Mine operators often have a clearer grasp of costs and risks than large insurance companies. Why not put that knowledge to work for more cost-efficient risk management?

By John G. Nevius, Esq., P.E., and Phillip England, Esq.

Mining is risky. Effectively managing risk can make the difference between running a successful mining operation and going bust. Many risks can be quantified and managed routinely, such as employee injury through Worker’s Compensation programs. Some risks can be quantified, but remain hard to manage, such as fluctuations in commodity prices. Financial assurance with respect to potential environmental liabilities or reclamation-and-closure obligations can be both difficult to quantify and hard to manage. Utilization of captive insurance is one way to lessen the impact of these elements of risk, to a mining company’s advantage, or, at least, to bring increased financial sophistication and a measure of control to a traditionally unpredictable set of mine-operation variables.

Part 1 of this article provides basic information on what a captive insurance company is and why a mining business would want to establish its own captive(s). Part 2 provides greater detail on the necessary steps to establish a captive and key considerations when doing so. Parts 3 and 4 then provide a more-detailed analysis of relevant tax and legal issues, respectively, for those who want to know more.

Whether a captive is right for a business at this stage in its development depends on both objective and subjective determinations. Everyone, however, should understand the basic principles involved. At some point many large businesses, both publicly- and privately-held, embrace the use of a captive. This article focuses on practical steps and more-traditional uses of captives. However, these are just guidelines. Captives can be used in myriad ways and can be especially advantageous when used creatively, depending upon the specific business and risk circumstances. Moreover, most people evaluate captives from a tax perspective, but, as discussed in more detail below, this is only one potential advantage. Accordingly, even if a captive did not seem to make sense in the past or is not presently an attractive choice, a captive likely will be advantageous from a different perspective or at some point in the future. Business partners and competitors likely are already using one.

What is a Captive Insurance Company and Why Have One?
A captive insurance company is an entity formed under the law of a particular jurisdiction (domicile) primarily to insure or reinsure, and better manage the risks faced by one or more corporate parents or related entities. Properly structured and administered, captives can provide significant cost savings over more-traditional commercial insurance coverage. An important portion of those savings arise from the special tax regime applicable to insurance companies. However, captives can pay for themselves simply through the more effective management of risk at an individual operation or company. Captives also can be used to insure the risks faced by unrelated entities in the same industry such as different mine operations in what is commonly referred to as a pooling arrangement. Previously under-insured environmental and other related risks, such as those associated with milling and refining, underground operations or reclamation, also may be pooled using a captive as well.  

In essence, a captive serves as a funding or financing vehicle for self-insuring the losses of the related organization that fall within a specific retention level designated by the parent which may be greater than in the conventional coverage program. In other words, by taking greater responsibility for managing more modest losses, captives can save money by avoiding or reducing premiums paid to outside commercial insurance companies. Moreover, by retaining a higher designated level of risk, funded by the captive, not only may substantial savings be achieved by both lower commercial-carrier premiums and tax planning, but also from more efficient and effective risk management at all levels of an operation. Part of the potential savings can arise by virtue of having a skin in the game, so to speak. Companies that embrace substantial self insurance programs send a message to commercial insurance companies that they are serious about managing risks and costs and should, as a result, save on basic premiums. At the same time, these same companies should be able to acquire a larger amount of more higher-level excess (or “wholesale” reinsurance) coverage at a reduced cost.  

When accepting a greater level of risk, captives apply the same principles as are applicable to evaluation of other traditional programs to save on premiums such as proposed deductibles, so-called self-insured retentions or retrospective premium programs. Many companies tend to avoid risk retention and prefer to outsource risks such as Worker’s Compensation. Most companies manage risks through the purchase of various primary insurance policies to directly protect property, or officers and directors, or to offset losses from casualties, lawsuits and errors and omissions, etc. By taking more direct control of risk management generally, and by using a captive, companies can also manage or assert greater control over insurance responsibilities such as risk assessment and claims handling. This, in turn, should allow a mine operator to achieve substantial additional control over outcomes in the event of a loss. Embracing risk management in-house has other potential advantages, such as avoiding disadvantageous arbitration of claim disputes, reducing claim denial and lowering inflated premiums.

