Tag Archives: captive

Captive Insurance Reinsurance Pools – Where's My Money?

As smaller captive insurance companies proliferate, so do reinsurance pools or exchanges that attempt to deliver sufficient “risk distribution” to satisfy the requirements of the Internal Revenue Service. Without risk distribution, the captive would not be considered an insurance company for tax purposes and would then lose many of its potential tax benefits, including the election for the exclusion of insurance revenues from income under section 831(b) of the Internal Revenue Code.

Previous articles I have written have explored the mechanics of these pools and have questioned whether the majority in fact meet the risk distribution requirements as a matter of law. This article will explore a more basic issue … are the funds being held by these pools secure?

Many captive managers have formed risk distribution mechanisms whereby the captives under management “swap” risk by ceding a portion of each captive's risk to the other captives and accepting a “retrocession” of risks from those other captives. Frequently, this exchange of risk is accomplished by a transfer of 50% or more of a captive's annual premium income to an entity that is affiliated with the captive manager, either as a “fronting” company to the captives or as a reinsurance company.

In either event, half of the funds paid by the insured to the captive are held for a year or more by this entity. Once losses are settled for the year in question, the balance, if any, is remitted to the captive. In the meantime, of course, if the captive has renewed its insurance policy to the insured, another annual premium has been received by the reinsurance entity and handled in the same manner.

The potential for abuse is immense. Cash is fungible. Whose money was remitted to the captive? The half that was held from last year or half of the latest premium received? This could create a classic case of a “Ponzi” scheme, where the money held from last year is spent and new money is used to cover the obligations from the previous year. The scheme collapses, of course, if there is a net drop in new captive formations for that captive manager.

These fronting companies or reinsurance companies are often domiciled offshore where annual audited statements may not be required and where litigation over mishandled funds would be difficult for the captive owner. Not all risk distribution mechanisms involve the retention of client funds; unfortunately, however, most of them do.

This article does not suggest that any captive manager has in fact mishandled client funds as described. But it is important to recognize the temptation and ask what, if anything, is being done to be sure that the temptation is never tested. A captive manager with 100 captives under management — each with $1,000,000 in annual premium — will have $50,000,000 or more of “float” to tempt him.

At a minimum, captive owners should require an accounting of retained funds by an independent CPA firm. Ideally, the captive owner should require that retained funds be held in a separate trust account by an independent trustee. But neither of these practices appears common in the captive insurance industry. In some cases, captive mangers have returned the “withheld” funds early, easing the fear of loss of the funds, but potentially making a mockery of the risk distribution mechanism itself.

What is the role, if any, of the captive insurance regulator? Captive legislation is not consistent when it comes to reinsurance pools. A review of the legislation of 14 of the most active captive domiciles reveals that 8 of them have no provision in their statutes to monitor or limit the activities of reinsurance pools (other than actual reinsurance companies licensed in their own domicile). The other 6 have specific language as follows:

The Commissioner may require any other documents, financial information, or other evidence that the pool, exchange or association will be able to provide adequate security for its financial obligations. The Commissioner may deny authorization or impose any limitations on the activities of a reinsurance pool, exchange, or association that, in the Commissioner's judgment, is necessary and proper to provide adequate security for the ceding captive insurer or segregated account and for the protection and consequent benefit of the public at large.

The domiciles break down as follows:

Specific language: Vermont, Missouri, District of Columbia, Kentucky, Montana and Tennessee.

No language: Delaware, Utah, South Carolina, Nevada, Arizona, Hawaii, Alabama and New Jersey.

It is interesting that the majority of small captives that use these reinsurance pools are domiciled in the 8 states that give the regulator no direct statutory authority to address the security of retained client funds. Of course, the regulators do have broad authority to question the overall efficacy of a captive's business plan. This review arguably could address concerns about the security of the captive's funds in the hands of third parties, particularly in the early years of a captive's life. But do they?

This author polled a number (but not all) of the regulators in these 14 states and got few responses from the 8 states without the specific language referenced above. Those few responses indicated that their view is that the relationship between the captive and the fronting company or reinsurer was a matter of private contract not subject to their regulation (other than determining that the reinsurance itself was real and met industry standards).

