captive insurance company reports · 2019-03-20 · 2 captive insurance company reports march 2019...

Pooling—An Analysis of Best Practices

Captive InsuranceCompany Reports

March 2019

2 Captive Insurance Company Reports March 2019

Pooling—An Analysis ofBest Practices

Michael Mead, CPCU, CICR Editor [email protected]

Editor's Note: Tax experts Bruce Wright and Saren Goldner, partners in the tax department of Eversheds Sutherland (US) LLP in New York, have put together a piece on pooling best practices from a tax perspective. They can be reached [email protected] [email protected].

Over the course of the last year, particularly in con-nection with the first and second micro-captive

cases[1] issued by the Tax Court, questions have arisen about the validity of “pooling arrangements.” As the Tax Court indicated in the cases, some pooling arrangements may be problematic, depending on the facts, but these arrangements are distinguishable from more conven-tional pooling arrangements that have historically been used to pool various insurance risks

In this regard, there have been a number of pooling arrangements that have consistently been treated as valid insurance arrangements,[2] with the followingas examples.

• Municipal liability pools in which a number of usually geographically close municipalities create a facility to provide coverage for losses of one or more of the municipalities

• Catastrophe pools, such as pools in which multiple insurers participate with regard to a single catastrophe line (e.g., airline liability or hull coverages)

• Group pools in which a number of insurers within a consolidated group share a portion of all of the group’s risk on an agreed basis

• Multi-insurance company group pools of specified risks, such as workers compensation or general liability risks shared pursuant to an agreed formula

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In this regard, there have been a number of pooling arrangements that have consistently been treated as valid insurance arrangements,[2] with the following as examples.

• Municipal liability pools in which a number of usually geographically close municipalities create a facility to provide coverage for losses of one or more of the municipalities

• Catastrophe pools, such as pools in which multiple insurers participate with regard to a single catastrophe line (e.g., airline liability or hull coverages)

• Group pools in which a number of insurers within a consolidated group share a portion of all of the group's risk on an agreed basis

• Multi-insurance company group pools of specified risks, such as workers compensation or general liability risks shared pursuant to an agreed formula

There are certain common elements that have caused these pooling arrangements to be continuously recog-nized as bona fide means to share risk, including the following.

• There are business reasons for entering into the pool.

• Risks are individually written.

• The insurance company pool participants experience an economic effect as a result of participation.

• The pool risks are insurable risks that have a realistic expectation of loss.

• Premiums are reasonably determined.

• Contractual arrangements are arm's length.

• Participants have knowledge of the risks.

• The risks are adequately described.

• There is compliance with regulatory requirements.

Each element can be a factor in whether a transaction is characterized as insurance for federal tax purposes, and each appears to have been missing in the Avraha-mi and Reserve Mechanical cases. Thus, these cases, given their facts, created a perfect storm of how not to operate a pool.

Individually Written Risks

Risks are individually underwritten when each insured whose risk is included in the pool pays a premium commensurate with its exposure. When each partici-pant in the pool pays a premium based on its insured risks, the risks are legitimate, and when the pool of risks experiences losses, it becomes clear that the pool does not create a circular flow of funds. In this situation, all pool participants will pay a premium into the pool, but each participant will receive loss payments in varying amounts, commensurate with their losses. The fact that one pool participant pays the same amount of premium into the pool as another is not necessarily determina-tive of what each participant will receive in loss pay-ments, provided the premium is commensurate with the risk of loss.

For example, two participants may each pay $50 of premium, but if one of those participant’s risk of loss is twice as high as the other, that participant’s coverage would generally be half of the other participant’s cov-erage. In addition, if the pool operates as it should and provides risk distribution, the total premium received by each participant should be adequate to cover its losses. Participants without losses will pay a premium, receive a premium, and will pay losses. Thus at the end of the pool, they will have experienced a negative economic effect. Participants with losses will receive loss pay-ments in addition to paying a premium and receiving a premium, in which case they may have a positive economic effect as a result of the pool. Because of the payment of losses, it is evident that there is not a circu-lar flow of funds in the pool.