A captive may be owned by a corporation or by non-corporate entities and can be domiciled onshore or offshore. The domicile will determine how the captive is regulated. Providing all of a captive’s actions are deemed prudent and within the scope of the captive legislation, it can “write” almost any line of insurance for related or unrelated entities, and charge a premium that the company and the regulators (of its domicile) find acceptable, with reference to applicable actuarial and loss projections. All decisions regarding the operations of the captive are made by its board of directors. Directors are elected by a captive’s shareholder-owners, including policyholders or owners of policyholders. This ensures the owning company(ies) maintains control of the captive’s operations and permits the captive to be as aggressive or conservative as desired with respect to the level of risk retention. It is important to keep in mind that a captive, as an insurer, is subject to all of the applicable laws and regulations of its domicile. Consequently, legal counsel is essential at the establishment of a captive and from time to time thereafter during operation of a captive. However, the heightened level of control and access to a broader array of risk-management options leading to lower cost coverage, make captives an attractive option for mining companies seeking more control and greater flexibility when it comes to risk management, including procurement of financial assurance. Captives also allow mining operations to achieve potential tax savings, as well as greater control over dedicated funds (i.e., those funds set aside for reclamation and closure). Embracing a captive is all about taking more control over how a company’s affairs are managed. It represents a significant step forward in, not just control, but financial sophistication.

When is a Captive a Good Idea?
Setting up a captive takes time and requires both upfront and ongoing allocation of resources. Accordingly, tax concerns should come second to the basic business purpose(s) of a captive. Although there are tax advantages that can be achieved with a captive, the initial premise and motivation for a captive must be non-tax.  

A captive insurance policy should use market premium data to establish rates on an “arm’s length” basis. This means that a captive can accrue for loss expectancy for currently unknown liabilities on the same basis as an independent insurance company. In fact, mine operators and their consultants often have a clearer grasp of mining costs and risks than large insurance companies that do not necessarily specialize in hard rock mining.

The major difference from commercial coverage is that the premium dollars do not simply come under the control of a third party. With traditional insurance, a third-party insurance company earns interest on premium dollars, retains them when there is no loss, and may refuse to distribute them fully or properly in the event of a valid claim. Third-party insurance companies have limited incentive to pay claims generally or in full and have been known to pursue implicit or explicit claim-handling policies of forcing policyholders to litigate large claims—especially when the liabilities involved are “environmental.”

The commercial insurance market may firm or soften over time when it comes to coverage availability. A parent company and its risk group can adjust to these market conditions by forming a captive to: (i) fund potentially higher retention levels, (ii) build strategic relationships with insurance markets, and (iii) reduce cost of coverage during a period when the market is up.

Thus, companies can save considerably on premiums by agreeing to absorb a greater initial portion of a loss. This, in turn, can reassure third-party insurance companies by reason of their policyholder having a greater incentive to control losses; i.e., by having more skin in the game. By being more involved in managing initial risks and procuring excess insurance that incepts at a higher level, the captive’s owners expand opportunities for developing strategic insurance market relationships. In addition, by appropriately domiciling a captive, relationships with government regulators of insurance and environmental financial assurance may assist the mine operator in managing the amount of cash or letters of credit necessary to collateralize either loss reserves or financial-assurance bonds. In other words, the overlapping government regulation should serve as reassurance that appropriate resources have been committed and are properly in place to meet bonding, or claim payment obligations.

Moreover, companies that have captives demonstrate to insurance markets that they are comfortable with the risks they face, through their willingness to retain that risk. In fact, the very existence of a captive can provide negotiation leverage for better premiums and coverage terms within the commercial insurance marketplace.

All organizations face risks of negative events or conditions that are expected to occur over time, but the events are unpredictable in terms of exactly when, and to what extent, they will surface. Should the risk of a catastrophic event need to be managed, a captive providing the primary coverage would have the option of accessing reinsurance markets for a finite-risk reinsurance program. In other words, a captive can be used to gain access to reinsurance markets in a manner which can be thought of as akin to purchasing higher levels of insurance at wholesale prices (obtaining reinsurance is also a standard means by which commercial insurance companies balance their own risk profiles in managing their own risks).