As the number of captives, captive managers and risk distribution pools continues to grow rapidly, the opportunity for a scandal in the captive industry also grows. The industry would not fare well if such a scandal made the front page of the Wall Street Journal. Captive owners should be aware of this risk and take action accordingly. And captive regulators should become more alert to possible abuses in this area and take action consistent with the powers available to them under their respective statutes.

Risk Distribution – Where Is The Risk?

What if a captive insurance company has virtually no real practical risk except to its own related insured? Is risk distribution really present?

Every captive insurance company must demonstrate, among other things, that it has sufficient “risk distribution” to qualify as an insurance company for tax purposes. This concept was first mentioned by the United States Supreme Court in 1941 with little further definition or guidance. As a result, since that time, many judicial opinions and two Revenue Rulings have attempted to interpret and quantify the “law of large numbers” inherent in the idea of distributing risk.

This article will not analyze all of the case law on the subject, but instead will highlight the typical manner in which captives today attempt to achieve risk distribution and will question whether the attempts will ultimately prove successful.

The Internal Revenue Service issued two Revenue Rulings in 2002 that set their standard for determining whether a captive insurance company has “adequate” risk distribution to be considered an insurance company for tax purposes. This determination is critical since the ability of the taxpayer to deduct premiums paid to a captive is dependent on a finding that the captive qualifies as an insurance company for tax purposes. The standards set forth in the Rulings are arguably tougher than those found in the judicial opinions on the subject, but they remain the basis on which the IRS conducts audits of captive insurance companies.

The two Revenue Rulings represent two different paths to risk distribution. Revenue Ruling 2002-90 examines the number of related companies that must be insured in order to sufficiently distribute risk. If the insured cannot provide a sufficient number of separate insureds, then the captive must rely on Revenue Ruling 2002-89. That Ruling establishes the amount of third party risk that a captive must carry in order to qualify as an insurance company for tax purposes.

Revenue Ruling 2002-90 requires that the captive insure at least 12 separate companies (single member LLCs do not count), with no one company representing more than 15% of the total premium paid to the captive. [In practice, the IRS seems to accept as few as 6 separate insureds with none paying more than 45% of the total premium, but it is difficult to rely too heavily on such practice as it may change without notice.]

Most closely-held companies cannot meet the standard of Revenue Ruling 2002-90. While the entrepreneur may own separate companies for real estate, distribution, etc., usually there is one main operating company that carries the bulk of the exposures.

Captives insuring those companies must therefore rely on Revenue Ruling 2002-89 for guidance as to risk distribution. That Ruling states that the captive must show that “more than 50%” of its risk comes from unrelated third parties. (“Risk” in this case is typically measured by premium). [For captives located in the Western United States, a Ninth Circuit Court of Appeals case reduces that percentage to 30%, but the opinion is not binding on the IRS outside of that jurisdiction.]

The typical way for small captives (such as those qualified under section 831(b) of the Code) to accept risk from unrelated parties is through a pooling mechanism where a number of unrelated captives “swap risk.” This risk sharing is accomplished a number of ways, with two common forms:

  • First, the captive may pay all of its premium to a single “fronting captive” (usually owned by the captive manager) who then will cede 50% back to the captive as reinsurance premium and retain 50% for a year or more to potentially pay losses of the other captives who are also using this fronting mechanism.
  • The second common method is a direct ceding/retrocession agreement among unrelated captives under which each promises to pay for 50% or more of the losses of the other captives who have signed the agreement.

In theory, either one of these approaches to third-party risk should qualify under Revenue Ruling 2002-89. But in actual practice, questions arise.

Many risk sharing programs exempt the first $250,000 of any loss of any single captive from the pooling arrangement. In other words, if the captive pays its insured less than $250,000 on any single claim, that captive will have no right to receive reinsurance from the other captives in the pool. Indeed, it is possible that the captive could pay multiple claims — each less than $250,000 — and still not have any reinsurance. On the other hand, any client considering such a pool might feel comfortable that his captive would not be at much risk to pay reinsurance out to other captives, absent a large loss.

