Although policyholders can buy terrorism insurance backed by TRIA, the coverage does not include nuclear, biological, chemical or radiological attacks. To broaden the coverage, policyholders can use their captive insurers to take on the risks; however, careful attention needs to be paid to premiums charged and how the IRS will treat the coverage for tax purposes, says attorney Matthew J. Howard, the senior tax partner at Moore Ingram Johnson & Steele L.L.P.

After the Sept. 11, 2001, terrorist attacks, many property/casualty insurers found it increasingly difficult to buy reinsurance coverage for acts of terrorism, and as a result began to exclude those losses altogether.

In 2002, Congress passed the Terrorism Risk Insurance Act to provide a reinsurance market for property/casualty insurers. In return for this federal backstop, the federal government requires insurers to offer their customers, by endorsement, the option to purchase terrorism coverage at fairly low rates under the same terms and conditions of the endorsed policy.

The Act was seen as restoring order to the marketplace. However, a few years later, the Government Accountability Office published two separate reports, the first in 2006 and the second in 2008, noting that procurement of the TRIA endorsement would likely not protect insureds against all acts of terrorism.

More specifically, acts of terrorism involving nuclear, biological, chemical, and/or radiological agents would likely be excluded under the endorsed policy's standard pollution and radiation clauses. The 2008 GAO report said the marketplace for coverage of such nuclear, biological, chemical or radiological acts is virtually non-existent, and those few insurers that do offer the coverage charge very high premiums compared with premiums for a standard TRIA endorsement.

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So what is one to do to procure complete terrorism coverage, including nuclear, biological, chemical or radiological acts? A business owner is seemingly left with three options as it relates to this risk: 1) try to find a commercial insurer to underwrite the risk at high rates; 2) do nothing and retain such risk; or 3) insure such risk through a captive. Since for many businesses, the first two options are not ideal, they have sought a captive.

However, terrorism insurance, in the context of captive insurance programs, has received an increased amount of attention in recent months. A few in the industry have taken the position that a captive's legitimacy could be called into serious question by the Internal Revenue Service, if such captive issues terrorism coverage.

The crux of their argument is that terrorism claims are rare, and as a result, captive premiums charged for terrorism coverage are excessive, compared with purchasing terrorism endorsements on the commercial market. Therefore, it is alleged that some captive practitioners are writing terrorism coverage simply for premium and/or reserve deductions.

While some captives may indeed charge excessive rates for terrorism as well as for other coverages, with little justification solely for tax benefits, it cannot be ignored that terrorism is a real risk, and a properly structured captive which charges premiums based on rates developed by independent, qualified actuaries, can provide practical risk management solutions for business owners.

In fact, many business owners have decided to insure these risks through a captive program, reasoning that if the only coverage available on the commercial market has been priced with high premiums why not manage such risk internally?

While it is always important to price a captive premium with market-comparable rates, it is not unusual for an actuary to price a captive's premiums higher than the commercial market given that a captive program has far fewer insureds and a lean capital structure.

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Still, some may question the real risk that an act of terrorism may pose to the U.S., and as such, are concerned the IRS may question such high premiums. In 2012, the Heritage Foundation released a report stating that at least 50 terror plots had been foiled since 2001. Furthermore, in 2008 the Rand Corp. issued a report estimating damages from a simulated nuclear, biological, chemical or radiological terrorist attack in southern California could cause damage of nearly $1 trillion.

Insurers are aware of this and have gone out of their way to exclude these risks, to which, one could reason: If these risks are not real, why are insurers clamoring to exclude them? If these risks are not real, why would the GAO publish two separate reports regarding the unavailability of coverage for these nuclear, biological, chemical or radiological events?

Given the high severity loss that an act of terrorism can produce, some captive owners may find it advantageous to pool their collective terrorism risks. Pooling of terrorism risks can be beneficial by offsetting a high severity loss but also can provide a practical benefit as well.

To be considered a legitimate insurance arrangement in the eyes of the IRS, a captive program must not only insure legitimate risks that are underwritten at market-comparable rates, but the program also must have adequate risk distribution.

To that end, the IRS-issued Revenue Ruling 2002-89 states that one way to attain adequate risk distribution would be for a captive to receive at least 50% of its premium from unrelated sources. Further, the revenue ruling implies that the unrelated risks insured by a captive should be similar or homogenous.

So assume there are 10 separate, unrelated businesses, and each has a captive program, respectively, referred to as captives one through 10. Each business owner is located in a different part of the country, and each would like to insure various risks, including its terrorism exposure, via its respective captive.

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This terrorism coverage will not only insure what the TRIA endorsement would insure, but also the exclusions for nuclear, biological, chemical or radiological attacks. Captive No. 1 would insure Business No. 1 directly for 50% of its total premium while the remaining 50% relates to the terrorism exposure of the other nine businesses. Captive No. 2 would insure Business No. 2 directly for 50% of its total premium, while the remaining 50% would relate to the terrorism exposure of Businesses No. 1 and Businesses No. 3 though No. 10, and so on. As a result, each business has insured its enterprise risk through its captive program, while each captive abides by the IRS's 50% homogenous unrelated risk rule.

Although there may be a few bad apples abusing terrorism coverage — and the abuse of the terrorism coverage is not likely the sole abuse — we should not let those practitioners sully the legitimate application of terrorism coverage provided through a properly structured captive.

While it is true that premiums for coverage of nuclear, biological, chemical or radiological terrorist acts are justifiably higher than commercially procured terrorism endorsements, that does not give captives license to randomly assign outrageous premiums. That is why it is imperative that terrorism premiums be priced by an independent and licensed actuary who possesses the skill and competence to accurately price such coverage.

Matthew J. Howard is the senior tax partner at law firm Moore Ingram Johnson & Steele L.L.P. in Marietta, Ga.

He can be reached at 770-795-5022 or MJHoward@mijs.com.