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The Captive Insurance Companies Association has issued guidance on commonly accepted practices for risk pools in response to a controversial tax court decision — a move praised by a captive regulator in a top U.S. domicile.
In 2018, a U.S. tax court ruled in Reserve Mechanical Corp. v. Commissioner of Internal Revenue that an Anguilla-based captive for Reserve Mechanical, an Osburn, Idaho-based mining and construction equipment repair firm that paid few claims and participated in a quota share reinsurance pool, did not involve the true risk distribution needed to qualify as insurance.
The court ruled that the quota share arrangement involved “a circular flow of funds,” with the premium paid for stop-loss coverage via the pool being returned to the captive via reinsurance. The ruling is being appealed.
“Risk pools are an important element in both commercial and captive insurance, but unfortunately their use is often misunderstood,” Daniel Towle, president of the Minneapolis-based association, said in an emailed statement.
Travis Wegkamp, captive insurance director with the Utah Insurance Department in Salt Lake City, called the CICA document “a fantastic resource” and said he was glad to see it specifically address some issues raised — “a bit unfairly” — in the Reserve Mechanical case.
“I like how they explained the relationship between the premiums paid and then the premiums retroceded back, that even though it’s dollar for dollar, it’s not necessarily a circular flow of funds,” he said.
In addition to captive owners, managers and service providers, CICA hopes the IRS and tax court will consider the document as “credible background information when reviewing risk pools in future audits and court proceedings,” Mr. Towle said.
“If managers and those involved with pools would follow this guidance and form arrangements in a prudent way, any issues that come up from the IRS would be soundly defeated or at least pass their test,” Mr. Wegkamp said.
Utah is considering improving the definition of pooling captives in its captive insurance code. “It’s entirely possible we could and will borrow some stuff from this paper,” he said.
State captive insurance regulators generally praised a new code of conduct that aims to guide captive managers in ethical business practices, although some regulators see ways the code could be strengthened.