These pools are constructed so that in a catastrophic loss, at least 50% is paid by the other captives. They therefore argue that the pool still qualifies under 2002-89. But few captive pools ever suffer such losses — particularly pools that share risk among 831(b) captives. The types of risks generally insured by these types of small captives rarely generate large losses. Indeed, one captive manager boasts that in 12 years, no captive in his pool has ever suffered a loss above that first “no reinsurance” layer.

So, is this really risk distribution?

Large group captives typically use a similar A/B loss structure, but the nature of the risks insured by group captives (auto, general liability and workers’ compensation) commonly result in losses above the A layer, so risk distribution is not an issue.

The judicial opinions on the subject of third-party risk have never addressed the question of layers within a risk sharing pool. Perhaps that is why these types of pools apparently continue to pass muster when one of their captives faces an IRS audit.

Several years ago at a national captive insurance conference, an IRS representative stated that if he found that actual captive losses always fell within an exempted layer, he would deny the existence of sufficient risk distribution. But he has now retired and there is no current indication that the IRS is thinking that way.

Logic would dictate that the lack of actual shared losses would also indicate the lack of risk distribution. The IRS may soon test this question in the Tax Court. If logic prevails, then many risk sharing pools will be in trouble.

Section 831(b) Captives – Where is the Common Sense?

A captive insurance company that qualifies for the tax exemption found in section 831(b) of the Internal Revenue Code is a time-tested and useful risk management mechanism that offers the entrepreneur excellent tax and financial planning benefits.

It looks simple — form a small insurance company and pay no more than $1,200,000 in annual premiums to it, which are fully tax-deductible and then later remove the profits of the captive at more favorable dividend (for now) or capital gains rates.

But it is not so simple. There are many pitfalls. Aggressive captive providers have proliferated recently who are ignoring common sense risk management and taxation issues to the potential peril of their clients. And they hide behind actuarial opinions and regulatory acceptance arguing that their plans and pricing are perfectly acceptable.

The problem is that actuarial opinions are only as good as the assumptions that the actuaries are given. And regulators examine different issues than the IRS when they are approving a captive’s license. The existence of an actuarial opinion or a license does not assure the client that their captive is truly compliant with the complicated tax issues that are involved.

There are two current “hot buttons” that anyone contemplating forming a captive should consider:

Pricing of Risk: Once the types of risks to be transferred to the captive are identified, the next challenge is to properly calculate the premium for such risk. Underwriting is as much an art as it is a science, with factors such as coverage details, loss history, limits, deductibles, exclusions and the financial strength of the issuing insurance company all coming into play along with sound actuarial practices.

Given these variables, it is easy for different people to offer diverse opinions on what an appropriate premium may be. But common sense must prevail. For tax purposes, the IRS will only allow a deduction for premiums that are reasonable in amount. The starting point for “reasonable” is the market rates for the coverages in question. However, market rates are not the end point for small captives, but they absolutely do create a benchmark. If a taxpayer is considering paying premiums that are vastly beyond that benchmark, they had better have very strong and well documented arguments for doing so.

Let’s take an actual case in point. A captive provider suggested that a client’s captive issue a $3,000,000 excess policy for Employment Practices Liability for a premium of over $250,000. Yet the client already had a $3,000,000 primary layer for this type of coverage for which he had paid less than $12,000.

Given that the primary layer would have to pay out full limits of $3,000,000 in order to trigger a loss on the excess layer, insurance companies would normally charge less than the premium paid for the primary layer of the same size. And when we compared what actual clients paid for this type of excess coverage, we found a rate of about $3.00 per employee. The suggested premium for the captive, however, equated to $808.50 per employee. A review of the actual excess policy language did not reveal any special provisions that could possibly justify such a high premium.

While it is true that a small insurance company may need to charge more than market rates because it has a very low capital base, common sense (and the IRS) would never accept a premium that is 269 times the market rate as in any way “reasonable.” [When presented with this argument, the captive provider in question simply stated that they felt that they could defend the premium in the event of an audit. The client was not comforted.]

Terrorism insurance is another area of controversy in the small captive market. It is a coverage that can legitimately be placed in a captive insurance company, but pricing is a serious issue. Given the fact that TRIA does not cover loss of income from a terrorist attack and that such coverage is not easily available in the domestic market, some captive providers have suggested that small captives can charge $500,000 to $600,000 for a $5,000,000 limit of such coverage.

