Scott Simmons, director of Verve Risk Services, and Michael Maglaras, president of Michael Maglaras & Company, shine a light on abuse in the captives industry through the use of 831(b) of the Internal Revenue Code and how firms can protect themselves
The most important thing to remember about the US insurance business, and secondly about the captive insurance business, in particular, is that it is generally not subject to any federal regulation.
Captives in particular are regulated by states and other jurisdictions that have adopted captive legislation.
These states and jurisdictions have identified themselves as adopting regulation, enabling the sound and appropriate establishment of captives within their borders under conditions that are generally acceptable throughout the industry.
Currently, the federal government is deeply and rightfully concerned about abuses in one part of the captive industry. In particular, abuses by captives utilising section 831(b) of the Internal Revenue Code. They have begun to intervene in micro-captive abuses through the Internal Revenue Service (IRS).
The abuses of the 831(b) concept and structure are well known to the industry — it is a travesty. This abuse violates the letter and spirit of the Tax Reform Act of 1986 signed into law by President Reagan. These abuses should be called out when they occur, as any attempt by the United States federal government to intervene at the federal government level in captive operations needs to be discouraged.
The captive industry is largely self-policing. The industry has self-managed and self-policed traditionally in a way which is admirable. The handful of individuals who have encouraged the abuse of 831(b), namely through the use of these micro-captives for purposes other than the bearing of insurance risk, have done the captive industry no favours.
With this article, we identify how captives, seeking for the first time or attempting to maintain 831(b) designation, can protect themselves from deeper scrutiny by taxing authorities.
What is the secret? The captive insurance company taking the 831(b) election must appear to be a legitimate insurance company. It must take risk; it should be insurance risk and should be risk that is distributed among entities that are associated with the captive’s original parent organisation. Any captive should never be formed primarily for any purpose related to tax. If a captive produces a tax benefit on a legitimate basis, then it is a cause for celebration. If it is formed for the avoidance of tax, it is a cause for concern.
It is important to examine the ways in which those wishing to establish a micro-captive or to continue to utilise the 831(b) designation can stay below the radar screen of taxing authority scrutiny.
A valid insurance contract
A micro-captive should issue an insurance policy for each and every kind of insurance underwritten. Each policy should resemble a standard insurance contract providing coverage for the line or lines of insurance in question. It should have insuring agreements, a classic conditions section, and typical definitions associated with the kind of coverage in question, as well as clear and unequivocal exclusions to coverage.
Depending on the line of coverage, the policy form should contain appropriate endorsements. An absence of an insurance contract issued by the captive to its parent is an immediate fail when establishing legitimacy under Section 831(b). If the captive in question is underwriting a reinsurance programme, then there should be a valid facultative reinsurance agreement tied to an issuing carrier’s policy form. The first thing that regulators and taxing authorities examine is whether there is a valid contract of insurance or reinsurance in force, insuring or reinsuring something, and doing so under terms and conditions that are recognisable in the commercial insurance industry.
A valid and appropriate premium
An insurance policy is a contract — there is no contract without consideration. The consideration in the case of a micro-captive is an appropriately calculated premium. The premium should be commensurate with the risk assumed by the captive. It should be based on an exposure and ultimate loss analysis provided by an independent actuary who has assessed parent prior claims history, evaluated the coverage that will be in force, and projected ultimate loss to which fixed and frictional cost components are added to arrive at a legitimate premium.
The premium must be set at a confidence level of ultimate loss that assures the possibility of at least, at a minimum, 10 per cent of the time the premium will be inadequate to cover the loss. A premium that is over-adequate with respect to potential loss, as that loss is evaluated by consulting actuary, is one of the first things that taxing authorities acknowledge when they evaluate an 831(b) programme. Simply put, show us a micro-captive where the premium charged is completely out of proportion to the commercial market equivalent, or represents more than 90 per cent of the actual limit of coverage afforded, and we will show you a micro-captive straight in the crosshairs of the IRS.
Independent and professional claims management
We recommend seeking the assistance of a professional third-party administrator able to investigate and manage claims on an arm’s length basis, set reserves, make recommendations as to when to settle, as well as make certain that the entire claims transaction is managed in a fair and objective way that can be easily benchmarked against a commercial market-equivalent policy claims process.
Solid, reputable and independent captive management
The most important service provider to any captive insurance company, whether a micro-captive or not, is the captive manager. That designation is not only statutory in every captive domicile, but the captive manager keeps all vital books and records as well as creates unaudited financial reports.
The captive manager is in charge of checking a captive’s vital signs. It is the captive manager that, when that management firm has significant experience, can advise the insured about the proper construction of a captive, and particularly one with the 831(b) designation.
