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As if the waters for small captive insurance arrangements hadn’t been muddied enough after Avrahami v. Commissioner, on June 18, 2018, the U.S. Tax Court issued the second opinion in a small captive case, Reserve Mechanical Corp. v. Commissioner, this time holding that the taxpayer’s participation in a risk pool failed to satisfy the risk distribution requirement (i.e., the sharing of a sufficient number of independent insurance risks so that no one claim can have too great an adverse financial effect on the insurer) to establish a bona fide insurance arrangement. Until this case, the general assumption about risk pools is that they provided a relatively sure way to achieve adequate risk distribution for small captives that otherwise lack sufficient exposure to third-party risk, such as a sufficient number of insured subsidiaries or independent risk exposure units. Although that should continue to be true, the lesson of Reserve Mechanical is that the devil is in the details of how the risk pool is set up and operated. In other words, the risk pool, like the small captive, must operate as a true insurance company and will be scrutinized by the IRS, and ultimately by the courts, to see whether it does.
Typically, small captive arrangements structured to achieve adequate risk distribution will involve a small business purchasing insurance from the related small captive, which then reinsures at least 50 percent of the total risk assumed with a risk pool insurer. A less common variant of this arrangement is where the risk pool sells insurance directly to the small business in an amount equivalent to at least 50 percent of the total risk insured. (The 50 percent threshold is derived from a risk distribution safe harbor established in Rev. Rul. 2002-89, although the courts have accepted a lower threshold than that). In the more common reinsurance arrangement, the risk pool insurer then reinsures or “retrocedes” a portion of the pool’s risk back to the small captive. The reinsurance by the captive of a percentage of the risks of the entire pool up to a predetermined maximum amount is accomplished through what is known as a quota share arrangement.
A potential problem with many of these risk pool arrangements is that the premiums charged by the risk pool insurer back to the captive tend to mirror the reinsurance premiums paid to the risk pool insurer by the captive. In Reserve Mechanical, the court noted the “circularity” of such an arrangement, pointing out that it was not reflective of an arm’s length contract. The court also found fault with the risk pool’s failure to properly underwrite the actual risks it assumed to derive an appropriate premium that was based on such risks, and not merely a premium intended match the premiums it received. Even further, the court determined that the risk pool insurer, which provided only excess insurance (i.e., insurance above a capped amount) had little to no risk that it would be obligated to pay any meaningful claims sufficient to justify the premiums charged the captive.
The take-away from Reserve Mechanical is that utilizing a risk pool in a captive arrangement to achieve risk distribution has become more uncertain. What is certain is that such pools, on the heels of Reserve Mechanical, will invite close scrutiny. Attention must be paid to whether the risk pool’s premiums are actually derived from sound underwriting of the pool’s own risks, whether the pool has historically paid a reasonable share of claims over time, including some of meaningful size, and whether the captive and the risk pool are truly operating at arm’s length (where the captive’s management is not merely ceding all authority and responsibility to the same party that manages the pool). Absent that minimum level of due diligence, taxpayers wading into the pool might ultimately find themselves “underwater.”