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Microcaptives again come under legal questioning

Posted On: Jul. 3, 2018 7:00 AM CST

Microcaptives again come under legal questioning

Microcaptive managers and owners could face more scrutiny of their captive insurers’ structures following a second unfavorable ruling on the alternative risk financing vehicles by a tax court last month.

The ruling called into question the legitimacy of a captive insurer set up by a mine servicing company that was established under section 501(c)(15) of the U.S. tax code and comes less than a year after another tax ruling in favor of the Internal Revenue Service in a case involving an 831(b) captive. Both structures offer tax advantages to captives set up by small and midsize businesses.

In Reserve Mechanical Corp. v. Commissioner of Internal Revenue, Judge Kathleen Kerrigan of the U.S. Tax Court in Washington last month found that the captive “was not operated as a bona fide insurance company, and there was no legitimate business purpose for the policies that Reserve issued for the insured.”

Reserve, an Anguilla-based captive, was established in 2008 for Peak Mechanical & Components Inc., an Osburn, Idaho-based company that services and repairs equipment used for underground mining and construction, including equipment used in a Superfund site, according to the ruling. Houston-based captive adviser Capstone Associated Services Ltd. helped establish the captive, and Atlas Insurance Management (Anguilla) Ltd. acted as Capstone’s representative in the domicile.

Over the next three years, Reserve issued at least 11 policies a year for Peak and its affiliates to cover various risks, including excess directors and officers liability, loss of major customer, business interruption, excess pollution liability, tax liability, cyber risk and product recall coverage, the ruling said.

As part of the structure, Reserve was covered under a stop-loss policy through PoolRe Insurance Corp., an Anguillan insurer that covered Capstone clients. Reserve and other Capstone clients entered in to a quota share reinsurance agreement with PoolRe to cover a specified portion of its risk. Reserve bore no losses under the quota share agreement during the three-year period, and the reinsurance premium it received matched the premium it paid to PoolRe for the stop-loss coverage.

After reviewing the arrangements, in 2016, the IRS notified Reserve that it was not a tax-exempt insurance company under 501(c)(15) and it had a tax deficiency of $477,261.

In the ruling, among other things, Judge Kerrigan said that, given the requirement that the insurance transactions between Reserve and PoolRe were required to be at “arm’s length,” Reserve did not explain why the amounts it received to reinsure PoolRe for a blended risk of the whole pool was the same it paid to the pool to cover its own risks. “The quota share arrangement involved a circular flow of funds,” the judge ruled.

“The only purpose PoolRe served through the quota share arrangement was to shift income from Peak to Reserve. Reserve has not established that PoolRe was created or operated for legitimate nontax reasons,” the ruling said.

In addition to the reinsurance arrangements, the fact that Reserve paid only one claim in the three years under examination also raises questions about its legitimacy as a “bona fide” insurer, the ruling said.

In addition, “the available history of losses for Peak and the other insureds shows that before the tax years in issue they never suffered any losses that would even come close to triggering the stop-loss coverage provided for in the stop-loss endorsements. PoolRe was removed far from any actual risk associated with the business or operations of Reserve’s insureds,” the ruling states.

After the ruling, Capstone and Reserve issued a statement saying they “respectfully disagree” with the court’s ruling, saying among other things that judge’s analysis of the pooling arrangement was “an unexpected rejection of a fundamental industry standard risk sharing mechanism dating back more than a century.”

In addition, “of even greater surprise, the court called out for evidence that an insured had experienced a loss before a company could buy insurance covering such event,” the statement said.

Taken together with the Avrahami ruling on an 831(b) captive last year, microcaptive owners should review how their captives are structured, legal experts say.

The ruling “puts into question a lot of the programs that are in operation today,” said Robert H. Myers Jr., partner in the insurance/reinsurance group at Washington-based law firm Morris, Manning & Martin L.L.P.

“What the judge is saying is that this is form over substance, meaning that, yes, it looks like it might be insurance, it looks like it may have risk distribution and real insurance policies, but, when you really look into it, it doesn’t provide what insurance is intended to provide, which is reimbursement for extensive losses and damages,” he said.

The judge also emphasized that there was no real nontax business purpose for the captive, “and I think that’s kind of a dagger in the heart,” Mr. Myers said.

The ruling could cause concerns for other microcaptive owners and managers, said Philip Karter, a Philadelphia-based tax lawyer and shareholder at Chamberlain, Hrdlicka, White, Williams & Aughtry.

“I’m sure this case is sending chills down the spines of various captive managers because they set these things up and they pretty much kind of set up a template,” he said.

In particular, captive managers often think they meet IRS requirements for risk distribution in captives by setting up a risk pool with each company taking a proportionate share of the risk expense in the pool, but in this case the court found there was little risk to the pool, Mr. Karter said.

“There are good ways to plan around this … but you really have to be diligent about everßevery? aspect of the transaction knowing that they are going to be scrutinized for abuse,” he said.