August 13 2015

13 Easily Identifiable Signs of a Sham Captive Insurance Arrangement

By: Sean King, JD, CPA, MAcc

Principal & In-House Counsel, CIC Services, LLC

As I have noted in prior articles, “rules of thumb” offered up offhand by the IRS and certain others for distinguishing a “sham” captive transaction from a legitimate one are often too broad to be helpful. With that in mind, I have compiled a list of 13 easily identifiable signs of a sham captive insurance arrangement. This list may not be exhaustive, but it should be sufficient to sound alarm bells in appropriate cases.

Evidence of a Sham Captive Arrangement

1- Prearranged written or verbal understandings that no or very few claims (even legitimate ones) will be filed

2-Prearranged understandings that insulate one or more insureds from bearing a meaningful portion of the losses associated with claims filed by other insureds

3-Premium pricing that is not actuarially determined

4-Actuaries that ignore sound modelling and knowingly (fraudulently) overprice policies or don’t provide sufficient documentation as to how premiums were derived

5-Premium amounts that are fraudulently altered by a captive manager, attorney, captive owner or any party after an actuary completes legitimate pricing calculations

6-A captive that is formed for tax or estate planning reasons only, with little or no attention paid to risk management

7-A captive owner that treats the reserves in the captive like a personal checking account, investing in ways that benefit the owner personally while jeopardizing the claims-paying ability of the insurance company

8-Related to the above, a captive owner that simply uses a captive as a “pass-through” vehicle, withdrawing material amounts of money from the captive very soon after it was formed

9-Captives that insure only one or very few entities (EG small captives with no risk pool or reinsurance arrangement)

10-Premium amounts that are simply made-up or determined without reference to the particular insured’s unique risk profile

11-Premium amounts that are not adjusted over time to account for the changing circumstances of the insured or the claims experience of the industry as a whole (when it comes to premiums, one can’t simply “set it and forget it”)

12-Captive managers that are not credentialed/competent/licensed

13-Captive owners that refusing to engage and sufficiently compensate competent professionals (captive managers, actuaries, claims administrators, lawyers, etc.) to ensure that the captive is managed properly and that insurance policies are drafted and priced properly

With this comprehensive list of sham indicators in mind, let’s turn our attention to perfectly legitimate practices that are NOT usually evidence of a sham arrangement but are often offered as evidence of such. I’ve provided links to thorough explanations on numbers one through six below.

NOT Necessarily Evidence of a Sham Captive Arrangement

1-Low frequency of claims by a captive or a reinsurance (risk) pool for small captives

CLICK HERE for a thorough explanation

2-Insurance premium rates are not lowered after several years of low claims rates

CLICK HERE for a thorough explanation

3-Third party commercial coverage is not replaced by the captive

CLICK HERE for a thorough explanation

4-The captive is introduced to a business by a financial advisor

CLICK HERE for a thorough explanation

5-Policy premiums paid to the captive are higher than typical premiums paid for “similar” commercial insurance

CLICK HERE for a thorough explanation

6-A business owner lacks “sophistication” regarding insurance and relies on a captive manager to operate a captive insurance company