Captive Insurance Opportunities and Solutions Post-COVID-19

May 21, 2020

Companies with coronavirus (COVID-19)-related losses and legacy liabilities may appreciate significant additional tax benefits from funding those legacy liabilities through a captive insurer before the end of this year. Companies looking to procure insurance to cover losses from the next infectious disease outbreak should explore the many benefits of insuring such risk with a captive.

While current insurance coverage programs may insure losses resulting from COVID-19, companies’ coverage claims will be contested and they additionally should expect the marketplace for any such coverage in the future (absent legislation requiring it) to tighten significantly, if not evaporate, as insurers expand the scope of virus related exclusions in all risk, property, business interruption and related coverages. Additionally, in the wake of insurers’ expectations that COVID-19-related losses across various other coverages will be the insurance industry’s largest in history,[1] insurers may manage their capacity across many coverages with considerations concerning potential increased liabilities or exposure to losses of their insureds, which may require companies to accept larger retentions or deductibles in their insurance programs, and/or pay higher premiums. In some instances, companies may not be able to secure the same amount of commercial insurance as in past years. In the absence or tightening of insurance options from traditional commercial insurers, captive insurance can fill in the gap, open up access to the potential reinsurance market, and prepare companies financially for the traditional and nontraditional risks that they may face in the future.

Companies with legacy liabilities such as environmental, asbestos, or other similar long tail claims may also benefit from tax changes in the CARES Act if they use a captive this year to insure legacy liabilities. These liabilities may already be reserved on their balance sheet. By properly establishing captive insurance subsidiary to insure substantive legacy liabilities, the contingent liabilities reserved on the parent company’s balance sheet should be transferred to the captive insurer’s balance sheet, thereby accelerating a deferred tax asset. And, if the company has a net operating loss (NOL) in 2020, that NOL can now be carried back for up to five years perhaps offsetting income that was taxed at a 35% rate resulting in an additional 14% tax benefit (compared to the current 21% federal rate for corporate taxpayers).

Captive Insurance

A captive insurer is a wholly owned subsidiary that is licensed to insure the risks of its affiliated companies through the issuance of insurance policies in exchange for the payment of premium. A captive is most commonly used to insure a deductible or self-insured layer of coverage, to reinsure a fronting commercial insurer, or to provide coverage that is not reasonably available in the commercial marketplace.

A specialized actuary retained by the captive typically sets the premium, which is composed of a loss reserve and a risk margin. In a typical commercial insurance setting, the third party insurer keeps the risk margin, which is the expected profit from the risk being insured. In the captive setting, the risk premium is retained by the captive and is invested for the benefit of its parent and affiliated businesses. A third party captive manager helps run the administrative side of the captive and interact with the domicile regulating the captive.

Experienced insurance coverage counsel can prepare a manuscript policy tailored to the specific needs of the businesses affiliated with the captive. In contrast, a third-party commercial insurer typically uses a standard form policy with exclusions added to limit the scope of coverage.

A captive provides its insured businesses a company with access to the broader reinsurance market where opportunities may exist to shift a portion of the captive’s risk to reinsurers in a cost effective manner.

Generally, loss reserves of a captive insurance company are immediately deductible (on a discounted basis) for tax purposes under IRC Section 832, thus accelerating the tax deduction within the company’s consolidated group and monetizing the associated deferred tax asset. Courts look to four criteria in deciding whether an arrangement constitutes “insurance” for federal income tax purposes:

  1. the arrangement involves insurable risks;
  2. the arrangement shifts the risk of loss to the insurer;
  3. the insurer distributes the risk among its policy holders; and
  4. the arrangement is insurance in the common accepted sense.

Legacy Liability Captives

Captives are a great tool to provide a source of dedicated, tax efficient funding to support a legacy liability ring fence structure. We have designed many such structures where legacy liability is moved to and distributed among multiple subsidiary legacy liability companies, with those companies in turn purchasing insurance from their brother sister captive insurance entity to fund the runoff of the legacy environmental, asbestos, toxic tort, or similar liabilities. Once the ring fence subsidiary structure is finalized and running, all legacy liability will be owned, managed, and funded (through captive insurance and historical insurance proceeds). Such a structure can potentially offer companies business, financial, and legal benefits depending upon a company’s specific circumstances and needs.

Using a captive to fund in whole or in part the legacy liability structure provides the additional benefit of potentially accelerating a deferred tax asset. Existing legacy liability reserves on a company’s balance sheet are typically not deductible for tax purposes until paid (i.e., an “all events test” is met under IRC Section 461), giving rise to a deferred tax asset.

By transferring the liability associated with existing reserves to the captive’s brother sister companies, and then insuring such liability with a qualified captive insurance company, the reserves could be moved from the parent’s balance sheet to the captive’s balance sheet via a loss portfolio transfer. As discussed above, loss reserves of a qualified captive insurance company are immediately deductible, thus monetizing the associated deferred tax asset at the current corporate tax rate of 21%.

