The Captive Medical Malpractice Insurance Company Alternative

Annals of Health Law Volume 5 Issue 1 1996 Article 7 1996 The Captive Medical Malpractice Insurance Company Alternative James A. Christopherson Dingeman, Dancer & Christopherson, P.L.C. Follow this and additional works at: http://lawecommons.luc.edu/annals Part of the Health Law and Policy Commons Recommended Citation James A. Christopherson The Captive Medical Malpractice Insurance Company Alternative, 5 Annals Health L. 121 (1996). Available at: http://lawecommons.luc.edu/annals/vol5/iss1/7 This Article is brought to you for free and open access by LAW eCommons. It has been accepted for inclusion in Annals of Health Law by an authorized administrator of LAW eCommons. For more information, please contact . Christopherson: The Captive Medical Malpractice Insurance Company Alternative The Captive Medical Malpractice Insurance Company Alternative James A. Christopherson* INTRODUCTION In recent years, health care providers, including hospitals, health maintenance organizations, and physician practice groups, have faced steadily rising medical malpractice premiums, which have led them to seek alternative sources apart from the traditional policies and services provided by large, independent, commercial insurance companies. One alternative of increasing popularity is the captive medical malpractice insurance company ("captive"). Rather than purchasing insurance from an independent insurance company, the insured can create a subsidiary or sister corporation, the captive, to act as a funding vehicle for the insured (the captive's owner(s) or its affiliate(s)) by assuming some or all of the owner's risk of financial liability for medical malpractice either through direct insurance or reinsurance. The relationship between an insured and its captive is distinguished by the high degree of control the insured can exercise over its insurer. As the captive's owner, the insured can be directly involved in major decisions made by the captive regarding underwriting, investment policies, claims management, and quality improvement. Direct involvement with these issues as well as with the captive's ongoing performance often means that the insured can reduce its risk-funding costs. Indeed, reducing insurance costs by effectively managing risks and by eliminating much of the overhead carried by an independent insurance company is what makes forming a captive an attractive option for many health care providers. * Mr. Christopherson is a member of the law firm of Dingeman, Dancer & Christopherson, P.L.C., in Traverse City, Michigan. He represents physician organizations, physician practice groups, management service organizations, and other health care providers and organizations advising them on a variety of issues. Mr. Christopherson received his undergraduate Bachelor of Arts, magna cum laude, from Michigan State University, and Doctor of Jurisprudence, cum laude, from Wayne State University Law School. He is a member of the National Health Lawyers Association and the American Academy of Healthcare Attorneys. Published by LAW eCommons, 1996 1 Annals of Health Law, Vol. 5 [1996], Iss. 1, Art. 7 Annals of Health Law [Vol. 5 Beyond reducing premiums and providing protection from premium fluctuations, there are several other reasons health care providers may decide to form a captive: * the insured(s) can control the investment of premium income and capital, which can reduce premium costs; * the captive can design loss prevention and claims handling programs for medical malpractice claims, a highly specialized area (including a unified legal defense among multiple defendants); * the captive can provide broader coverage than may be available in the commercial insurance market (or for some risks the only coverage); and * the captive can access the reinsurance market. A practitioner who attempts to form a captive for a health care provider must be aware of many issues.1 An extremely sig- nificant issue is the tax treatment of the premiums the insured pays to its captive: a for-profit insured must be able to deduct as business expenses the premiums it pays its captive, 2 and not have them treated as nondeductible loss reserves. The recent Sixth Circuit Court of Appeals decision in Malone & Hyde, Inc. v. Commissioner3 highlights some of the tax traps that await the unwary practitioner when forming a captive. While it is beyond the scope of this article to describe in detail the tax advantages and disadvantages of a captive, it will discuss Malone & Hyde and, more generally, the Internal Revenue Code's treatment of corporate insurance, providing an overview in this area. In addition, a practitioner must consider the tradeoffs in- volved in domiciling the captive. Offshore domiciles are extremely popular because of the greatly reduced regulatory 1. For more guidance, see Donald A. Winslow, Tax Avoidance and the Definition of Insurance: The Continuing Examination of Captive Insurance Companies, 40 CASE W. RES. L. REV. 79 (1990); Joseph C. Safar, When Federal Tax Law FrustratesPolicy: The Confused Rules Governing the Deductibility of Captive Insurance Premiums, 34 Duo. L. REV. 105 (1995); Julie A. Roin, United They Stand, Divided They Fall: Public Choice Theory and the Tax Code, 74 CORNELL L. REV. 62 (1988); Note, Revenue Rule 77-316 and Carnation Co. v. Commissioner: An Analysis of the Attack on Captive Offshore Insurance Companies,2 VA. TAx REV. 111 (1982); Theodore D. Moskowitz & Walter A. Effross, Turning Back the Tide of Directorand Office Liability, 23 SETON HALL L. REV. 897 (1993); Stuart R. Singer, When the InternalRevenue Service Abuses the System: Captive Insurance Companies and the Delusion of the Economic Family, 10 VA. TAX REV. 113 (1990); William B. Barker, FederalIncome Taxation and Captive Insurance, 6 VA. TAX REV. 267 (1986). 2. See generally Winslow, supra note 1. This issue is not important to the taxexempt organization. 3. 62 F.3d 835 (6th Cir. 1995). http://lawecommons.luc.edu/annals/vol5/iss1/7 2 1996] Christopherson: The Captive Medical Malpractice Insurance Company Alternative Captive Medical Malpractice Insurance Companies 123 burden, lower capitalization requirements, and certain federal tax advantages for tax-exempt organizations. This article will discuss the reasons for forming a captive medical malpractice insurance company, the different types of captives, and the due diligence considerations that the practitioner will face when forming a captive. I. REASONS TO FORM A CAPTIVE MEDICAL MALPRACTICE INSURANCE COMPANY Most entities looking at the possibility of forming a captive do so because they believe that they can reduce risk-funding costs. There are two primary ways a captive can reduce premiums. First, a captive should be able to minimize the administrative costs (including taxes) and eliminate the profit margins included in a commercial insurance company's premium. Second, a captive may be able to reduce loss exposures and manage cl (...truncated)