What does the recent U. S. Department of Labor ("DOL") proposed exemption for Columbia Energy Group mean? For Columbia Energy, it means paving the way to add employee benefits to its captive insurance program. For other corporations, it may open the floodgates to potential tax savings and increased employee benefit cost controls if the DOL adopts this approach as their new position.

In this article, we address the following questions:

1. Does the new DOL position make sense?
2. What is "unrelated" business for the DOL and the IRS?
3. What are the potential costs/benefits to a company?
4. What are the potential costs/benefits to the entire industry?

1. The DOL Position

We applaud the DOL for their new position. It provides better protection to plan participants than the old position, recognizes the sophistication of the captive market and its regulators, and gives the DOL a tool to keep an eye on things.

Protection - the 50% Rule

Prior to the Columbia Energy ruling, the DOL required that in order to have employee benefits be part of a captive insurance program, 50% of the premium in the captive company needed to be for other "unrelated" exposures. For the DOL, "unrelated" excluded the parent company's own property, liability, and workers' compensation risks. So if there were $10 million of employee benefits premiums and $20 million of property/casualty premiums, related premiums were $30 million, and an additional $30 million of "unrelated" premium was required in order to put the $10 million of employee benefits in the captive company.

That meant that the parent's captive would have to find other risks to insure, and there were no guidelines or limitations as to what might be included in such an "unrelated" portfolio. It could potentially include large catastrophic exposures. It could also include exposures with unknown loss potential, either due to lack of historical data, or a lack of knowledge and/or sophistication on the part of the captive. The sheer magnitude of the 50% threshold was usually a non-starter, and even if it could be achieved, the risk of underwriting losses just wasn't worth it. Yet this was the DOL's position. It could be argued that the DOL was encouraging companies to take on more risk than they could or should.

With Columbia Energy, the DOL has granted an exemption to the 50% rule. Now, the same company does not need any unrelated premiums, and, in our example, doesn't need $30 million of other business to put the employee benefits program in the captive. This seems to protect the benefit plans relative to the prior position because the employee benefit plans will not be exposed to risks outside of the scope and control of the parent, and are more likely to be paid out under the new position.

Captives and Captive Regulation

The DOL requires the use of a domestic captive, and the exemption has a number of conditions that must be met, including evidence of a recent financial examination by the captive's regulatory authorities. Since the original DOL ruling, a major change has been the maturity of the captive industry, and the regulation of captives. When the 50% rule was adopted in 1976, there were no true captive domiciles in the US, and even insurance regulation for non-captives was somewhat lax (for example, actuarial opinions were not required for US insurers in all states until the late 1980's).

Today, the captive industry in the US has matured significantly. Regulators monitor captives, require annual audits and actuarial opinions, require regular updates to business plans, and perform financial examinations. This is not to say that other captive domiciles are less of a force in terms of regulating financial solvency. And perhaps some day, the requirement to use a domestic company will be dropped by the DOL. For now, it appears that the DOL would like US laws and regulations to govern the way business is conducted where these exemptions are present.

In summary, the maturity of captive insurance regulation provides protection against insolvencies of captives, and further protects plan benefits.

DOL Requirements

Finally, the DOL requires, among other things, that an independent fiduciary annually opine on the employee benefit portion of the captive program. This additional "check and balance" allows the DOL to stay involved with the process, and serves as another layer of protection to plan participants.

2. Unrelated Business

The DOL defines both the parent's property/casualty premiums and employee benefits as "related" business. Unrelated business would be for exposures generally outside of the parent's scope of operations. However, conventional wisdom is that the IRS considers employee benefits as unrelated business. Further, many companies that seek tax deductions for all of their captive premiums try to achieve a 30% ratio of unrelated premiums under the IRS definition of related/unrelated. While the 30% unrelated figure is not in the IRS code, it is often viewed as a barometer for achieving tax deductibility.

Using the example outlined above, a $30 million program consisting of $20 million of property/casualty premiums and $10 million of employee benefits would be considered as 0% unrelated to the DOL, but 33% unrelated to the IRS. This would exceed the 30% "threshold" for the IRS. Without the DOL exemption, the captive would need to find another $30 million of "other" unrelated business to reach the DOL threshold. With the exemption, the addition of the employee benefits may have created a tax deduction for the property/casualty premiums that were otherwise not deductible before. Will the IRS take exception to this? Time will tell. In the meantime, what is the tax benefit worth?

3. Costs/Benefits - Single Company

If a company chooses to follow in Columbia Energy's footsteps, it will incur costs, but it may achieve a federal tax benefit along the way. Costs include the following:

1. Improvement in plan benefits - required by DOL
2. Increase in administrative costs (fiduciary opinion, legal costs, etc.)
3. Increase in captive premium taxes

Benefits include the following:

1. Potential accelerated tax deduction
2. Potential increased control over employee benefits costs (integrated disability, etc.)

Let's use the example above of $20 million in property/casualty premium and $10 million in employee benefits, and assume that the incremental costs are $400,000, based on the following assumptions:

• Plan benefits increase by $300,000
• Annual administrative costs increase by $60,000
• Premium tax on the $10 million of employee benefits is $40,000 (0.4% Vermont premium tax)
• There is an existing captive insurance program
• Captive premiums are currently not deducted for federal tax purposes

Our prior research on the benefit of accelerated tax deductions shows that for a typical block of casualty lines (workers compensation, general liability, and auto liability), the annual benefit is about 3.0% of the underlying losses. While this amount varies depending on a number of assumptions such as loss payout patterns and discount rates, the 3.0% is representative, in our opinion. In this case, using $20 million in premium, the benefit is $600,000. Subtracting out the incremental costs of $400,000, the net annual gain to the corporation would be $200,000, or 1.0% of the property/casualty premiums. This gain ignores any potential savings generated by increased efficiencies/control of costs. It focuses solely on federal taxes.

4. Costs/Benefits - Entire Industry

Extending the 1.0% gain to the entire industry, we estimate that the annual federal tax gains could be as much as $50 million. This assumes that $5.0 billion of casualty premiums in single parent captives, which are not currently taken as deductions, could qualify if employee benefits could be used as the unrelated premiums to justify deducting all premiums paid to the captive. The $5.0 billion is derived as follows:

In 1999, Vermont had 278 active single parent ("pure") captives, who wrote $3.3 billion of gross premiums. In Bermuda, there were 421 class 1 captives, which are analogous to Vermont's "pure" captives. We assumed that these captives had the same average gross premiums per captive as those in Vermont, or $12 million, which produces approximately $5.0 billion of gross premium. The total gross premiums in 1999 for single parent captives in Vermont and Bermuda are then $8.3 billion. Adding in single parent captives in other domiciles, along with inflation and exposure growth, we selected $9.0 billion as the base.

We then assumed that about 1/4 of the industry, or about $2.25 billion worth, is already taking the deduction. Finally, of the remaining $6.75 billion, we assumed that about 1/4, or another $1.7 billion, would not result in material savings (e.g., property lines where short payout all but eliminates the value of accelerated tax deductions). This brings the figure down to $5.0 billion. Applying the 1.0% savings to this produces the $50 million annual federal tax benefit.

5. Conclusion

The DOL proposed exemption is a favorable turn of events for corporate America. Whether or not the exemption is applicable to large numbers of companies remains to be seen. Also, whether or not the IRS positions remain static also remains to be seen. The savings available to companies under current federal tax circumstances could be substantial.