Want to learn what it takes to be considered a valid captive? 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 deductible for the IRS.
While risk shifting is an easy way of taking off the balance sheet of one company and pasting it onto another, risk distribution has a lot 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 captives tend to do risk distribution through risk pooling. In doing so, captive insurance companies evenly spread out financial risks throughout their contributors to any given 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.
What Is Risk Distribution?
Risk distribution is based on the law of large numbers where larger insurance companies span over many different countries and have lots of clients able to 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 by virtue of it being a giant corporate entity.
However, suppose the insurance company is smaller. In that case, such kinds of risk distribution based on the law of large numbers do not help overcome risk management problems. So, to become risk-averse, these smaller captive insurance companies blend and share their risks together, creating a risk distribution pool. Hence, clients pay money to their captive insurance company to stay within the membership in a risk distribution pool.
Dangers of Risk Pooling
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 that the captive 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. This risk pool is insured by a pooling captive who then takes a percentage of risk back to its own captive insurance company.
According to the IRS, however, the risk is never really 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 there are enough members who are treated fairly within the pool.
However, in recent tax court cases, the IRS claims that the pool exists in name only and that it 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 gives all of that money back from the risk that is taken from somebody else. This becomes an informal agreement, where no claims are submitted, and no claims are paid out of the pool. And the IRS deduces that the risks are not taken, which renders risk pooling redundant on paper.
Another danger that the IRS finds is in the domain of the 50% risk transfer. Some captive managers have taken that as the following: 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 from all the other captives. This way, the IRS cannot come for one captive alone. In the past, the IRS has termed risk pools to not be valid because of a lack of enterprise risk management. So, in order to mitigate risk in commercial activities, reinsurance treaties are a good idea.
Let's pose another example: When your captive has a $10,000 claim, and you're in a treaty with 50 other companies, then your captive pays $5000. The other 50 captives pay their portion filling the other $5000.
This way, you are doing exactly what the IRS wants, which is risk distribution, and it 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.
Overall, there are many risk pooling structures, and the IRS does not necessarily like risk pooling. And 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 are giving their risk to other captives and assuming risk from those captive insurance companies.