The Mendacity of Micro Captives

A new phrase entered the legal lexicon and was quickly added to my Urban Dictionary: “An Odor of Mendacity.” Mendacity is the quality of being mendacious, or untruthful. This phrase was used in a court ruling by a judge against the prosecution. Ironic, as the case brought by that same prosecution stemmed from an alleged mendacity of the defendants. Unfortunately, I see this same irony and mendacity in many of the micro captive proposals I review.

I don’t offer tax or legal advice, so why am I writing about micro captives? This article has little to do with tax and everything to do with legitimate insurance and reinsurance. My company’s name is RAIN: with the R standing for reinsurance and the “I” for insurance. Some may still deem me unqualified but that never stopped me from talking or writing about insurance and reinsurance before. I will probably continue to do so.

Background

Micro captive is the name commonly used to describe captives taking an 831(b)-tax election. They are called micro captives because the premium put in them to qualify for special tax status is capped.

Section 831(b) was added to the tax code in 1986 with the purpose of aligning the taxation of mutual and stock companies more closely. Companies who qualify could elect to be subject to an alternative tax and underwriting profits are exempt from federal income tax. That’s a big deal. It’s why they are so popular.?

Part of the mendacity of 831(b) captives is that people think the IRS doesn’t like them and wants to shut all of them down. If that were true, why did they add a premium inflation clause when they amended the law in 2016? The premium cap for 2023 was $2.65M – a $200K increase over 2022. For 2024, that amount is $2.8M dollars. Abuse of this law is a different issue, and the IRS has been cracking down on abuse.

The Dirty Dozen is an annual IRS list of 12 scams and schemes that put taxpayers and the tax professionals at risk of losing money, personal data, and more. Micro captives made the dirty dozen list again in 2023 – and have been on this list since 2014. Do you see the irony here too? The IRS is warning the public about scams and schemes in the 831(b) space. But it’s not telling folks not to form them, just be careful who you work with.

Abusive micro captives involve schemes that lack many of the attributes of legitimate insurance. Structures often include implausible risks and the unnecessary duplication of existing commercial coverage. Often, excessive premiums paid with little relationship to the exposure. Reinsurance pooling structures often offer little or no coverage and return premiums/profits are often guaranteed.

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Diversification vs. Distribution

Neither the IRS nor the Treasury define the term insurance. Case law has helped guide the development of an “accepted” four-part test of what many believe insurance to be.? First, there must be an insurance risk. Two and three are risk shifting and risk distribution. Four is it must be insurance in a commonly accepted sense.?

Congress changed the 831(b) qualification requirements in 2016 to address perceived abuse. The first change was the indexing of the premium cap for inflation, and the second was a diversification requirement. This diversification requirement was added to address estate and gift tax evasion issues. It did not address federal income tax concerns. In general, to meet the diversification requirements, no one policyholder may pay more than 20% of the premium. This is why most 831(b) sponsors offer reinsurance pooling to help clients meet their diversification requirement.

Some of you know the Rent-a-Center tax case helped define the IRS risk distribution requirements in winning their case. Rent-a-Center was not an 831(b) captive, but the facts of the Rent-a-Center case do not appear to meet the 20% 831(b) diversification requirement. Rent-a-Center corporate had far more than 20% of the premium in the group captive – it was closer to 60%. Would a “Rent-a-Center” type captive structure qualify for 831(b) treatment? I have no idea. I’m not a tax attorney. I don’t even play one on TV. I’ll leave that question to a tax professional. The diversification/distribution issue however is not just a tax issue. The Achilles heel of many 831(b) structures is the improper use of reinsurance pools by their sponsors. ?

One of the latest IRS victories verse 831(b) captives focused on a lack of risk diversification/distribution and the commonly accepted notion of insurance. The facts of a recent case presented the loss ratios of a reinsurance pool ranged from a low of 0.13% to a high of 7.91% over a four-year period. The industry’s reinsurance loss ratio for the same period was closer to 60%.

Putting 20% or 30% of your premium into a reinsurance pool does not guarantee qualification as risk distribution. Particularly if your risk of loss is zero or close to it. I’m not saying you can’t have a zero percent loss ratio. This is not uncommon for property risk such as quake, wind, and flood or long tail liability lines such as construction defect or general liability that can take 5 to 7 years to manifest. However, when losses come, they are usually substantial.

Lack of Real (Re)insurance

Tiny loss ratios suggest premiums are higher than what a risk calls for. It questions whether there was an actual insurance arrangement intended to distribute risk. Reinsurance premiums paid should not depend on a client’s preferences or a sponsor’s suggestion of a percentage. Adjusting reinsurance premiums to “whatever level necessary” to hit the sponsors risk distribution suggestion is not a good approach. The same applies to insurance. I have seen proposals where the premium is maximized for tax purposes and then the sponsor or sponsors actuary backs into an “acceptable” exposure.

This is not just an 831(b) issue. This same negative air surrounds enterprise risk captives. Enterprise risk captives are formed to cover exposures of the company’s enterprise not covered by traditional insurance. Gaps in existing coverage for E&O and cyber are good examples. Some enterprise captives request 831(b) treatment while others request pooling to qualify as insurance.

IRS is now 6-1.

A recent jury verdict brought welcome news to one captive manager and to the micro captive world in general.? The verdict put an end to 14 years of litigation.? Following industry best practices and adhering to regulatory guidance is a winning formula for doing micro captives right.? One captive manager can now declare victory.? The IRS had secured 6 guilty verdicts in a row. They knew what they were looking for.? Micro captives now have a court tested formula for how to do it right.? ?

A Final Word

The final mendacity I want to cover is a lack of disclosure in proposals for both 831(b) and enterprise risk captives. Most usually state what the charge is for the reinsurance pool. They are not as forthcoming about the other insureds who will be sharing risk. One such group just made the news for writing longtail financial guarantee coverage in their pool – bet that was a surprise to most of the other participants. Another red flag is when you are promised your reinsurance premium will be returned 30 or 45 days after the close of the policy year less a small fee. Does anyone really believe heterogeneous risk pools can settle all claims within 45 days of policy expiration? Who is handling those claims? How can I hire them?

As the IRS dirty dozen states, watch out for scams and schemes. This is always good advice, not just for captives. The decision to challenge the IRS even if you feel you did nothing wrong is a substantial investment in time and money. The time can be several years, requiring experts and include a trial. The merits of your case need to be compared to the litigation cost and the potential for a positive outcome. Do your homework. There are some great sponsors out there.??

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