Captive Insurance Companies and Manager-Owner Conflicts

Abstract

INTRODUCTION Captive insurers are formal insurance subsidiaries established to primarily finance risks of their parent organizations. Over the past 35 years, captive insurers have become popular self-insurance mechanisms among corporate risk managers. The 1996 Captive Insurance Company Directory includes a total of 2,880 single-parent captive insurers, as compared to the 156 listed in 1975 when the directory was first published. The growth of captive insurers has been explained variously as an attempt by corporations to create income tax savings, a response to the inability of corporations to obtain favorable commercial insurance coverage, a way to reduce a corporation's cost of risk and to improve its cash flow, and as the creation of another profit center in the corporation. However, none of these reasons may fully explain the dramatic increase in the number of single-parent captive insurers. An infrequently voiced hypothesis for the growth of captive insurers is that they enhance the stature of managers. Data are not available to accurately measure the benefits as compared to the costs of operating a single-parent captive insurer, or to whom such benefits and costs accrue. However, there are sufficient data to examine whether corporations with heightened manager-owner conflicts of interest are more likely to operate a single-parent captive insurer. BACKGROUND LITERATURE Income Tax Relief The Internal Revenue Service (IRS) has changed its position on the tax-deductibility of premiums paid to captive insurers since the initial surge in formation of single parent captive insurers by United States corporations. Cross, Davidson and Thornton (1987, 1988), Wood, Glascock and Bigbee (1988) and Borch (1990) conclude that the initial popularity of captive insurers arose from their ability to provide income tax relief to their parent corporations. Before 1977 parent corporations were able to deduct the premiums paid to their captives from federal income tax. If the captive was domiciled in the United States, the Parent Corporation paid federal income taxes on the net income of its captive, but it could deduct from federal income tax the captive's reserves. If, however, the captive was located outside the United States, under Sub-part F of the Internal Revenue Code, the parent corporation could defer paying taxes on the net income of its captive until such income was repatriated to the United States. After 1977, with Revenue Ruling 77-316, the IRS prohibited corporations from deducting from their federal income tax the premiums they paid to their wholly owned captives. This prohibition was upheld in 1978 (Carnation Co. vs. Commissioner, 71 Tax Court 39, 1978) and on appeal in 1981. The Tax Reform Act of 1986 modified Sub-part F of the Internal Revenue Code. It reduced the ability of corporate parents that established captives outside the United States to defer payment of taxes on their captives' net income. Thus the original status of a captive insurer as a tax relief device cannot fully explain why the formation and operation of single-parent captive insurers by United States corporations has continued to grow at varying rates of intensity.(1) Studies have also examined whether the formation of a captive insurer affects the price of a corporation's stock. based on their studies Cross, Davidson and Thornton (1987, 1988) concluded that when the premiums paid by a parent corporation to its captive insurer are viewed as tax deductible, the stock market reacts favorably to the formation of a captive insurer. Conversely, when the premiums paid by the Parent Corporation to its captive insurer is considered not tax deductible, the stock market reacts unfavorably to the formation of a captive insurer. Wood, Glascock and Bigbee (1988) also have concluded that when the premiums paid by the parent corporation to its captive insurer are viewed as tax deductible, the stock market reacts favorably to the formation of a captive insurer, but the stock market is indifferent to the formation of a captive insurer when the premiums paid by the parent corporation to its captive insurer are not viewed as tax deductible. …