A common myth in the captive insurance industry is that captives should be managed as much as possible like third party, commercial insurers. Specifically, captives should look to the standards of third party, commercial insurers when making such decisions as setting premiums, determining which lines of coverage to offer, establishing reserves and deploying assets.
Comparing the management decisions of captives to third party insurers is to compare apples to oranges. Captives are formed for unique purposes and have special challenges that large third party insurers usually don’t. Managing a captive like a large commercial insurer might make the IRS feel better, but it would often be highly imprudent nonetheless.
Clearly, the U.S. Tax Court agrees. In January 2014 the U.S. Tax Court decided that payments by Rent-A-Center to its Bermuda-domiciled captive insurance company, Legacy Insurance Co. Ltd., were deductible as an insurance expense, despite the fact that the captive was managed very differently from “normal” insurers.
On two specific points during the case, the I.R.S. attempted to justify its argument that Legacy was a sham transaction because Legacy did not look or behave like a third party, commercial insurer. Specific arguments made by the IRS (or the expert witness for the I.R.S.) were as follows:
– The premium-to-surplus ratio indicated Legacy was a sham
– There was not adequate risk shifting and risk distribution
The majority of the Court was unimpressed by such arguments and even described them as “specious.” The I.R.S. argued that “during the years in issue, Legacy’s premium-to-surplus ratios were above the ratios of U.S. property and casualty insurance companies and Bermuda class 4 insurers.” Describing the testimony of the expert witness for the I.R.S., the Court noted,
“His comparison, of Legacy’s premium-to-surplus ratios with the ratios of commercial insurance companies, was not instructive. Commercial insurance companies have lower premium-to-surplus ratios because they face competition and, as a result, typically price their premiums to have significant underwriting losses. They compensate for underwriting losses by retaining sufficient assets (i.e., more assets per dollar of premium resulting in lower premium-to-surplus ratios) to earn ample amounts of investment income. Captives in Bermuda, however, have fewer assets per dollar of premium (i.e., higher premium-to-surplus ratios) but generate significant underwriting profits because their premiums reflect the full dollar value, rather than the present value, of expected losses. Simply put, the premium-to-surplus ratios do not indicate that Legacy was a sham.”
The point is simple. Captives are different from commercial insurers. Not only are captives different, they are expected to be different. Not only are they expected to be different, these differences are prudent from a business perspective.
The Court also ruled that Rent-A-Center’s captive was not required to look or behave like a third party, commercial insurer in its method of risk distribution. The majority opinion noted that the expert witness for the I.R.S. emphasized the, “Captive program [did] not involve risk shifting that [was] comparable to that provided by a commercial insurance program.” Such a comparability analysis was determined to be irrelevant, and the majority blatantly rejected the assertion that a captive insurance company should mirror a third party insurer. In the words of the court, “The risk either was, or was not, shifted.” Comparison to third party insurers is not the standard or basis for determining if risk-shifting has occurred.
The recent Rent-A-Center captive ruling was another in a long string of losses by the I.R.S. where the Service based part of its argument on the failure of captives to mirror commercial insurers. This line of argument qualifies as Myth # 2 in Our Top 10 Captive Myths, and the U.S. Tax Court ruling validates that this is a myth.