In Avrahami, however, the Tax Court found a “circular flow of funds” in the amounts flowing through Pan American, the pooling insurer. This resulted from the way Pan American’s transactions were structured. Each small business related to a captive insurance company (a “captive”) that participated in the pool would pay Pan American a premium for specified insurance coverage. Pan American would then reinsure all the risk it had as-sumed from each small business to its related captive. Because there were no losses, there was no economic effect on any captive.

For the 2009 pool, the small business at issue in the case, American Findings, paid Pan American $360,000 for up to $5,525,000 in terrorism coverage, and Pan American paid American Findings’ related captive,



Feedback, $360,000 for reinsuring 1.79 percent of Pan American’s insured risks. The 2010 pool was structured in virtually the same way. Because no participant in the pool had losses, the end result of 2 years in the Pan American pool was the transfer of $720,000 from American Findings (owned 100 percent by the Avra-hamis) through Pan American to Feedback (owned 100 percent by Mrs. Avrahami).

If pool participants had losses, the captives providing coverage for those losses would have experienced economic consequences, which may have mitigated the court’s conclusion that there was a circular flow of funds. Without losses, the pool appeared suspect, and the court looked to the particular facts of the case to consider why. In this regard, the court found that the premium was excessive, the premium rate was “one size fits all,” the contracts were not arm’s length, customary fees were not paid to Pan American, and, in some cases, it appeared that the conditions of the policy did not provide any coverage to the insured because of the insured’s factual circumstances. The Tax Court seemed to conclude that there was no expecta-tion of any losses and, thus, that the pool participants were not concerned about receiving an appropriate premium.

Business ReasonsThe fundamental nontax business reason for being in an insurance pool, given the cost of participation,[3] in most instances is to improve risk distribution and reduce the variability of loss for each participant (which may take place over a period of years). The type of risk pooled impacts how variability is reduced.

In this regard, catastrophe property risk may be pooled to spread the risk of an infrequent severe occurrence over a group of insurance companies. For example, if property risks along the US Eastern seaboard are pooled by a number of insurance companies, each with risk in a particular geographic area, and a hurricane hits the Carolinas, the insurance company that originally wrote the coverage of risks in the Carolinas has spread its losses among all insurance companies participating in the pool, and variability has been reduced.

Another pool may cover a significant number of fre-quently occurring losses (such as workers compensa-tion), and the pool might affect both frequency and to some degree severity, depending on the coverage

terms, as well as variability. In this situation, for exam-ple, if one insurance company’s volume of losses are increased in a particular year because there is an event, like a factory accident, that generates a large number of workers compensation claims, that company will have succeeded in spreading the risk of its economic exposure over all insurance companies participating in the pool.

Economic EffectWhether there is a circular flow of funds, or the mere movement of funds from one entity to another with no economic effect, will be influenced by the spreading of risk and smoothing of variability discussed above. When risk is spread, an economic effect should result, and it should be apparent that a circular flow of funds is not present.

When considering whether a pooling arrangement has an economic effect, the entire pooling mechanism over an appropriate amount of time must be considered. The amount of time will depend on the length of the payout periods for the risks written and/or the type of coverage written. Thus, for example, if insurance companies A, B, C, and D participate in a pool and pay premium, respectively, of $10x, $20x, $30x, and $40x to insure (or reinsure) their risks and receive back similar amounts as premium payments to insure a per-centage of the pool risks of all the insurance company participants, it might appear that there was a circular flow of funds. However, over the period that the losses run off, there will be a difference between the losses experienced by each insurance company participant that is covered by the pool and the amounts each pool participant has to pay out in losses to the other pool participants. This difference will result in an economic gain or loss to each insurance company pool partici-pant over the period that the insured losses run off.



In the Reserve Mechanical case, the Tax Court appears to conclude that for the pool in question there would never have been any losses that could result in any economic effect and, thus, concluded that there was a circular flow of funds because Reserve, the captive insurer in the case that participated in the pool, never recorded and did not contend it ever had any losses.

Risk of Loss and Insurance RiskAs noted above, important factors for insurance characterization include whether the risk insured is an “insurable risk” and whether there is a realistic expec-tation of loss “actuarial risk.” The first factor involves an analysis of the type of risk that is insured, includ-ing, for example, whether it is a fortuitous risk and whether the risk is adequately defined so that it is not amorphous. Consideration of the second factor might involve a multifaceted analysis, depending on the facts. If, for example, the risk is really remote actuarially (e.g., a 1-in-100-year event),[4] a number of questions may be worth considering.

