By: Sean King, JD, CPA, MAcc
Principal & In-House Counsel, CIC Services, LLC
Question: Is it reasonable and legitimate for policy premiums paid to a captive insurance company to be higher than typical premiums paid for “similar” commercial insurance?
A typical attack leveled by the I.R.S. against captive insurance companies to suggest evidence of a sham transaction is that the premiums paid are “exorbitant.” Not surprisingly, the I.R.S. doesn’t clarify or define what constitutes “exorbitant” premium amounts. This is yet another area where uncertainty tends to benefit the I.R.S, and so the Service goes out of its way to create it. Uncertainty regarding what is, or is not, legitimate ensures that many perfectly legal arrangements are nonetheless avoided. Where the legal cliff is shrouded in fog, keeping one’s distance is the only safe course of action. So, from the I.R.S.’s perspective, the more fog the better.
Everyone can agree that if a captive’s premiums are made-up or inflated to achieve a higher tax deduction, the arrangement is clearly a sham. Nonetheless, there are many legitimate reasons why a captive may charge more than commercial carriers for seemingly “similar” types of coverage. They all generally involve the fact that the coverages often are not as “similar” as they may appear by reading the cover page of the respective policies.
For instance, many commercial insurance policies are laden with exclusions that often don’t exist in captive policies. Fewer exclusions invariably mean higher premiums. Many comparisons of captive premiums to commercial premiums fail to take this into account, and so compare apples to oranges.
Second, unlike most commercial coverages, many captive policies have broader insuring clauses, protecting the insured against not just property loss or the direct out-of-pocket expenses that result from a given peril (as is common with coverage offered by commercial carriers), but also against decreases in revenue resulting from that peril (which is very rarely available at a reasonable price via commercial carriers). Consequently, captives often assume far more risk than commercial carriers, and this additional risk must be reflected in the calculated premiums.
Third, captives may insure low frequency but high severity risks. Also, the risk of loss is spread among a relatively small number of insureds (often as few as twelve). By contrast, commercial carriers often insure a wider variety of risks (such that claims in one line of coverage can be offset by premiums in another), including many that are higher frequency but lower severity. As a result, they spread that risk among thousands of insureds (such that claims from one insured can be paid by premiums from others). The combination of insuring a larger variety of risks and spreading those risks among a greater number of insureds, means that commercial carriers benefit more from the principle of risk distribution and the law of large numbers. Consequently, their frequency and amount of claims are actuarially more predictable, meaning that they can price policies with much smaller margins of error. Knowing that they can use profits on Peter’s auto insurance premium to help cover Paul’s unexpected fire loss means that they don’t have to risk their own capital, or solvency to the same extent that captive insurers do. Captives, which insure a fewer number of risks and distribute that risk among fewer insureds, must “price in” their higher uncertainty (regarding the amount and timing of claims) by building in a larger “margin of error” into their premiums.
Clearly, seemingly high priced captive insurance policies aren’t necessarily evidence of a sham. Sadly, the I.R.S.’s intentionally broad and ambiguous statements on this subject are designed to create uncertainty rather than to actually benefit, inform and warn taxpayers. Meaningful guidance on this subject would be easy for the Service to provide were it truly interested in doing so.
For instance, here are some “real” indicators of sham premium pricing:
–Premiums that are simply made-up
–Premiums that are not developed by an actuary using accepted actuarial practices
–Premiums that are determined without reference to the particular insured’s unique risk profile
–Premiums that are developed by actuaries knowingly “cooking the books” to achieve a desired outcome
–Premiums that are fraudulently altered by a captive manager, attorney, captive owner or any party after an actuary completes legitimate pricing calculations
–Premiums 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.”