It’s All in the Assumptions

It’s All in the Assumptions

Companies or individuals who own captive insurance companies generally prepare three sets of financial statements:

  1. Statements complying with Generally Accepted Accounting Principles (GAAP),
  2. Statutory financial statements filed with state insurance departments, and
  3. Tax returns.

Company liabilities, either current or future, can be transferred to a captive insurance company without changing the valuation of those liabilities on the GAAP financial statements.  However, once in the insurance company, the liabilities must be valued according to state insurance laws, which are intentionally conservative.  That means that the value of a liability is likely to be larger in a captive insurance company than it is in a general-purpose corporation.

The federal tax law for insurance companies specifically states that the value of a liability on a tax return is equal to the smallest allowable value for that liability on the statutory financial statement.  Thus, when a liability is placed in a captive insurance company it will have a higher value on the tax return.

As an example, consider a pension liability of $1,000,000 on a GAAP financial statement.  When that liability is transferred to a captive insurance company its value must be calculated using conservative assumptions for mortality and interest.  These conservative assumptions might cause the same liability to be valued at $1,200,000.  When the insurance company prepares its tax return, and that return is consolidated with the parent, the liability will be valued at $1,200,000 for tax purposes.  Thus, an additional tax return liability of $200,000 has been created.  At a 35% tax rate, that additional tax return liability will defer $70,000 of taxes.  Further, the deferral won’t reverse until the pension is paid out, and that may take 20 years or more.

State insurance laws specify conservative assumptions for valuing many kinds of liabilities.  Further, if no assumptions are specified, the state insurance department depends on the appointed actuary of the captive insurance company to set the reserves.  Appointed actuaries can be fairly conservative in their own right.

Captive insurance companies can certainly be very useful financial vehicles.

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