As we have covered in prior articles (located here), “rules of thumb” offered up offhand by the IRS and certain others for distinguishing a “sham” captive transaction from a legitimate one are often too broad to be helpful. With that in mind, we have put together a list of 13 characteristics of a sham captive insurance arrangement. This list is not exhaustive, but it should be sufficient to sound alarm bells in appropriate cases.
Characteristics of a Sham Captive Insurance Arrangements
- Prearranged verbal or written agreements/understandings that very few claims or none will be filed, even legitimate ones.
- Captive insurance companies that have prearranged understandings that insulate one or more insureds from bearing a significant or meaningful share of the losses associated with claims filed by other unrelated or related insureds.
- Captive insurance company owners or marketers that utilize premium pricing that has not been actuarially determined by a qualified professional.
- Actuaries that overprice policies when compared to reasonably available commercial insurance coverages for similar policies. The premium calculations ignored sound modelling and knowingly (fraudulently) overpriced policies or don’t provide sufficient documentation as to how premiums were derived.
- Captive premium amounts that are fraudulently altered by a captive insurance company manager, attorney, captive owner or any party after an actuary arrives at legitimate and sound pricing calculations.
- A captive insurance company that is formed with little or no attention paid to risk management and is formed primarily for the purposes of tax or estate planning.
- A captive insurance company owner that uses the assets in the captive as they would with their personal checking account. This includes investing in ways that personally benefit the owner and potentially jeopardize the ability of the captive insurance company to pay claims.
- A captive owner that simply uses a captive insurance company as a “pass-through” vehicle. This practice involves the withdrawal of impactful funds from the captive very soon after it was formed.
- Small or micro captives that do not use legitimate risk pools or reinsurance arrangements. This includes captives that insure one or very few insureds
- Captive premium amounts that are just “pulled out of thin air” or determined without taking into account the unique exposures, hazards and loss history of the insured.
- Captive premium amounts that are not periodically recalculated to account for the changing hazards, exposures and other circumstances of the insured. The claims experience of the industry and loss history of the insured are also used in these new calculated captive insurance company premiums.
- The use of captive insurance professionals (captive manager, captive formation specialists, captive attorney, risk managers, etc.) that are not credentialed, competent, or licensed.
- Captive owners that do not engage and sufficiently compensate competent professionals to ensure that the captive is operated and managed properly and that insurance policies are drafted and priced properly.
With these items in mind let’s turn our attention to perfectly legitimate practices that are NOT usually evidence of a sham arrangement but are often offered as evidence of such.
NOT Necessarily Evidence of a Sham Captive Arrangement
- Low frequency of claims by a captive or a reinsurance (risk) pool for small captives.
- Insurance premium rates are not lowered after several years of low claims rates.
- Third party commercial coverage is not replaced by the captive.
- The captive is introduced to a business by a financial advisor (see our LinkedIn article on Captive Insurance and the Finance Professional).
- Policy premiums paid to the captive are higher than typical premiums paid for “similar” commercial insurance.
- A business owner lacks “sophistication” regarding insurance and relies on a captive manager to operate a captive insurance company.
More detail regarding each of frequently misrepresented legitimate strategies above can be read in our recent series “How to Tell a Good Captive From a Sham” located here. Combine these items with the “Top 10 Captive Insurance Questions” and you will have a solid and accurate foundation on which to start your conversation on captive insurance company ownership.
About Assurance Partners:
As one of the largest providers of risk management services in the Midwest, we specialize in partnering with strategic advisors to help them guide their clients through the process of determining risks that are unique to their organizations. We then translate those risks into an acceptable insurance program allowing them to obtain the protection and financial benefits that are unavailable in the traditional insurance marketplace all while strengthening the advisors’ value and providing opportunities for additional revenue.
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