The foregoing summarizes a number of reasons why formation of a captive can advance business objectives as an integral part of a company’s or a group’s strategic planning. The next step in this description of the captive process is to explain certain components of the feasibility study, which a proposed captive would need to undertake as an initial step in order to confirm how the captive will address the various needs of its owners. That feasibility study will review the nature of coverages to be written; range of premiums rates based on actuarial studies and loss history; administrative costs; tax planning; cost of sunk capital; choice of domicile and regulatory environment. We will review several of these elements below.

Getting Started
There are well over 4,000 active captive insurance companies worldwide, nearly 1,500 of which are domiciled in Bermuda. Vermont, the largest U.S. domicile, has nearly 500 active captives. There are a number of other potential captive domiciles, although these two dominate. Also, it may be possible to create a captive in one domicile and then transfer to another subsequently more-advantageous domicile.

Issues to Consider in Selecting a Domicile
On-shore (domestic, such as Vermont-based) and offshore (international, such as Bermuda-based) domiciles each have different characteristics. These characteristics are at the heart of the basis for domicile selection. The decision of where to domicile a captive generally depends upon an organization’s prioritization of these domiciles’ characteristics and their relative advantages and disadvantages. A decision on domicile should be based on the parent company’s overall risk-management objectives, the international nature and distribution of business operations, including mining and milling locations, and the ultimate objectives it wishes the captive to pursue. Factors relating to domicile choice include:  

  • Regulatory environment
  • Organization/operation costs
  • Investment restrictions
  • Capitalization and reserve requirements
  • Restrictions on use of any surplus(es)
  • Taxes (premium tax, federal excise tax, etc.)
  • The types of coverage to be offered

Important Considerations Involving the Regulatory Environment
The most important benefit of non-U.S. domiciles is their flexible regulatory environment. An offshore captive generally provides more flexibility on the type of business it can “write;” i.e., the types of risks that can be managed or insured against.

Once a captive is formed in Bermuda, for example, it is, in practice, subject to relatively limited ongoing regulation. No specific prior approvals are needed to make changes to a captive’s business plan, although Bermuda does exercise certain oversight regulations. Also, Bermuda must initially approve a captive’s business operations profile and a business plan of a proposed captive must pass the scrutiny of various regulatory committees.

On-shore captives in Vermont generally are regulated more closely than their off-shore counterparts and must operate entirely within the confines of the specific elements of a filed business plan. However, these required business plans can be altered relatively easily with the cooperation and approval of the domicile’s regulators.

Incorporation and Operation Costs
As set forth above, the formation and operation of a captive generally entails various expenses, including the following:

  • Organizational costs
  • Actuarial fees
  • Management fees
  • Legal fees
  • Audit fees
  • Premium taxes

Regulatory requirements dictate that records must be kept and transactions must take place within the captive domicile. Generally, however, the management of captive insurance companies is outsourced to a dedicated professional insurance broker affiliate or independent management firm with experience and resources in that domicile.  

Generally, overall organizational (and first year of operation) fees and costs can range from about $30,000 to more than $100,000 depending upon the complexity of the captive’s program.

Investment Restrictions and Capitalization Requirements
Restrictions on the types of permissible investments by a captive exist in most jurisdictions and each jurisdictions’ rules must be examined as part of the feasibility study. Similarly, capital requirements for a newly formed captive can vary widely between jurisdictions from less than $150,000 to more than $1 million, depending upon various factors including the proposed scope of coverage offered by a captive and the nature and relationships between and among the various insured entities.

The Financial Value
The use of a captive can, by virtue of its taxation under the regime applicable to insurance companies in the U.S. Federal tax code, result in additional savings, which dramatically reduce the cost of coverage. This makes captives very attractive in many business settings, but generally is less of a factor in mining given the potential for losses. Under a basic, fully self-insured arrangement, a company would recognize losses paid out over time as a year-to-year tax deduction. For example, Worker’s Compensation losses which occur within one underwriting period might be paid out over a period of eight to ten years. As such losses are paid out, however, the tax deduction may be taken, or is recognized, in the financial period during which the expense is actually incurred.

