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:
Each of these elements will be explored in turn.
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.
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:
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.
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2020.06.24 ... The U.S. Department Of Justice Files Suit To Enforce An IRS Summons Against The Delaware Department Of Insurance For Artex Transactions
2020.05.19 ... Coronavirus Pandemic Threatens Run On Business Interruption Policies Sold By Captive Insurance Risk Pools
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2020.03.25 ... The IRS Sends Soft Warning Letters To Thousands Of 831(b) Risk-Pooled Captive Owners
2020.02.04 ...The IRS Strikes A Rich Seam Of Tax And Penalty Gold In Risk-Pooled 831(b) Captives And Is Sending In More Miners
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U.S. Tax Considerations For Captive Arrangements
§ 831(b) Captives
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