How to Tell a Good Captive Insurance Company from a Sham—Part 1

By Sean G. King, JD, CPA, MAcc

Principal & In-House Counsel, CIC Services, LLC

There is growing concern among regulators, the IRS, and captive insurance professionals that too many captive insurance companies, especially the small 831(b) variety, lack economic substance—that is, that they are shams constructed for the purpose of avoiding taxes rather than for real insurance and risk management reasons.   The criticism is that some captives are formed to achieve tax objectives while failing in substance to provide any meaningful insurance or risk management benefits.

While we share this concern, many of the guidelines offered up by some captive professionals, and even the IRS, to help the public differentiate good and bad captive (and good and bad captive advisors), are mostly useless.  In many cases the proffered guidelines are both too broad (in that they tend to suggest that some perfectly legitimate captive arrangements are shams) and too narrow (in that they fail to identify many abusive arrangements).

One such guideline frequently offered up is that captives with a low frequency of claims are inherently suspicious and likely bogus.  While it’s true that bogus captive arrangements are often characterized by a very low claims ratios (claims paid by the captive as a percentage of premiums received by the captive), a low claims ratio is NOT indicative of a sham captive.  To argue otherwise is equivalent to arguing that all humans are likely murderers because all murderers are human.

Fire insurance gives us a perfect example of why a legitimate captive insurance company might have very low claims frequency. Readily available statistics show that approximately 0 .3 percent of homes experience a fire-related loss in a given year.

Thus, an insurance company with only a thousand insured homes (randomly chosen from the pool of all insured homes) would, statistically speaking, expect to have only three claims per year. If the insurance company instead insured only three hundred homes in total, it would expect to have about one claim per year.  If it insured only one hundred homes, it might expect only one claim every three years, meaning two out of every three years it might have no claims at all.

Query:  Does the fire insurance in question become any less “real” based solely on  the number of insureds covered by the insurance company?  Actually…it does down to a point.  An inherent attribute of real insurance is the spreading of risk among multiple insureds.  Without this risk distribution element, we don’t really have an insurance arrangement at all.  Thus, an insurance company with only one insured is, by definition, not an insurance company at all.

This begs the question…how many insureds are necessary before we have a “real” insurance arrangement?  This question has actually been the subject of contention with courts ruling that, at least under some circumstances, as few as 7 or 8 insureds are sufficient.

To alleviate the uncertainty (at least from a tax perspective) as to how many insureds are necessary before we have a “real” insurance arrangement, the IRS issued two different Revenue Rulings in 2002 establishing two important safe harbors.  These two rulings, perhaps more than anything else, have led to an explosion in the use of captives over the last decade.

Provided that a few other tests are met, the Revenue Rulings tell us that twelve insureds are sufficient for achieving risk distribution.

But, notice that an insurance company: 1) complying specifically with IRS safe harbors, 2) that insures only the minimum twelve homes against fire, and 3) that experiences industry-standards claims of 0.3 percent per year,  might reasonably be expected to go a full 30 years between claims.  30 YEARS!

The critical insight provided by this simple example, which is often overlooked by the IRS and even some captive professionals, is that the low claims frequency commonly experienced by some varieties of captives is not necessarily a result of insuring “bogus” or extremely remote risks, or of insureds failing to file claims against their captive, or of any other nefarious motive or purpose.  Rather, it is simply a mathematical result of the fact that captives distribute their risk among a comparatively small number of insureds.  Even the largest risk pools commonly used by 831(b) captives will usually have, at most, a few hundred insureds.  With such a few number of exposures, it would be unusual if such a captive did NOT experience low claims frequency and low loss ratios in most years.  The only way to overcome this mathematical principle would be to have the captive insure very high frequency risk, which might not be advisable within a captive structure in many cases.

An added benefit – in many ways a priceless benefit – of insurance is peace of mind.  Most homeowner’s will (thankfully) go to their graves having paid fire insurance premiums their entire lives and having never filed a claim.  What were they therefore purchasing all those years?  Peace of mind.

The peace of mind afforded by insurance – whether through a commercial carrier or issued by one’s own captive insurance company – enables a business owner and its leaders to function.  Peace of mind helps business owners and leaders make good decisions and prevents fear and indecision from paralyzing the enterprise.  For this reason, peace of mind for small business owners is also good for the economy and the job market.

Since only one in every three hundred homes is statistically predicted to have an annual fire loss, should you drop fire insurance on your own home?  Hopefully, you answered “no.”  If you have a mortgage on your home, the bank will no doubt answer for you and require you to insure against fire loss.

The same is true for a very wide variety of risks that small business owners face every day.  This straightforward example invalidates the notion that low claims rates somehow nullify the insurance coverage provided by small captive insurance companies and reinsurance provided by corresponding risk distribution pools.  Numerous other examples in the commercial insurance market could be brought forward to further illustrate the point.  For now, we will let the numbers speak for themselves.

Low claims frequency is therefore not evidence of a bogus captive, anymore than being human is evidence that you are a murderer.  Rather, bogus captives are characterized by a number of other things, including:

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

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

–Other characteristics that will be addressed in future articles