On the other hand, under a captive arrangement, premiums are paid on a prospective basis and are arrived at by calculating the ultimate-loss cost associated with the events assumed to be occurring in any given year (i.e., the total losses associated with the events), in addition to other expenses, such as premium taxes and the captive’s operating costs.

Should the payment of premiums into the captive demonstrate sufficiently proper elements of insurance under existing U.S. Internal Revenue Service rules, then the captive premium could be recognized as a tax deductible expense by the policyholder payor in the current period, just like a premium paid to a commercial carrier. On the other hand, the captive is able to establish deductible insurance loss reserves against a significant portion of premium received (since the captive is structured as, and is in fact treated under the tax code as, a true insurance company) in the current period for layers of assumed risk. The net result potentially enhances cash flow and reduces overall taxable income for the captive and, therefore, its corporate owners reporting on a consolidated basis.

Tax Issues in Choice of Foreign Domicile
Because insurance companies domiciled in Bermuda are deemed foreign insurance companies when it comes to U.S. policyholders, there is a U.S. federal excise tax of 1% on gross ceded reinsurance and 4% on direct property and casualty premiums. If the premiums paid by the policyholder to its captive are not treated as insurance premiums for U.S. federal taxation purposes, they would be exempt from this U.S. federal excise tax.

One alternative that may allow a U.S. parent to avoid federal excise tax is for the off-shore captive to take the 953(d) Election of the U.S. Tax Code. This election allows foreign insurance companies to be treated as U.S. taxpayers. Some of the more important concerns for a parent company to consider in this regard include:

  • The captive would be taxed at the captive  level; and its operating results could not  be consolidated with that of its ultimate  owner, therefore, losses could not be  used to offset gains from other of a parent’s subsidiary operations. (Losses  could, however, be carried forward and  used to offset future captive income).
  • However, this election, once made, is  permanent and irrevocable.
  • A bond must be posted in an amount  equal to 10% of the prior year’s premiums of the captive shareholder, subject  to a minimum of $75,000.
  • Also, an elector must waive any other wise applicable tax treaty benefits.

There are potentially significant benefits in taking the 953(d) Election. For example, because the captive is treated as a U.S. taxpayer, the interest on inter-company loans between the off-shore captive and a U.S. parent would not be subject to any withholding tax of 30%.  

U.S. shareholders in an offshore insurance company that is a “controlled foreign corporation” or CFC are also subject to the U.S. subpart F anti-deferral rules. An offshore insurance company with 25% of the shares of its stock owned by U.S. shareholders qualifies as a CFC and a pro-rata share of the company’s income must, therefore, be included as personal income each year for its shareholders. Under these circumstances, the offshore company’s income is calculated based on U.S. insurance tax accounting rules and only that portion of income attributable to U.S. shareholders is included (i.e., portions attributable to non-U.S. shareholders would not be taxable). In the event of an actual distribution of dividends from the offshore company, a shareholder is permitted to exclude such distribution from income to avoid being taxed a second time.  

As noted above, under section 953(d) of the Internal Revenue Code, an offshore insurance company can make a permanent and irrevocable “domestic election” whereby it is taxed as if it were a U.S. company. Also, as noted above, although the company would be subject to tax on its worldwide net income, it would not be subject to a premium excise tax. Accordingly, it need not be concerned about inadvertently becoming subject to a 30% branch profits tax because it engages in a U.S. trade or business. The domestic election is most appropriate for an offshore company that only has U.S. shareholders. All of the income earned by such a company would be taxable in any event under the CFC rules in the absence of an election, so making the election eliminates various tax issues that would otherwise exist.

State Tax Issues in Choice of Domestic Domicile
One component of the choice of domicile process generally is evaluation of the incidence of premium, self-procurement and surplus lines taxes. The cost, for example, of a Vermont captive, as compared to an offshore situs such as Bermuda, would be the state premium tax that is due regardless of the IRS treatment of premiums paid to the captive. Vermont imposes a state premium tax of 0.4% on the first $20 million of direct insurance premiums (and uses a declining scale thereafter) as well as 0.225% tax on the first $20 million of reinsurance premiums written (and also uses a declining scale thereafter).

