurance into the discussion early in the sales process is somehow inconsistent with the captive's objective of underwriting risk. It should be noted that people with insurance licenses, be they life insurance brokers, P&C brokers, health insurance brokers, or all three, are in the risk-management business. Helping people mitigate risk is the very definition of what they do. Some focus on the risk of dying, others on the risk becoming sick or disabled, others on commercial risks, and yet others on the risk of losing money due to markets, lawsuits, taxes, etc. Various types of insurance are useful in responsibly managing each of these risks, no?
So, there's nothing improper or unseemly about a risk manager or insurance broker being involved with a risk-management entity like a captive. A captive is simply another means of mitigating risk, which is what insurance brokers do.
Additionally, fixed life insurance products in general, and Equity Indexed Universal Life Insurance contracts in particular, are uniquely-suited to managing what, next to a catastrophic claim, is perhaps the greatest risk to a captive--namely, a diminution or erosion of its assets due to market losses (whether in real estate, stocks, commodities, etc.), lawsuits, taxes, or the like. Modern high cash value life insurance contracts are highly liquid, uniquely stable (coming as they do with numerous built-in guarantees), and tax-efficient. Although it is beyond the scope of this post to elaborate, I'm confident that I could demonstrate to Hale why, ignoring any and all benefits of life insurance to the business owner or his family, life insurance is an ideal investment vehicle for the captive itself--that is, that captives investing into life insurance are more prepared and able to pay expected claims rather than less. There are certainly exceptions where life insurance is not a fit, but those exceptions simply prove the general rule.
Assuming what I have said above is true, then why does it suddenly become improper or suspect for a risk management specialist who just happens to have a life insurance license to suggest layering one risk-management technique (life insurance) on top of another (captive insurance). Captive insurance protects the business, and investing into life insurance protects the captive from market losses and other risks and helps insure that it is best able to pay claims. So...what's the issue?
The answer is that there shouldn't be one. There is nothing inherently inconsistent between a captive investing into life insurance and it fulfilling its "basic legal function of a captive insurance company--to underwrite risk." Quite the contrary--in most cases, the former supports the latter. However, there is admittedly a danger that the IRS or courts could perceive an inconsistency here. For instance, if a captive were formed with no regard for underwriting risk but merely as a shell through which its owner can purchase tax-deductible life insurance, then clearly there's cause for concern. But, if that's indeed the motive, isn't this motive equally improper regardless of the captive's investment vehicle? For instance, a sham captive formed mainly for the purpose of purchasing tax-deductible real estate as an investment is just a wrong as one formed for mainly the purpose of purchasing tax-deductible life insurance, no?
That being the case, the question resolves itself down to this: Does creating an investment policy statement and integrated investment plan for the captive from the outset, even prior to it's formation, jeopardize its legitimacy? I don't know anyone who suggests that it does, unless life insurance, which is demonstrably a superior investment for most captives, is involved. Why is that? Why does the presence of a particular type of risk management and investment specialist, a life insurance broker, at the outset of a deal (as opposed to, say, an non-insurance licensed investment advisor or a real estate agent or a bank or a captive manager or an attorney) make it significantly more likely in anyone's mind that the captive was formed for improper purposes?
Honestly, I don't see the connection. We don't question a client's motive in forming a captive when a captive manager or attorney brings the deal to the table, do we? And, like the life insurance broker, don't captive managers and attorneys make more money only if the prospective client actually implements the captive and, in some cases, invests the money with them? Isn't convincing clients to form captives and then managing them or their assets how these guys make a living? Assuming so, don't they have just as great a motive to convince a client to do a captive as the life insurance broker does? As a result, aren't' they just as (un)likely to overemphasize the tax planning benefits of a captive, as opposed to its risk management benefits? Why do we expect that the client's motives will be more pure when they deal initially with a captive manager or attorney, neither of whom are typically licensed risk management specialists and both of whom have ulterior motives, rather than a true risk management specialist like a life insurance agent?
