831(b) ground rules emerge post Syzygy

The Syzygy opinion is the third recent loss for a microcaptive in the US Tax Court, following the Reserve Mechanical and Avrahami decisions. While we think that some of the issues will be clarified on appeal, ground rules to ensure the viability of small captives are beginning to emerge.

The court’s focus was to determine whether the Syzygy captive constituted insurance in the commonly accepted sense, and whether its 831(b) election was valid. Syzygy is the first of the recent Tax Court cases in which a fronting company was used to issue policies. It is also interesting that this case is now citing Avrahami for reference, notwithstanding that Avrahami is a poster child for a “bad” captive.

Some of the particular issues examined in this case are discussed below.

Pricing

The captive manager set the premiums using “wild ass guess” principles, which are obviously not recognised in the professional actuarial world. This, by itself, is enough to place the pricing and coverage credibility in doubt. The icing on the cake was that the captive owner fired the manager due to unhappiness that premiums had decreased year over year.

Captive Alternatives (CapAlt) ensures that coverages and insurance premiums should be determined by a professional, independent actuary. This is non-negotiable.

Policies

The majority of Syzygy’s policies were written for excess coverage, and the largest policy was a kind of generic deductible reimbursement coverage. Additionally, policies were not issued in a timely manner: in two of the three years in question, the policies were not issued until after the policy period had already ended.

CapAlt has strict standards on coverage, market comparatives and industry-related forms. Ideally, most coverage will be first dollar and not duplicative of existing coverage. Incidental excess and guaranteed asset protection (GAP) coverages are acceptable, provided that a deep understanding of commercial coverages is present. Of course, policies should be issued as quickly as possible and always timely for the coverage period.

Risk distribution

The fronting company created two layers of reinsurance for any claims. The optics indicate that the captive was designed to pick up most of its own claims (if any) in layer 1, and the allocated third party claims in layer 2 would be less likely to affect the captive, thus limiting risk distribution. CapAlt believes that it is important that policies be issued by a licensed insurance company, that coverage pricing be actuarially determined, and that no artificial limitations on risk distribution be in place.

Investments

At the end of 2011, Syzygy’s largest investments were two life insurance policies that totalled more than 50 percent of the captive’s assets, with heavy restrictions on access. This is clearly contrary to the way a traditional insurance arrangement operates. CapAlt’s position is that a conservative investment policy that discourages illiquid and exotic investments is fundamental to any professional captive model.

Claims period

Claims could be made only within seven days after the policy period closed, with no option to purchase an extended claims-reporting period.

Industry standard reporting periods are 30 to 60 days. Hiring an independent claims third party administrator will go a long way to mitigating concerns about arm’s-length claim processing.

It’s worth noting that the policy years being reviewed in this case are roughly a decade old. Since then, the industry has expanded oversight and put regulations in place to improve best practices across all jurisdictions.

CapAlt is dedicated to being exacting and diligent in our management of private insurance companies.

The future of the captive insurance industry remains bright, but we hope and expect that the Internal Revenue Service will continue to clarify its position and create clear rules regarding the implementation and running of captive insurance companies.

David Kirkup is chief operating officer at Captive Alternatives. He can be contacted at dkirkup@captivealternatives.com