Risk Shifting Captive Insurance Company

Risk Shifting

 

Risk-shifting for tax purposes means that the risk of loss has truly passed from the insured to the insurance company. This has two elements:

1. There is a binding and explicit insurance contract that clearly binds the insurance company to liability for the loss; and
2. The insurance company has the financial strength to pay for the loss (to the contractual limits) above and beyond the premium received from the insured, which is often expressed as the captive having "some skin in the game".

Each of these elements will be explored in turn.

Insurance Contract

For a valid insurance contract to exist, it is important that the risk being insured is clearly defined. If the coverage is vague, it creates the negative impression that the coverage is discretionary, i.e., the insurance company has the discretion to deny or allow the claim.

One of the biggest benefits of captive insurance is the ability to captive owners to draft their own policies so as to cover, or not cover, risks that are included or excluded in the insurance policies of commercial carriers. However, extreme caution must be advised in policy drafting, so that it is clear what risks are covered and what are not. In IRS challenges against captives, it is a frequent argument that the coverage is so amorphous that it is impossible to discern if something is covered or not, thus giving the captive owner the discretion whether or not to pay claims -- this does not qualify as an "insurance contact" for tax purposes. This is frequently seen in so-called "business interruption" policies, which sometimes are tightly drafted, but too often are so wide-open in their terms as to potentially cover anything (or not).

Suffice it to say that loosely-drafted policies also make the defense of premium amounts and reserves much more difficult. Commercial carriers very tightly draft their policies for good reason: They need to know exactly what their exposure is so that they can properly calculate premiums and reserves. Captives should be held to no lesser standard.

Capitalization

Whether the captive has "skin in the game" goes to the capitalization of the captive. The captive must be adequately capitalized so that it can actually pay the claim that it has insured, with more than simply the premiums that it has received from the insured.

A sketchy (but useful) "rule of thumb" has developed within the captive industry that capital should not be less than the following:

1. In the first year, premiums should not exceed capital by more than 5:1 and
2. In subsequent years, premiums should not exceed capital and surplus by more than 3:1.

In the first year, this ratio is reflective of the fact that even if some losses occurred in the first year, not all are likely to fully materialize into a payable liability until the captive's second year, because of the ordinary delay in processing claims.

In subsequent years, the captive is able to use the underwriting profits from the first year as additional reserves and surplus such that additional capital is usually (but not aways) not needed.

The IRS has frequently challenged captives, particularly small captives, as being inadequately capitalized. These challenges have often focused upon offshore captives, since some offshore jurisdictions have minimal capital requirements -- some as low as $10,000 regardless of the amount of insurance risk the captive is taking on. However, local regulatory requirements have little if any bearing upon whether a captive is adequately capitalized for tax purposes, i.e., the U.S. Tax Court is unlikely to be impressed if a captive has a premium-to-capital ratio of 20:1 just because some offshore jurisdiction allows that.

 

 

 

2021.07.23 ... Delaware Department Of Insurance Loses IRS Summons Fight For Artex And Tribeca Captives But Can Appeal

2021.05.20 ... U.S. Supreme Court Rules On Anti-Injunction Act In Microcaptive Context

2021.04.26 ... The IRS Warns Again On Microcaptives And Announces A New Office Of Promoter Investigations

2021.03.22 ... The U.S. Tax Court Drives A Stake Into The Heart Of Microcaptives In Caylor Land

2020.12.31 ... U.S. District Judge Denies Blanket Assertion Of Attorney-Client Privilege In Moore Ingram Microcaptive Promoter Audit Case

2020.10.22 ... IRS Announces A Second Settlement Initiative For Abusive Microcaptive Tax Shelters But With Much Stricter Compliance Requirements Requiring Independent Counsel

2020.10.02 ... IRS Warns Microcaptive Shelter Penalties To Get Much Worse, Taking On The Puerto Rico Deal And Other Next-Generative Captive Shelters

2020.09.23 ... U.S. Tax Court Affirms Most Penalties In Patel Microcaptive Shelter Case But Kicks Out Some For IRS Procedural Errors

2020.09.12 ... Microcaptive Manager Artex And Related Professionals Dodge The Class Action Bullet In Shivkov

2020.09.10 ... GAO Report To Grassley At Senate Finance Slams Offshore Microcaptive And Variable Life Insurance Transactions

2020.08.24 ... Buyers Of Jade Risk Get Taken To Woodshed In Litigation Arising From Merger Of Captive Insurance Managers

2020.08.08 ... IRS Sends Second Wave Of Soft Letter Warnings To Certain Captive Owners For A busive Microcaptive Transactions

2020.07.27 ... Microcaptive Tax Shelter Promoter Investigation Of Moore Ingram Law Firm Leads To Attorney-Client Privilege Issues With Client Documents

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General Resources

• Articles On Captives ... An archive of articles by Jay Adkisson on captive insurance companies
• Captive Insurance Litigation Issues ... Procedural and similar court issues involving captive insurance company arrangements that are in litigation.

 

State Regulation

• State Regulation Of Captives ... Issues related to the regulation and taxation of captives by the states

 

U.S. Tax Considerations For Captive Arrangements

• Captive Taxation Generally ... An overview of captive taxation, including the IRS's abandonment of its "Economic Family Theory"
• Protected Cell and Series Captives ... Considers the unique tax issues that involve protected cell companies (PCCs) and series business units (SBUs)
• Tax: Risk Distribution: Multiple Insureds ... Considers the IRS safe harbor for multiple insureds and risk distribution through many "points of insurance" generally
• Tax: Risk Distribution: Unrelated Insurance ... Describes the IRS "50% unrelated third-party insurance" safe harbor and related issues
• Tax: Risk Distribution: Risk Pools ... Introduces the concept of risk pools which are sometimes used by captive managers to assist their clients in obtaining 50% third-party insurance, and which are currently under heavy scrutiny by the IRS
• Tax: Risk Shifting ... Considers the tax law requirement that an insurance arrangement have a true shifting of risk between the insured and the insurer

 

§ 831(b) Captives

• 831(b) Captives Generally ... Discusses the unique characteristics and problems of captive insurance companies that qualify for the IRC section 831(b) election

• Class action lawsuits related to 831(b) risk-pooled captive tax shelters

 

Expert ... Expert witness and available for consultation as an expert regarding captive insurance company matters

 

Evaluation & Formation ... Jay has been involved with the formation of well over 100 captive insurance companies since 1998, and now assist prospective captive owners in evaluating their suitability for a captive, and in forming the captive and obtaining its insurance license

 

Litigation ... Frequently serves as counsel in disputes involving insurance companies

 

Remediation & Closing ... Remediation and termination of defective captive arrangements, and consulting and second-opinion reviews of existing captives

 

 

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• Creditor-Debtor Law - An explanation of common creditor remedies, strategies and tactics to enforce a judgment, including a discussion of common debtor asset protection strategies.

 

• Voidable Transactions - Discussion of the Uniform Voidable Transactions Act (a/k/a 2014 Revision of the Uniform Fraudulent Transfers Act) and fraudulent transfer law in general.

 

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• Charging Orders - The confusing remedy against a debtor's interest in an LLC or partnership is explained in reference to the Uniform Partnership Act, the Uniform Limited Partnership Act, and the Uniform Limited Liability Company Act.

 

• Protected Series LLCs - An examination of the single most complex statutory legal structure yet created, with particular reference to the Uniform Protected Series Act of 2017.

 

• California Enforcement of Judgments Law - Considers the topic of judgment enforcement in California, including the California Enforcement of Judgments Law and other laws related to California creditor-debtor issues.

 

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