Jay isn't out there publishing Forbes articles warning the public to, "run if a captive manager approaches you about a captive, especially if he emphasized the tax advantages. After all, he only makes money if you do the deal and he'll say anything to get you to do it." Why is that? I agree wholeheartedly that "if underwriting risk is not the primary reason for forming the captive -- the transaction runs counter to the primary legally defensible reason for forming a captive", but once again, why does the presence of a life insurance agent, as opposed to any number of other professionals, make an improper motive any more likely? Are life insurance agents any more likely than other professionals to use improper sales material or emphasize the tax angle? Not in my experience. I hate to say it, Hale, but it seems to me to be a simple matter of captive managers and attorneys wanting to protect their traditional turf from another class of risk management specialists--the licensed brokers, including life insurance brokers, who have until recently largely overlooked captive planning.
Regarding Hale's contention number 2, that it makes no sense to invest into a tax-advantaged product inside of a tax-advantaged vehicle, I could put forth innumerable retorts. Let me just offer up a few in the interest of time.
First, as to its earnings, captives are not in any way "tax advantaged". Earnings are taxed at ordinary C-corp rates, and are taxed again if and when they are distributed as dividends. Perhaps start-up captives might be in a fifteen percent tax bracket, but long-established ones certainly won't be. Regardless, trying to shelter those earnings from at least some of these taxes is an imminently reasonable thing for any company to do, and captives are no exception.
Hale's analogy to municipal bonds is misplaced. Folks making $30,000 per year shouldn't invest in municipals because equally-rated corporates offer a higher expected after-tax yield. This is not the case with life insurance at all. Rather, just the opposite. At least as compared to fixed life insurance products and equity indexed universal life, equally (un)risky investments most definitely do not offer captives a higher expected after-tax yield in today's world. Quite the contrary. This isn't just some opinion but rather is easily demonstrated numerically.
Second, Hale's whole argument on this point rests upon the assumption that the reason captives invest into life insurance is simply to avoid tax. In my considerable experience, this is not the case at all. In my experience, captives invest in life insurance because it provides a unique bundle of features that simply cannot be obtained anywhere else. Included among these is the ability to earn market-based returns while enjoying stability of principal, high liquidity (versus real estate, limited partnerships, or other common captive investments), the ability to borrow against the policy on a non-recourse basis at a very favorable rate upon a moments notice without having to apply or be approved for the loan and regardless of one's credit rating, the ability to defer payments on such loan indefinitely so long as the life insurance policy stays in force, asset protection (in some states), and, yes, tax efficiency. Can you name for me any other vehicle that provides a corporation with this unique bundle of benefits? Isn't it obvious how this unique bundle of benefits could benefit most captives, enhancing their ability to pay claims?
Hale's argument 3 above is founded on the premise that a captive investing into life insurance results in a mismatch of assets and liabilities. Specifically he says: "The duration of the average life insurance policy is far longer than the average expected P and C claim." That sounds somewhat intuitive, but...is it true? No!
Hale seems to think that we need to wait for the death benefit of the policy to mature before we have sufficient liquidity to pay claims. This completely ignores the fact that the cash surrender value of the policy is compounding all along at rates that similarly (un)risky options simply can't touch. It's the cash surrender value that the captive will access to pay claims, not the death benefit. And, this cash surrender value is highly liquid. It can be accessed on a moment's notice either by cashing the policy in or, more likely, by simply borrowing against it. In the latter case, no gain/loss upon sale is realized, so there's no adverse tax consequence to paying the claim. Compare this to any other investment where the captive would have to sell assets to pay claims, triggering a potential tax liability or else locking in losses at a potentially unfavorable time.
