Judge Kerrigan makes this crystal clear in a couple of comments:
There is no true arm's length transaction between either the operating businesses and the risk pool, or the risk pool and the owner's captive. If the premiums charged by the risk pool to the operating business are about the same as charged by the owner's captive to the risk pool, such that nearly all the money paid to the risk pool flows right back into the captive, then it becomes obvious that the risk pool is little more than a passthrough bank account just to create a facade of risk sharing. The Circularity Of Premiums Creates Terrible Optics. If after reading all this you started to get the idea that these transactions are circular, take solace that the U.S. The reinsurance policies usually mirror the underlying insurance policies, and the reinsurance premiums charged by the captive to the risk pool are nearly identical to the premiums charged by the risk pool to the operating business. There are also reinsurance policies between the risk pool and the owner's captive, by which the owner's captive takes some significant share of the risk in the risk pool. There are insurance policies between the operating business and the risk pool. A few captive managers will even go below 30%, which is nothing short of insane. Recognizing that clients aren't happy to lose control of so much of their funds, even for a brief time, some aggressive captive managers will go under 50% and down to 30% which is a position that they claim is supported by case law. The net effect is that all of the premiums for a give year end up in the captive.Ī conservative split here is that 50% of total premiums are paid by the operating business directly to the captive, and then the other 50% of total premiums are paid to the risk pool. These latter premiums then make their way to the captive by way of reinsurance contracts between the risk pool and the captive. To obtain risk distribution, captive managers will first have the operating business of the client purchase some number of policies from and pay premiums directly to their captive (a/k/a "direct write" insurance), and then second the operating business will purchase other policies from and pay premiums to the risk pool. So look carefully for the two words arm's length in the discussion that follows.Ī risk pool is essentially just an insurance company that is owned and/or controlled by the captive manager. In general, captives for large corporations win their cases because they are able to prove that the operating business/captive relationship was an arm's length transaction, but smallish 501(c)(15) and 831(b) lose their cases for the very reason that they cannot establish an arm's length transaction. Readers should also note two very important words, being "arm's length", which permeate both the Avrahami and the Reserve Mechanical opinion, as well as other recent captive insurance opinions involving large corporate captives.
Each of these grounds will be explored at length below, as well as the issue of Reserve Mechanical's 953(d) election being invalidated and the consequences as to tax liability. Second, Reserve Mechanical was operated in a way such that it was not engaged in the business of insurance "in the commonly accepted sense". First, Reserve Mechanical was attempting to satisfy the tax law requirement of risk distribution by participating in a risk pool (PoolRe as operated by the captive manager Capstone Associated), but PoolRe was not itself an insurance company for tax purposes and therefore provided no (or de minimis) risk distribution for Reserve Mechanical. Judge Kerrigan ruled that Reserve Mechanical lost on two grounds. That article simply summarized the opinion of Judge Kerrigan this article analyzes the issues in that case and the lessons to be learned therefrom. Comm'r in my article Capstone's PoolRe Fails To Provide Risk Distribution In Reserve Mechanical Captive Insurance Case. I previously wrote about the decision of the U.S.
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