• Does the insurer providing the coverage have the financial resources to pay the potential loss, and if not, has it truly provided the stated coverage (i.e., if the risk covered could produce a substantial economic loss, does the policy provide coverage for the loss if the insurance company does not have the financial resources to pay the loss)?

• Does the policy provide for the payment of only lower limits of a potential substantial economic loss, which may result from the insurer’s limited resources (e.g., limits of $50,000 for a catastrophic loss of a $500,000 property)?

• Would an insured exercising reasonable business judgment purchase the coverage if either of the above situations was the case?

• Is the premium that is paid by the insured substantially higher than it actuarially should be?

When entering into a pool to spread risk, it is typically best (but not necessarily determinative) if the risks covered are of a nature that is commonplace in the commercial market and/or result in regularly occurring losses. In addition, it might help if it is clear that the insured’s purchase of the coverage was a reasonably sound business decision.

In Reserve Mechanical, the court appeared skeptical that the insureds needed the coverage provided by their captive, noting that it was significantly more expensive than their commercial insurance policies that provided the majority of the insurance coverage that would be relied on in the event of a loss. The court also appeared skeptical that the coverages provided by the captive had any expectation of loss.

Knowledge of Risks WrittenTypically when reinsuring risks, an insurance company is aware of the risks it is reinsuring. In a pooling situ-ation, this may be accomplished by other means than the insurance company actively underwriting the risks. For example, all of the insurance companies in the pool could agree to a list of acceptable lines to be written and a set of parameters, such as attachment points, limits, and insured profiles (including business types or sizes), and an actuarial firm could be hired to review the parameters and pricing of all the risks being con-sidered. Alternatively, it could be agreed that all risks in the pool would be the same (e.g., a layer of workers compensation risks of up to $50,000 per claim for US manufacturing companies of a certain size).

In both the Avrahami and Reserve Mechanical cases, the Tax Court expressed concern with the fact that the insurance company pool participants lacked knowl-edge about the operation of the pool, the risks they were covering, and who the other participants were. In these cases, there also appeared to be an absence of concern by the insurance company pool participants

In both the Avrahami and Reserve Mechanical cases, the Tax Courtexpressed concern with the factthat the insurance company pool

participants lacked knowledge about the operation of the pool, the risks they were covering, and who the

other participants were.

“”



about this lack of knowledge, which seemed to be tied into the fact that there was no expectation of the occurrence of any losses that would give rise to any economic effect. The facts of the case beg the ques-tion that if losses were expected, would the pooling insurers have been so complacent in providing cover-age for risks they had no information about? Thus, the court’s apparent concern may have been alleviated if risks accepted into the pool had been accepted by all members; underwritten by a single source on behalf of the pool participants based on underwriting guide-lines established and agreed by the pool participants, or a hired third party, in each case with appropriate knowledge and experience; or accepted based on analysis of past underwriting of such risks and the experience thereon (e.g., a commercial reinsurer has for many years insured a book of business with a relatively consistent loss ratio, and another reinsurer would feel comfortable participating based on past underwriting experience).

Arm’s Length ContractsAnother core factor in a typical insurance arrangement is the existence of arm’s length contracts between the parties. Many factors may play a part in the determi-nation of whether a contract is arm’s length. The court in the Avrahami and Reserve Mechanical cases focused on some of these factors and showed concern that the contracts did not appear to be arm’s length. In this regard, some of the factors considered by the court included the apparent lack of actuarially determined premium, the coverage descriptions, and the loss ex-pectations (or lack thereof).

In the Reserve Mechanical case, the court found that the perfect matching of premium under the insured’s stop-loss policies and the pool’s quota share policy indicated the quota share was not arm’s length. The court noted that given all of the insureds covered, the quota share premium paid to the insurance company pool participants should have varied from the premium paid by the insurance company’s related insured.