Under the CARES Act, the monetized deferred tax asset can be eligible to be carried back for up to five years. For example, if a legacy liability captive is formed and funded in 2020 to insure environmental and asbestos legacy liability for which the parent carries a reserve of $300 million on its balance sheet, that reserve will be transferred to the captive’s sheet and potentially be immediately deductible. Prior to the CARES Act, that deduction would be worth 21% or $63 million based on the applicable federal corporate rate. After the CARES Act, that deduction, if associated with captive policy funded in 2020, may be carried back to 2016, provided the company has an NOL in 2020 (as well as in 2017-19) and had taxable income in 2016 when the tax rate was 35%. In that scenario, the federal income tax deduction for the company would be worth $105 million instead of $63 million, for an additional cash benefit to the company of $42 million. The captive may also have the potential to create state tax benefits.

With that said, taxpayers would be well advised to consider carefully the indirect consequences and ramifications associated with carrying back NOLs to prior years. For example, doing so may require amending both federal and state tax returns for prior years, which can open statutes of limitations that were previously closed.

Using Captives to Insure Future Infectious-Disease-Related Risk and Other Future Gaps in Coverage

All efforts should be made to determine whether your company’s current all risks property and business interruption coverage responds to the myriad of losses that companies continue to experience as a result of COVID-19 and civil authority orders. Our recent LawFlash discussed how companies can best preserve and pursue claims against their insurers.

In conjunction with reviewing current policies to assess the scope of coverage available to pay COVID-19-related loss and offerings by insurers in upcoming renewals of all of a company’s insurance programs, your company should also identify any coverage gaps and consider strongly filling any such gaps with captive issued coverage. If your company already owns a captive insurer, check its business plan to make sure it has the authority to write this type of direct coverage, and if not, consider amending the business plan. If your company does not have an existing captive, one can be set up to be ready to write coverage in connection with your next renewal as needed. This can and should be done in the short term.

In the longer short term, companies should prepare for a possible tightening of the commercial property/casualty insurance market at the time of the next renewal of coverage. At a minimum, commercial insurers may seek to add broad exclusions for infectious-disease-related losses, and may require significantly higher premiums for less limits with higher deductibles or retentions for other coverages. Setting up a captive now will allow companies the flexibility to add quickly and efficiently coverage that otherwise cannot practically be placed from their captive at renewal time.

Captive insurance counsel can tailor pandemic coverage to the specific needs of businesses based on assessment of losses experienced in the current pandemic and an analysis of additional losses that may be experienced in future events. Data analytics is a helpful tool to assist with the assessment. Specialized actuaries can then use the data and related assessment to price the coverage based on the limits of liability needed and the risk profile of the company.

As captive coverage is drafted to respond to the losses a company’s businesses are likely to experience, it can include contingent business interruption coverage (CBI) in addition to business interruption (BI) coverage resulting from the loss or damage to the insured’s own property to provide the maximum possible protection. CBI more broadly protects against revenue-related losses by covering lost earnings because of a distributor or third-party supplier shutdown that impacts a company’s ability to produce a product or provide a service. CBI coverage can pay for continuing and ongoing expenses including payroll, rent, and other expenses.

In the longer term, a captive that insures BI and CBI loss related to an infectious disease outbreak has the potential to access the reinsurance market, which has historically tended not to tighten as much as the direct insurance market, to share the risk with the captive in a cost-effective manner.

How We Can Help

It is important for companies with legacy liabilities, confronting significant COVID-19-related business interruption losses, and/or confronting a tightening commercial insurance coverage market to confer with experienced captive insurance and tax counsel that can advise on the many immediate and long-term benefits of using a captive insurer.

We have experience assisting clients in setting up and managing legacy liability captive ring fence structures and counseling companies on how best to use a captive insurer to supplement their existing insurance programs. We work closely with all major captive manager firms, captive actuaries, and accounting firms to set up captive programs in a tax efficient manner, and counsel on the best uses of captive insurers. For assistance with these or any other issues, contact any of the Morgan Lewis lawyers listed below.

Coronavirus COVID-19 Task Force

For our clients, we have formed a multidisciplinary Coronavirus COVID-19 Task Force to help guide you through the broad scope of legal issues brought on by this public health challenge. Find resources on how to cope with the post-pandemic reality on our NOW. NORMAL. NEXT. page and our COVID-19 page to help keep you on top of developments as they unfold. If you would like to receive a daily digest of all new updates to the page, please subscribe now to receive our COVID-19 alerts, and download our biweekly COVID-19 Legal Issue Compendium.


If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Washington, DC
Daniel E. Chefitz
Paul A. Zevnik
Gerald P. Konkel
Teri J. Diaz

David L. Harbaugh 

San Francisco
Jeffrey S. Raskin
Barton W.S. Bassett

Los Angeles
Charles Malaret
David Sean Cox

Ariane Baczynski

[1] See Coronavirus will be the largest loss on record for insurers, Lloyd’s of London says, CNBC (May 14, 2020)