Micro-captive owners should rely on their captive managers for a broad range of experience in dealing with the kinds of questions that taxing authorities may ask a captive owner. It is imperative to choose a captive manager who is involved with captives, other than simply 831(b). Captive managers that specialise in 831(b) alone may not be able to offer the breadth and depth of advice as to how a firm’s 831(b) captive benchmarks with similar captives in the industry and in domiciles beyond the domicile of the firm’s micro-captive.
Domicile
Domicile is important. Several captive domiciles are managed effectively from the top down — meaning, a strong nationally recognised regulator imposing discipline, good business judgement and order on the captive organisation and management process. However, not all domiciles are alike. Captive owners, or those looking at an 831(b) structure, should avoid domiciles with loose regulatory scrutiny, particularly outside the United States, and where those domiciles are not among the top 10 or 15 recognised domiciles within the industry. Again, show me an 831(b) organised in a domicile not among the leading captive domiciles in the world, and we will show you a micro-captive about ready to come under the scrutiny of the IRS.
The audit
We think it is vitally important that an independent auditor be engaged to provide, at a minimum, a statutory audited financial acceptable to the domicile in question. The auditor is responsible for reviewing all operations within the captive, including financial management and other internal controls. This role is vital, as regulators, reinsurers and others depend upon audit revealations for the decisions they make with respect to supporting micro-captives.
Governance
What does the IRS look for when it decides to investigate a specific 831(b)? One of the easiest ways to detect when an 831(b) captive is moving beyond the boundaries of acceptable best business practices in the captive industry is to take a look at the composition of the board of directors.
What are the red flags? A board of directors composed largely of family members, including the children of the owner of the business, insured by the 831(b) is a so-called red flag. Children who may be largely absentee directors not otherwise participating in the actual management or governance process, is a key indicator. In every captive domicile a representative of the local domicile is usually an important requirement, such as a professional representing the captive management firm or local counsel, and it is essential that these “outside” directors exist.
Taxing authorities can easily penetrate through an 831(b) structure if there is an absence of minuted action. At a minimum, there should be an annual general meeting of the shareholders or members of the 831(b). Minuted action should be recorded and taken. Officers should be re-elected or replaced. The premium should be agreed upon after consultation with a consulting actuary. The renewal of service provider contracts should be discussed and approved. Investment performance and results should be discussed.
Most importantly, there should be minuted action which clearly states that claim activity in the captive has been discussed for the year in question and that there is a clear path of learning backward from the captive’s claim experience to the parent about how claims suggest improvements in quality and performance at the parent level. Lastly, the independent captive manager should include as part of the board package a detailed stewardship report assessing the temperature of the captive’s operations and its compliance with regulatory requirements and best practices standards.
Financial issues beyond premium
When the IRS examines the operations of an 831(b), it frequently looks for ways in which the financial operations of the micro-captive fall outside acceptable best practices within the captive industry. For example, they expect a premium to be paid on a regular basis and paid in its entirety on an annual basis at the point when it is fully earned. What is the easiest way to come under the scrutiny of the IRS? It is to end the policy or fiscal year with a premium receivable in the captive that the insured permits to spill over to the subsequent or following years.
Another important point that the taxing authorities will often examine is whether there is a succession or one or more loans between the captive and its parent organisation. Loans that are provided on a 24-hour demand note basis, but where the domicile in question has no direct knowledge of the creditworthiness of the parent. At the end of each year and on an after-tax basis, the best place for micro-captive retained earnings is for those earnings to fall into the contributed surplus of the 831(b), where they will help to strengthen the micro-captive’s claims-paying ability and promote its longevity.
In summary
The 831(b) structure is one of the most important hallmarks of the captive industry.
It is time that all market participants in the industry take the necessary steps to help middle-market businesses understand how to utilise this important provision within the Internal Revenue Code — a law signed by President Reagan in 1986 to maximise their ability to manage their risk, recapture premium from the commercial market at an appropriate level and over an appropriate timeline, and gain control of the important connection between claims activity and improvements in the quality of the business being insured through a micro-captive.
Any captive formed at any time or in any way for “estate planning purposes” or for federal tax avoidance, or for any other reason unrelated to the maintenance of insurance risk, the control of claims and the improvement of quality within the parent company’s operations, should be avoided. There is no reason why the 831(b) structure should not prosper in an environment where increasingly more privately-held middle market insureds are searching for robust solutions in increasingly difficult financial times. The 831(b) micro-captive is but one tool in the toolbox available to middle-market and other insureds. It is up to all market participants to make sure that these insureds make the right choice, do the right thing, and above all else remember that captives are about the provision of insurance and reinsurance. There is no other purpose for the formation of a captive at all.
