A quick Arrival to help you Attentive Insurance

Over the past 20 years, many small businesses have begun to insure their particular risks by way of a product called “Captive Insurance.” Small captives (also known as single-parent captives) are insurance companies established by the owners of closely held businesses seeking to insure risks which can be either too costly or too difficult to insure through the traditional insurance marketplace. Brad Barros, a professional in the field of captive insurance, explains how “all captives are treated as corporations and should be managed in a way consistent with rules established with both the IRS and the right insurance regulator.”

According to Barros, often single parent captives are owned by a trust, partnership or other structure established by the premium payer or his family. When properly designed and administered, a company could make tax-deductible premium payments to their related-party insurance company. Depending on circumstances, underwriting profits, if any, can be paid out to the owners as dividends, and profits from liquidation of the organization may be taxed at capital gains.

Premium payers and their captives may garner tax benefits only when the captive operates as an actual insurance company. Alternatively, advisers and business owners who use captives as estate planning tools, asset protection vehicles, tax deferral or other benefits not linked to the actual business purpose of an insurance company may face grave regulatory and tax consequences.

Many captive insurance companies tend to be formed by US businesses in jurisdictions outside of the United States. The reason for this is that foreign jurisdictions offer lower costs and greater flexibility than their US counterparts. Generally, US businesses may use foreign-based insurance companies as long as the jurisdiction meets the insurance regulatory standards required by the Internal Revenue Service (IRS).

There are many notable foreign jurisdictions whose insurance regulations are recognized as safe and effective. These generally include Bermuda and St. Lucia. Bermuda, while more costly than other jurisdictions, is home to most of the largest insurance companies in the world. St. Lucia, a far more reasonably priced area for smaller captives, is noteworthy for statutes which can be both progressive and compliant. St. Lucia can also be acclaimed for recently passing “Incorporated Cell” legislation, modeled after similar statutes in Washington, DC.

Meeting the high standards imposed by the IRS and local insurance regulators can be a complex and expensive proposition and should only be done with the assistance of competent and experienced counsel. The ramifications of failing continually to be an insurance company can be devastating and may include the next penalties:

Overall, the tax consequences may be more than 100% of the premiums paid to the captive. In addition, attorneys, CPA’s wealth advisors and their clients may be treated as tax shelter promoters by the IRS, causing fines as great as $100,000 or even more per transaction.

Clearly, establishing a captive insurance company is not at all something that needs to be taken lightly. It is critical that businesses seeking to establish a captive work with competent attorneys and accountants who have the requisite knowledge and experience essential to steer clear of the pitfalls associated with abusive or poorly designed insurance structures. A general guideline is that the captive insurance product needs to have a legal opinion covering the primary elements of the program. It is well recognized that the opinion must certanly be provided by an independent, regional or national law firm.

Risk Shifting and Risk Distribution Abuses; Two key elements of insurance are those of shifting risk from the insured party to others (risk shifting) and subsequently allocating risk amongst a large pool of insured’s (risk distribution). After several years of litigation, in 2005 the IRS released a Revenue Ruling (2005-40) describing the primary elements required to be able to meet risk shifting and distribution requirements.

For those who are self-insured, the usage of the captive structure approved in Rev. Ruling 2005-40 has two advantages. First, the parent does not need to share risks with every other parties. In Ruling 2005-40, the IRS announced that the risks can be shared within the exact same economic family as long as the separate subsidiary companies ( no less than 7 are required) are formed for non-tax business reasons, and that the separateness of those subsidiaries even offers a company reason. Furthermore, “risk distribution” is afforded as long as no insured subsidiary has provided a lot more than 15% or significantly less than 5% of the premiums held by the captive. Second, the special provisions of insurance law allowing captives to have a current deduction for an estimate of future losses, and in some circumstances shelter the income earned on the investment of the reserves, reduces the cash flow needed seriously to fund future claims from about 25% to nearly 50%. In other words, a well-designed captive that fits certain requirements of 2005-40 may bring about a price savings of 25% or more.

While some businesses can meet certain requirements of 2005-40 within their particular pool of related entities, most privately held companies cannot. Therefore, it is common for captives to buy “alternative party risk” from other insurance companies, often spending 4% to 8% per year on the quantity of coverage necessary to generally meet the IRS requirements.