The obligation to pay direct-placement tax may arise as a result of the direct procurement coverage from a non-admitted insurance company. When a captive is defined as non-admitted, the policyholder may potentially be liable for paying such taxes based on the net amount of the captive’s written premium for the particular coverage. When the coverage is placed with an admitted insurance company, the insurance company is responsible for paying such taxes; whereas for placements through a surplus lines carrier, the agent responsible for the transaction is liable for such taxes.

Direct placement tax may be payable based on variable state-to-state rates applied against the proportion of total premiums allocated to each state. Some states do not impose any direct placement tax.

Key Tax-related Issues
The fundamental federal tax issue in captive insurance cases is whether payments made to the captive insurance company are properly classified as “insurance premiums” and underlying the answer to that question, is whether actual risk shifting and distribution are taking place. A comprehensive judicial analysis of many captive insurance issues can be found in Kidde Industries, where the U.S. Court of Federal Claims articulated a sequence of relevant determining factors using a six-pronged analytical framework:

  1. Determination of business purpose.  Consistent with Moline Properties v.  Commissioner, 319 U.S. 436 (1943),  when applying the tax laws to captive  insurance companies, courts initially  have sought to determine whether the  arrangements between the captive insur ance company, the parent, and any thirdparty companies could be classified  under the circumstances as a “sham.”
  2. Is there a sham? If the court determines that the corporate arrangement is a  sham, then the inquiry ends and the payments to the captive insurance company  are treated as nondeductible reserves  rather than “insurance premiums.” 
  3. Test conformity with commonly  accepted notions of insurance. Next,  either as part of this analysis of whether  a sham exists, or as part of a separate  analysis of whether the payments to the  captive insurance company otherwise  should be characterized as “insurance premiums,” courts have analyzed  whether the arrangement among the  parties is consistent with commonly  accepted notions of insurance. If the  arrangement is not consistent with commonly accepted notions of insurance,  then the payments are not deductible  from income. 
  4. Apply the “Le Gierse approach.”  Finally, assuming the arrangement is not  a sham and is otherwise consistent with  commonly accepted notions of insurance, courts generally have proceeded to  apply the definition of “insurance” set  forth in Helvering v. Le Gierse, 312 U.S.  531 (1941) to determine whether appropriate…(5) Risk shifting…and…(6) Risk  distribution…are present.1

The IRS’ most recent revenue rulings pertaining to the captive issue more or less provide a safe harbor for characterizing a captive as an insurance company where the following conditions are satisfied:

Economic Substance Requirements

  • No guarantees from the corporate parent of  any kind are made in favor of the captive.
  • The captive does not loan funds to its  owner or to any policyholder.
  • Capitalization is adequate.
  • A valid non-tax purpose motivates the  formation of captive.
  • The captive’s business operations and  assets are kept separate from the business operations and assets of its owner(s).

Conformity with Commonly Accepted Notions of Insurance

  • Premiums are priced at arm’s length and  are established according to customary  insurance-industry rating formulas.
  • The conduct of interaction between the  captive and policyholders is consistent with  the standards applicable to an insurance  arrangement between unrelated parties.
  • The captive properly investigates and  establishes the validity of claims before  paying them.
  • The captive either performs all necessary  administrative tasks using its own personnel or it outsources those tasks at prevailing commercial market rates.
  • The policyholders truly face insurable  hazards.
  • The transaction is of a type that involves insurance in the commonly accepted sense.
  • The captive holds all required licenses to  conduct insurance business in the jurisdictions in which it operates.

