Ducking the taxman: the growth in numbers of RRGs formed by non-profit health care organizations to respond to a lack of primary liability coverage in the commercial market is striking. For many non-profits, a key concern in forming a captive RRG is to achieve tax efficiency, the author argues

Risk & Insurance, April 1, 2004 by Kevin Moriarty

The past few years have witnessed a dramatic increase in the number of non-profit organizations forming captive risk retention groups, which qualify under the federal Liability Risk Retention Act of 1986 to provide their members with liability insurance coverage in any state with only limited registration requirements.

The growth in numbers of RRGs formed by non-profit health care organizations to respond to a lack of primary liability coverage in the commercial market is striking. For many non-profits, a key concern in forming a captive RRG is achieving income tax efficiency--an RRG subject to minimal federal taxes or exempt from federal income tax altogether.

Two options for achieving this are the formation of the RRG as a reciprocal insurer or the formation of the RRG as a tax-exempt, non-profit corporation.

Forming Reciprocal RRGs

A reciprocal insurer is an unincorporated association formed under a state's insurance laws. Subscribers to the reciprocal hold the equity interests in the reciprocal (comparable to shareholders of a corporation) and they are insured by the reciprocal. For nonprofit groups, the subscribers are usually the member institutions of the group. The subscribers appoint an attorney in fact, which acts on behalf of the subscribers to exchange contracts of insurance among them.

For federal income tax purposes, insurance companies are subject to a special set of tax accounting rules, which are found in subchapter L of the Internal Revenue Code of 1986. The insurer uses these rules to compute its annual taxable income. Code Section 832(f) has a special provision unique to reciprocal insurance companies, which allows the reciprocal to deduct annual net income that the reciprocal allocates to a "subscriber savings account" established for each subscriber. The reciprocal allocates its income to the SSAs, but it is not required to distribute any of the allocated amounts to the subscriber until the subscriber leaves the insurance program. With the caveats noted below, the deduction for SSA allocations may allow the reciprocal to zero out its taxable income annually, and eliminate federal income tax. At the same time, the reciprocal can retain the income allocated to the SSAs and use the funds to support its insurance operations.

From the subscribers' perspective, the annual SSA allocations are treated as dividends paid. The subscribers must take these dividends into account for purposes of their federal income tax liability under the usual tax rules applicable to dividends. If the subscriber is a tax-exempt organization, the dividend is not taxable, as dividends are not considered taxable unrelated business income. In sum, a reciprocal RRG with tax-exempt subscribers can operate without any federal income tax payable by the RRG or its subscribers.

Achieving this "zero federal tax" result depends on the structure and operation of a reciprocal's insurance program. Most important is that the reciprocal qualify as an "insurance company" for federal income tax purposes. Simply being licensed as a reciprocal insurer by a state insurance department is not enough. The insurance arrangements must result in risk shifting from the subscriber to the reciprocal, and there must be sufficient distribution of independent insurance risks within the reciprocal.

Second, to the extent possible the reciprocal's insurance program must eliminate differences in its annual income determined for regulatory accounting purposes versus its annual income determined for tax purposes. SSA allocations are based on the reciprocal's statutory income or book income, as reported on the annual statement filed with the National Association of Insurance Commissioners.

The Code rules used to determine a reciprocal's taxable income are not identical to the accounting rules used to determine book income. The most significant sources of disparity between taxable income and book income are unearned premium, capital losses, and the difference between the discount factor used to value insurance loss reserves for book purposes and the mandatory discount in loss reserves for tax purposes. These disparities have the effect of decreasing book income relative to taxable income (before the SSA allocation deductions). Since SSA allocations are based on book income, if these book/tax disparities exist, the deduction for SSA allocations will not fully offset the reciprocal's taxable income. The result is that the reciprocal cannot zero out its taxable income, and it will have a federal income tax liability.

Book vs. Tax Disparities

* Capital Losses. For accounting purposes, capital losses are deductible against ordinary income and capital gain; for tax purposes the losses are deductible only against capital gain.

* Loss Reserve Discount. For tax purposes, unpaid loss reserves must be discounted before they are deducted from underwriting income (this is true of all insurance companies, not just reciprocals). If the loss reserves are not discounted for book purposes, or if they are discounted at a substantially lower rate than the tax discount rate this will decrease the reciprocal's book income relative to its taxable income.