In fact, such a policy is available from Lloyds of London at rates significantly lower than those used by these captive providers. For example, one of our clients, a $100 million (revenues) company in Dallas, Texas was recently quoted a price of $10,000 for $5,000,000 of terrorism coverage that includes loss of income as a result of a terrorist attack anywhere in the United States, not just in Dallas. Lloyds obviously has the financial strength to price risks lower than the average captive, but the disparity between the real market price and the pricing quoted by captive providers with little or no insurance experience once again defies common sense.

One of the basic tenets of risk management is that if the risk of loss is severe, and coverage can be purchased at a low price from the third-party market, it is not a sound business decision to self-insure that exposure. If a client is truly concerned about a terrorism related loss, it therefore would make more sense to buy the coverage from Lloyds rather than self-insure it in their own captive. Except, of course, for the tax benefits of doing so. Thus, the decision to form and fund such a captive clearly indicates a lack of economic substance and is motivated primarily by tax considerations. Such a captive would most likely fail an audit by the IRS.

Of course, even Lloyds might not have the ability to pay a claim in the event of an enormous terrorist event, which could be a reason to self-insure this risk in a captive. But pricing the premium at a “worst case plus” rate is not sensible and would likely not survive an IRS audit.

Finally, terrorism quotes in the captive market rarely take into account individual risk characteristics. If the client is located in a “target rich” area, such as near a nuclear facility, some higher rates certainly can be justified, but common sense says that such a rate is not applicable to everyone, particularly in lower exposure areas.

What about an actuarial opinion? Certainly an opinion that is specific to the actual policy coverages in question and to the client’s unique risk characteristics can go a long way to justifying the given premium. But clients must be careful that a proffered opinion truly relates specifically to them and not just to the type of coverage in general. When it comes to terrorism insurance, however, we submit that there can be no such “coverage in general” that makes economic or common sense.

Life Insurance: Whole life insurance can be an acceptable part of a captive’s investment portfolio. But that statement has opened the door to abuses — abuses that the IRS is well aware of and is determined to quash. A captive must be formed first and foremost for risk management purposes. The tax benefits that follow are wonderful, but must be secondary, and the investment portfolio then ranks third.

Some life insurance agents (who likely know nothing about property & casualty risk management) are touting the formation of a captive for (effectively) the benefit of purchasing life insurance with the premiums received by the captive. This, in effect, allows life insurance to be purchased with pre-tax dollars. Not only does this approach likely violate section 264 of the Internal Revenue Code (that disallows the deduction, directly or indirectly, of premiums paid for life insurance), it violates the economic substance doctrine.

Again, common sense would show that if the primary purpose of forming a captive insurance company is to buy life insurance with pre-tax dollars, that would not constitute a valid reason to become involved with what is, first and foremost, a risk management vehicle.

It is our understanding that the Internal Revenue Service has a specific internal mandate to find and close captives that are marketed in this manner.

To avoid this issue, we suggest the following: (a) do not purchase a captive from anyone promoting it as a vehicle for the purchase of life insurance, particularly an immediate purchase; (b) make any life insurance decisions a part of an overall investment strategy; (c) do not use any unearned premium to purchase life insurance (which means no purchases in the first year); and, (d) do not use more than 50% of the captive’s premiums in such an investment.

These issues of pricing and the use of life insurance are particularly important to the CPAs who are being asked to sign the client’s tax return showing deductions to a captive. CPAs now have a higher financial and professional risk when signing a tax return and must be acutely aware of these potential issues with respect to their clients’ captives.

Historically, many good business ideas that have tax benefits have been abused and distorted by greedy promoters and unsuspecting taxpayers. The end result is often a complete closure of the benefit by Congress or the IRS. We hope that the few “bad actors” in the 831(b) space do not cause the same result with this excellent risk management and financial planning tool.

James Landis collaborated with Rick Eldridge in writing this article. Rick Eldridge is the President & CEO of Intuitive Insurance Corporation and, along with James Landis, a Managing Partner of Intuitive Captive Solutions, LLC.