Core Requirements
Want to learn what it takes to be considered a valid captive insurance company?
Well, the Internal Revenue Service (IRS) says you’ll need two things: risk distribution and risk shifting.
These are also two elements that make a captive insurance deductible for the IRS. While risk shifting is an easy way of taking off one company's balance sheet and pasting it onto another, risk distribution has many more nuances. Risk shifting is simply the transfer of risk of one company onto another party or entity. Risk distribution is spreading your risks across multiple companies. To understand this, you’ll first need to understand the use of risk pools. Most captive insurance companies tend to distribute risk through risk pooling. In doing so, captive insurance companies evenly spread financial risks throughout their contributors to any program. That way, any unprecedented financial risks are not entirely borne by the company alone. They are shared. Nonetheless, such risk pooling does not come without its own set of operational hurdles. So, let’s discover the dangers of risk pooling in captive insurance arrangements.
Risk Distribution Fundamentals
Risk distribution is based on the law of large numbers, where larger insurance companies span many different countries and have many clients who can distribute their risks accordingly. These are traditional forms of insurance companies that are often so large that event A, affecting one facet of the company, will not take down the entire company because risks are widely spread out because it is a giant corporate entity. However, suppose the insurance company is more minor. In that case, such risk distribution based on the law of large numbers does not help overcome risk management problems. So, to become risk-averse, these smaller captive insurance companies blend and share their risks, creating a risk distribution pool. Hence, clients pay their captive insurance company money to stay within the membership in a risk distribution pool.
Risk Pooling Challenges
The dangers of risk pooling come from the IRS since they don’t particularly like this practice. The IRS revenue ruling 2002-89 (Safe Harbour), a captive insurance law, says the captive insurance company must have at least 12 separate entities insured, or 50% third-party risk included. So, in the latter scenario, the captive must move 50% of its risk to other captive insurance companies. When many captives give off 50% of their risk, it creates a risk pool. A pooling captive insures this risk pool, taking a percentage of risk back to its own captive insurance company.
According to the IRS, however, the risk is never distributed equally among all members. The risk pool is supposed to be independent, run separately from the members with separate books and records. The captive manager should be able to show that enough members are treated fairly within the pool. However, in recent tax court cases, the IRS claims that the pool exists in name only and isn’t taking any risk of its own in these transactions, thus making the captive invalid. Let’s look at an example: In a traditional risk pool, a captive pays a 50% premium to a third-party entity, which simultaneously returns all of that money from the risk taken from somebody else. This becomes an informal agreement where no claims are submitted or paid out of the pool. And the IRS deduces that the risks are not taken, which renders risk pooling redundant on paper.
Another danger the IRS finds is in the 50% risk transfer domain. Some captive managers have taken that as follows: If you have a $1 million policy, then the captive takes the first $500,000, and the risk pool takes the other half. This essentially creates an excess of loss. Such risk transfer is not something the IRS prefers because there is no risk-sharing. The risk for the first $500,000 of the claim is a lot more expensive and probable than the second $500,000 of risk. Hence, the IRS claims that these risk pools are invalid again.
Sophisticated Risk Management Advice
One of the private insurance solutions that we like is a “reinsurance treaty.” This is when insurance companies are going out to get reinsurance treaties signed by other insurance companies for larger reinsurance placements.
For example, there are 50 captive insurance companies, and "Captive A" will sign a reinsurance treaty with all the other captive insurance companies. This way, the IRS cannot come for one captive alone. In the past, the IRS has termed risk pools invalid because of a lack of enterprise risk management. So, reinsurance treaties are a good idea to mitigate risk in commercial activities.
Let’s pose another example: When your captive insurance company has a $10,000 claim, and you’re in a treaty with 50 other companies, your captive insurance company pays $5000. The other 50 captive insurance companies pay their portion, filling the other $5000.This way, you are doing precisely what the IRS wants: risk distribution, which is all done above the board. 50% of your risk is paid for by other companies, which essentially distributes it. In this case, you are not using artificial deductibles, and your claim is not paid for by one single company that the IRS can potentially come after.
Strategic Implementation
There are many risk pooling structures, and the IRS does not necessarily like risk pooling. Since captive insurance arrangements are typically deductible, many risk pools fail to survive IRS audits. Hence, a much better captive insurance structure uses a reinsurance treaty, where the companies give their risk to other captive insurance companies and assume the risk from them.
Find out if a captive insurance company is the right fit for your business.
Take the assessment to learn more:
https://www.riskmgmtadvisors.com/captive-insurance-fit-assessment