Risk Distribution Characteristics or Pooled Risk

  • In a brother-sister insurance arrangement, i.e., one that involves related entities under the same corporate parent,  there must be at least 12 affiliated corporate policyholders that pool their risk.  In an association captive arrangement,  there must be at least seven policyholders. (For mines, separate policyholders  traditionally own different properties. A  group of owners would pool corporate  risks, however, such as associated with  closure and reclamation of mills, tailings  facilities or certain existing environmental conditions associated with  groundwater or waste rock piles, etc.)
  • No single policyholder’s risk accounts for  more than 15% of the captive’s aggregate maximum exposure to loss. In other  words, there is a true pooling of risk.
  • The volume of potential loss events is  significant. Presumably, “significant”  volume means volume that is significant from a statistical standpoint; i.e.,  the statistics are sufficient to enable an  actuary to assign probabilities to the  insurance company’s potential under writing losses.
  • Potential loss events are independent.
  • Pooled risk is essentially homogeneous  in character.
  • A net underwriting loss generated by one  policyholder is borne in substantial part  by premiums paid by other policyholders.
  • There is a real possibility that a policyholder will sustain a covered loss in  excess of the premium it pays. (Mine  operations can vary considerably and catastrophic events do not always lend  themselves to actuarial certainty, nonetheless there are plenty of operational,  health and environmental risks associated with mining. By more effectively managing risks that may not have previously  been addressed, it may be possible to  safeguard life and property better while  saving on taxes.)
  • Premiums are not experience-rated. That  is, a policyholder is not obligated to  pay additional premiums if its actual  losses exceed its premium during any  period of coverage, nor will a policyholder be entitled to a refund if its premium  exceeds its actual losses during any period of coverage.

The 20 conditions in Rev. Ruls. 2002-89, –90 and –91 constitute the comprehensive approach utilized by the IRS to evaluate captive insurance arrangements.
 
Essential Element of Risk Transfer
It is worth elucidating the specific test implied in the risk transfer analysis. Per Rev. Rul. 2002-89, a policyholder may not, in significant part, pay for its own risks. This notion holds that “true insurance…must rid the insured of any economic stake in whether the loss occurs.”2 In FSA 200202002, the IRS traced this notion back to testimony in the Humana case:3   …the essential element of an insurance  transaction from the point of view of the  insured (e.g., Humana and its hospital  network) is that no matter what insured  perils occur, the financial consequences  are known in advance. Expressed another way, once an insured pays a premium,  in the true insurance situation, the  insured is neutral as to whether the loss  event occurs.

The foregoing statement is the essence of whether risk transfer is deemed to exist. It is fundamental that for a captive to be treated as an insurance company under the federal tax code both risk transfer and risk distribution must exist. It is also important, however, to note that while risk transfer is and has been the subject of much IRS scrutiny, at the present time, the IRS seems more concerned with actual risk distribution at the captive operational level.4

Conclusion
The foregoing is a general summary of captive insurance concepts, including an overview relating to domicile choice and tax planning. The regulatory rules of a particular jurisdiction in terms of taxes, environmental operations and financial insurance requirements, as well as the thinking of the IRS regarding captives, continually evolve. Forthcoming promulgation of financial assurance requirements for mines under CERCLA § 108(b) is one example of this potential evolution. Accordingly, prior to the implementation of a captive program, as noted above, contact with any specific proposed domicile must be part of any analysis of its suitability. In addition, a captive program must be sensitive to the possibility of changing IRS and other regulatory (EPA, MSHA, OSHA, etc.) trends. The starting point is preparation of a detailed feasibility study and business plan which is consistent with the mine-operation plan, and specifically tailors the captive arrangement accordingly in order to ensure that a captive proposal addresses the above issues and makes fundamental business sense.

The authors are shareholders at Anderson Kill & Olick, P.C. Nevius is chair of the firm’s environmental law group and England is chair of the firm’s captive insurance group. Anderson Kill routinely represents mining operations with respect to various environmental risk-management matters, including financial assurance and the establishment of captive insurance companies. The authors emphasize that this article is for informational purposes only and is not a substitute for specific legal advice. Please contact the authors before taking steps to implement a captive insurance program.

  1. See Kidde Industries v. U.S., 81 A.F.T.R. 2d 98-326 (40 Fed. Cl. 42) (1997).
  2. Clougherty Packing v. Commissioner, 811 F.2d 1297 (9th Cir. 1987). 
  3. Humana Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989).
  4. For example, see IRS Rev. Ruling 2005-40.

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