The Proper Role of Life Insurance And Captives

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 analagous 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.