If each insured’s risks had been separately underwrit-ten, even if the insured’s related captive had received an amount of premium under the quota share agree-ment equal to the amount paid by the insured, the court might have reached a different conclusion. This is because the quota share percentage of the pool that related to that premium amount would have been

commensurate with the actual risk assumed by the insurance company pool participant, and losses paid by that insurance company would be expected to result in an economic effect.

Although the court in Reserve Mechanical found that the fact that the premium paid by the insured equaled the premium received by its related insurance company was per se problematic, this should not always be the case. Provided premium is independently (and prefera-bly actuarially) determined so that it is commensurate with the risk transferred, the fact that all insureds pay an amount of premium equal to the amount of premi-um received by their related insurance company pool participant is not per se problematic because, in this scenario, the captive has assumed risk of the overall pool commensurate with that premium. Of course, the risk assumed must be real and include the potential for loss. If the risk of loss is present, each insurance com-pany participant would be expected to have economic gain or loss as the pooled risk runs off. In effect, the court concluded that a “one-size-fits-all” premium is inconsistent with an arm’s length pooling arrangement and might indicate that the possibility for loss is not present.



Actuarially DeterminedPremiums

The Tax Court in Reserve Mechanical also seemed con-cerned that the premiums were not actuarially deter-mined. However, there might be circumstances when an actuarial determination may not be possible and in such circumstances utilizing comparable commercial rates might serve as an alternative. The court’s prefer-ence for actuarially determined premiums appeared to stem from its concern about the absence of a standard methodology of projecting expected loss and the pric-ing for the risk of such loss for each pool insured. The court criticized the underwriting in Reserve Mechanical on this basis.[5]

Compliance with Regulatory Requirements and Adequate

CapitalizationThe Tax Court in Reserve Mechanical concluded that the captive in question met regulatory requirements and seemed to be satisfied that the captive met regula-tory “minimum capital” requirements. Minimum capital, however, may be an inappropriate standard when con-sidering whether a captive is adequately capitalized. Under most captive regulatory regimes, adequate capi-tal is based on an actuarial analysis of capital necessary to meet random unexpected adverse loss experience, so typically a captive’s minimum capital requirements are inadequate for this purpose and must be augment-ed in order to secure a certificate of authority.The better view is that capital is adequate when it is sufficient to meet the requirements for capital for the lines of business written. The fact that a significant amount of premium is reinsured through a company holding only minimum capital may be an indication that neither the party forming the captive or the regulator believes that any losses will materialize or that if they do they will not be very significant.

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The risk assumed must be real and include the potential for loss.“ ”



Credit Risk of Pool ParticipantsTo limit exposure to the credit risk of insurance com-pany pool participants’ ability to pay losses, a pooling arrangement typically establishes a single account or entity to serve as a loss fund from which losses will be paid. In some structures, an agent for the pool may collect funds in an account maintained on behalf of all pool participants and pay losses from this account. Another structure might involve a pooling entity col-lecting loss payments from insurance company pool participants, which may be collateralized by letters of credit, or holding amounts in a trust account and then paying losses from these funds. Other arrangements may rely on ratings and/or the captive’s resources.

No Provisions That Significantly Limit Participant Loss

From the Tax Court’s perspective, the attachment points and other limitations seemed likely to result in no payment of loss to pool participants. The point being if the pool is one in name only because there can be no, or virtually no, benefit from pool participation, mere participation in the pool likely will not be respected as insurance. The pool must operate in such a manner as to have the economic effect described above.

Footnotes:

1. Avrahami v. Commissioner, 149 T.C. No. 7 (2017), and Reserve Mech. Corp., f.k.a. Reserve Cas. Corp. v. Commissioner, T.C. Memo 2018-86.

2. See PLR 200907006.

3. The costs typically relate to determination and allocation of premium, actuarial review of losses and premium, keeping books and records, and management.

4. A policy could be drafted in a way to further limit the risk of the coverage of an already remote risk. In which case, the likelihood of the presence of actuarial risk would be further diminished.

5. The IRS in Rev. Rul. 2002-89 2002-2 C.B. 984, which addresses the deductibility of premiums, makes reference to actuarially determined premium.

captive insurance company reports · 2019-03-20 · 2 captive insurance company reports march 2019...

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