One of many essential elements of the purchased risk is that there’s a fair likelihood of loss. As a result of this exposure, some promoters have attempted to circumvent the intention of Revenue Ruling 2005-40 by directing their clients into “bogus risk pools.” In this somewhat common scenario, an attorney or other promoter can have 10 or even more of the clients’ captives enter in to a collective risk-sharing agreement. Within the agreement is a written or unwritten agreement not to produce claims on the pool. The clients like this arrangement simply because they get most of the tax advantages of running a captive insurance company without the danger associated with insurance. Unfortunately for these businesses, the IRS views these types of arrangements as something other than insurance.

Risk sharing agreements such as for instance these are considered without merit and must certanly be avoided at all costs. They amount to only a glorified pretax savings account. If it can be shown that the risk pool is bogus, the protective tax status of the captive can be denied and the severe tax ramifications described above will undoubtedly be enforced.

It established fact that the IRS talks about arrangements between owners of captives with great suspicion. The gold standard on the market is to buy alternative party risk from an insurance company. Anything less opens the doorway to potentially catastrophic consequences.

Abusively High Deductibles; Some promoters sell captives, and then have their captives be involved in a large risk pool with a higher deductible. Most losses fall within the deductible and are paid by the captive, not the danger pool.

These promoters may advise their clients that because the deductible is indeed high, there’s no real likelihood of alternative party claims. Levens verzekeringen  The problem with this sort of arrangement is that the deductible is indeed high that the captive fails to generally meet the standards set forth by the IRS. The captive looks more just like a sophisticated pre tax savings account: no insurance company.

A different concern is that the clients may be advised that they’ll deduct each of their premiums paid into the danger pool. In the event where the danger pool has few or no claims (compared to the losses retained by the participating captives utilizing a high deductible), the premiums allocated to the danger pool are simply too high. If claims don’t occur, then premiums must certanly be reduced. In this scenario, if challenged, the IRS will disallow the deduction produced by the captive for unnecessary premiums ceded to the danger pool. The IRS can also treat the captive as something other than an insurance company as it did not meet the standards set forth in 2005-40 and previous related rulings.

Private Placement Variable Life Reinsurance Schemes; Through the years promoters have attempted to create captive solutions designed to provide abusive tax free benefits or “exit strategies” from captives. One of many very popular schemes is in which a business establishes or works with a captive insurance company, and then remits to a Reinsurance Company that percentage of the premium commensurate with the percentage of the danger re-insured.

Typically, the Reinsurance Company is wholly-owned by a foreign life insurance company. The legal owner of the reinsurance cell is a foreign property and casualty insurance company that’s not susceptible to U.S. income taxation. Practically, ownership of the Reinsurance Company can be traced to the cash value of a life insurance coverage a foreign life insurance company issued to the principal owner of the Business, or perhaps a related party, and which insures the principle owner or perhaps a related party.

Investor Control; The IRS has reiterated in its published revenue rulings, its private letter rulings, and its other administrative pronouncements, that the owner of a life insurance coverage will undoubtedly be considered the income tax owner of the assets legally owned by the life span insurance coverage if the policy owner possesses “incidents of ownership” in those assets. Generally, in order for the life span insurance company to be looked at the owner of the assets in a different account, control over individual investment decisions mustn’t maintain the hands of the policy owner.

The IRS prohibits the policy owner, or perhaps a party linked to the policy holder, from having any right, either directly or indirectly, to require the insurance company, or the separate account, to obtain any particular asset with the funds in the separate account. In effect, the policy owner cannot tell the life span insurance company what particular assets to invest in. And, the IRS has announced that there cannot be any prearranged plan or oral understanding as to what specific assets can be committed to by the separate account (commonly called “indirect investor control”). And, in a continuing series of private letter rulings, the IRS consistently applies a look-through approach with respect to investments produced by separate accounts of life insurance policies to get indirect investor control. Recently, the IRS issued published guidelines on when the investor control restriction is violated. This guidance discusses reasonable and unreasonable degrees of policy owner participation, thereby establishing safe harbors and impermissible degrees of investor control.

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