If you think about it for a minute, a captive is highly analogous to a non-qualified deferred compensation plan ("NQDC") like those offered by many large companies. In fact,, from an asset/liability matching perspective, it's much more analogous to a NQDC comp plan than it is a traditional insurance company. NQDC plans receive "contributions" each year, the total amount "invested" in the plan typically grows over time (since contributions generally exceed withdrawals), and a few times a year the company will need to access the money in these plans to pay out a termination or retirement benefit. Likewise, the typical captive will receive premiums each year, the total amount invested in the captive (i.e., its assets) typically grows each year (since premium income generally exceed its expenses), and a few times a year (for most captives) it will need to use a portion of its assets to pay claims.
However, like a NQDC plan, and unlike a "real" insurance company, captive expenses are unpredictable in timing and amount (e.g., in the case of the NQDC plan, a key executive could retire unexpectedly and cash out a large portion of the plan, and in the case of a captive a massive claim could be file ). Unlike traditional insurance companies, the law of large numbers does not lend predictability to the captive insurance company's expected claims rate, and claims flow can be highly variable and unpredictable. In most years a captive may have a very small amount of claims (in dollar terms), but in some years it could have massive claims--claims so big that they nearly bankrupt the company. Consequently, like with NQDC plans, the stability, predictability and liquidity of its investment portfolio is paramount. In other words, if one is not sure when he's going to have to cough up a large amount of money on a moment's notice, he better keep is safe and liquid in the meantime, right?
Thus, while a traditional insurance company can invest in a large, diversified portfolio of riskier and hopefully higher yielding assets, and can count on the tenants of diversification and the law of large numbers to help protect it against massive losses (either market losses or claims or both), captives can't be, or at least shouldn't be, so bold.
This is why the Hale's argument that you-never-see-real-insurance-companies-invest-most-of-their-assets-into-life-insurance--so-captive's-shouldn't-either is misplaced. You also never see "real" insurance companies invest most of their assets into money market funds or bank accounts, which captives often do. But nobody complains about that, and they shouldn't. The simple fact is that a typical, professionally-managed captive's investment portfolio shouldn't look anything like that of a "real" insurance company regardless of whether or not it invests in life insurance. Why? Because of the very asset/liability mismatch that Hale notes above. The risk and investment considerations that govern a "real" insurance company's portfolio decisions are simply inapplicable to most captives. Thus, it would be highly irresponsible for most captives to mirror an investment portfolio based on how "real" insurance companies invest.
Hale just gets it exactly wrong is by suggesting that using life insurance aggravates the asset/liability mis-match. It doesn't. It actually resolves it! And this is exactly why using life insurance makes so much freaking sense for most captives. It's the same reason why nearly seventy percent of Fortune 1000 companies invest all their NQDC plan money, which has an asset/liability profiles highly analogous to captives, into life insurance. Fixed or indexed life insurance arrangements allow these companies to get market-based returns with stable asset values, high liquidity, tax-advantaged growth, and tax-advantaged access to their funds when needed. All of these things are of little importance to a "real" insurance company, which can count on principles of diversification and the laws of large numbers to protect it against large losses, but it's of critical importance to a captive or a NQDC plan that can't.
To conclude, using life insurance within most captives is in no way inconsistent with its primary purpose of underwriting risk. In fact, life insurance often supports this objective like no other option can. Fixed and indexed life insurance represents an imminently reasonable compromise between earning no yield in a money market or bank account, and exposing the captive's assets to significant potential market losses or liquidity risks by chasing higher returns elsewhere. If the IRS doesn't understand this for some reason, then it should be made to. It's current failure to grasp the concept (if Jay is to be believed) is no reason for honest taxpayers motivated by genuine risk management concerns to forfeit all the benefits that life insurance arrangements can offer them. The benefits of life insurance to the captive, not to mention its owners, are enormous and shouldn't be passed on lightly.
DISCLOSURE: IRS regulations require me to inform you that this post is not intended or written by me to be used (and cannot be used by you) for the purpose of avoiding penalties that may be imposed with regard to the tax consequences arising from any matters discussed in this message or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed in this message.