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Don’t heed the ‘Chicken Littles’: the outcomes of recent court cases should not hurt the legitimate wing of risk pools, says Nate Reznicek of CIC Services.
Fear, uncertainty and doubt—FUD—is usually evoked intentionally in order to put a competitor at a disadvantage. A disinformation strategy used in sales, marketing, public relations, politics, cults, and propaganda, FUD is generally a strategy to influence perception by disseminating negative and dubious or false information and a manifestation of the appeal to fear.
The term made famous in the late 1970s and still quite popular in the tech/hardware space is once again rearing its ugly head, this time in captive insurance. To an unsuspecting audience these faux warning cries seem alarming and often come from someone you would normally consider to be credible, like a tax professional or an attorney.
They are often accompanied by the overarching theme that “Impending doom is upon you and I’m the only one that can help!” or “everybody does it wrong except for maybe this one group that I can introduce you to!”. The approach is being used as a sales crutch, by desperate promoters grasping at the straws of two recent US Tax Court decisions, trying as hard as they can to gain an audience in an industry that’s passed them by.
For folks outside the captive insurance industry here’s a recap of what has transpired.
Avrahami v Commissioner of Internal Revenue
A successful small business based out of Arizona elected to form an offshore (St. Kitts) captive insurance company to insure the risks of its related entities. The Commissioner alleged that premiums paid by the Avrahamis businesses did not constitute insurance for federal tax reasons and that related deductions should be disallowed.
This particular captive took the position that it achieved risk distribution through a reinsurance pool—a pool in which they shared 30 percent of their premiums and participated as a reinsurer for terrorism risks only. This captive also made an unusual amount of loans back to related entities (often issued without prior approval from the domicile regulator), had policies with unclear and contradictory language, no prior claims history, and an actuary who was unable to communicate effectively and defend his pricing methodology.
Although the court commented on a number of items, ultimately the fate of the Avrahamis would be determined by whether the captive achieved acceptable levels of risk distribution. Upon examination of the shared terrorism policies and questioning of the pricing methodology the court determined that the premiums paid to the reinsurance pool did not qualify as insurance.
Ultimately this case had a unique set of facts and was decided in favour of the Commissioner: the deduction taken for insurance premiums by the tax payor were denied.
What did this case tell us? Unfortunately, not much. The court emphasised that it was a combination of several somewhat unusual factors that led it to conclude that the reinsurance pool was not bona fide. But a few lessons can be learned. For instance, have premiums that are not only appropriately priced, but also have the ability to adequately defend the pricing methodology. Don’t issue policies with contradictory and confusing language. The insurance company should follow the rules of the domicile regulators, invest its assets as an insurance company would, review and approve claims as appropriate, etc.
Reserve Mechanical v Commissioner of Internal Revenue
Peak Mechanical & Components (Peak), a successful mining equipment company out of Idaho, formed a captive insurance company off-shore (Anguilla) to insure the risks of its affiliated insureds. The Commissioner alleged that premiums paid by Peak’s businesses to Reserve Mechanical (Peak’s captive insurance company) did not constitute insurance for federal tax reasons and that related deductions should be disallowed.
As in Avrahami, Peak also took the position that its insurance company achieved risk distribution through a risk pool. Unlike in the Avrahami case however, Reserve Mechanical purchased stop loss insurance coverage from the reinsurance pool for all the policies it issued (and not just terrorism insurance) on quota share basis.
Under the quota share arrangement the Reserve Mechanical captive received back premiums from the reinsurance pool in the exact amount that it paid—but unfortunately for the tax payor it could not prove that it received the same amount of risk back from the pool.
Although Reserve Mechanical operated appropriately under the laws of its regulatory body the court determined that the premiums paid to the risk pool didn’t equate to the premiums it received. Said another way, the reinsurance premiums weren’t actuarially determined.
Consequently, the court determined that Reserve Mechanical didn’t have sufficient risk distribution, and since adequate risk distribution is an inherent requirement for qualification of insurance for tax purposes, the policies issued by Reserve Mechanical therefore do not qualify as insurance and the applicable deductions were subsequently denied.
What did this case tell us? More than Avrahami but still a limited amount. First, having a manager that touts attorney-led captive planning doesn’t get you far in US Tax Court. Second, unlike Avrahami, the outcome of this case turned primarily upon the (deficient) method used by the tax payor to achieve risk distribution. As the tax payor was unable to provide sufficient evidence that the reinsurance premiums were adequately priced, premiums received didn’t necessarily equal risk received, which equals no insurance, which means no deduction.
What these cases didn’t tell us
Note that the only items of substance that these two cases had in common was that they attempted to achieve risk distribution through a reinsurance pool. That’s it. Each pool was completely different from the other not only in the way it attempted to transfer risk from a layering perspective, but also the policies they shared, and the methodology by which they were priced.
What they didn’t say is what ‘Chicken Little’ promoters are now attempting to shout from the rooftops to an unsuspecting audience. The Tax Court emphatically did not say that appropriately pooling risk from unrelated parties was not an acceptable method of achieving risk distribution. It did not say that quota share arrangements are per se improper. It did not say that it’s impossible for risk pools to be operated at “arm’s length”. And the last time I checked the safe harbours listed in Internal Revenue Service (IRS) Bulletin No 2002-52, Rev. Rule 2002-89 were still alive and kicking.
I’m not jumping on the “only we do it right” bandwagon. A number of captive insurance professionals do things the right way. In those arrangements, multiple risks are pooled, risk is reasonably priced by accredited actuaries, policies are professionally underwritten and clearly defined, claims are filed, adjudicated and paid appropriately, captives pay unrelated third-party losses, etc.
Their managed captives look, smell, and feel like real insurance companies—because they are. After more than 30 years of losing almost every captive insurance case of consequence, the IRS finally had some wins of questionable relevance. The IRS selected cases it believed it could win, and did. Do I agree with all the statements made the by courts in these cases? Absolutely not. I’m also not going to play fortune-teller and try to guess which of the rules will change and when (because they will, they always do).
What I can state with a high degree of certainty is that educated captive owners quite often own the most successful captives. People who take the time to evaluate and understand the pros and cons of a situation often make better decisions in this inherently risky business. A number of captive owners are now looking for new managers and a number of managers are no doubt scrambling to make changes to the ways they operate.
I would strongly encourage all captive managers who are going through this process, or considering shuttering their captives, to have a discussion with a reasonable, level-headed, and qualified management firm.
I would also advise that they pause before giving any consideration to snake oil salesmen who shout “The sky is falling!” from a paid blog soap-box. Just like in the children’s tale, these Chicken Little promoters will be eaten by the fox of progress. We just need to be smart enough not to blindly follow.
Nate Reznicek ACI is the director of operations at CIC Services. He can be contacted at: firstname.lastname@example.org
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