Are claims an essential element of an insurance transaction? Looking at micro-captive cases, they were either nonexistent, barely occurring, reported only after a tax audit started, or existing and unreported—facts that the courts used in ruling against the taxpayers. The US Treasury believes a high claims ratio is mandatory, at least for micro-captives.
Recently proposed regulations 1 for Internal Revenue Code section 831(b) would label a micro-captive with a cumulative claims ratio 2 below 65 percent for less than 9 years as a transaction of interest 3 and a cumulative claims ratio below 65 percent for 10 years as a listed transaction. 4 One micro-captive decision approvingly referenced a 70 percent claims ratio for property and casualty insurers. 5
But claims activity is far more varied and nuanced. To begin with, there are two claims payment patterns.
- High frequency, low severity (regularly occurring, small dollar) claims. The insurance industry most commonly thinks of these as the first layer of a commercial auto or workers compensation policy. For example, Acme Manufacturing determines 80 percent of its workers compensation claims are below $100,000. It purchases a workers compensation policy with a $100,000 deductible and forms a captive to fund the first $100,000 of risk. If the company is large enough (for example, it's a member of the Fortune 1,000), it may have enough activity for regular claims activity. But a smaller company belonging to a group captive program may have fewer claims, explaining why it joined the group in the first place. 6
- Low frequency, high severity (irregular, larger claims). These are commonly understood to be property claims. It is common for property insurance to mandate that the insured assume named-storm deductibles calculated as a percentage of the total insured value (TIV). If the property is worth $100 million, the insured must fund the first $10 million in coverage from its captive. Depending on the property's location, it might not pay a claim for a decade or longer.
In comments to the proposed regulations, the American Academy of Actuaries made two key observations about losses. First, in its comment letter on the proposed micro-captive regulations, dated June 13, 2023, it stated that variability of losses is a key element of risk transfer, meaning that the insured is paying the insurer to assume the risk could be very large. It next noted that over 63.7 percent of all insurance lines have loss ratios below 65 percent. As best expressed by CICA's comment letter to the same transactions, "losses are evidence of risk, but lack of losses is not evidence of lack of risk."
Claims Handling
States regulate the insurance claims process and personnel. Regulators not only audit insurers' claims handling but also sanction them for statutory violations. Insureds can file complaints with state regulators for process violations. Finally, claims professionals adhere to a standard process that utilizes commonly understood practices and procedures.
That said, micro-captive cases are littered with examples of poor claims handling protocols. Some programs used an "ad hoc" process, and others had irregular or nonexistent processes. One captive failed to file eligible claims. A second had captive managers participate in the pool where the claim was filed, creating a clear conflict of interest. None used licensed claims adjusters.
Captive Investments
The captive's investment portfolio has three purposes.
- It provides liquidity for claims payment. To accomplish this, assets must be readily convertible to cash.
- It provides an income stream to smooth earnings, giving the insurer a buffer to mitigate premium increases.
- It provides a conservative store of value, stabilizing the insurer's balance sheet.
The portfolio is usually composed of cash and investment grade bonds, and assets must be sufficiently diversified to minimize the impact of market fluctuations.
The micro-captive investment portfolios are ill-suited for insurance companies. In Avrahami v. Commissioner, 149 T.C. 144 (2017), the Avrahamis transferred $1.2 million to a limited partnership owned by the insured's children that invested in land. Both Syzygy 7 and Patel 8 owned life insurance policies. The captive in Royalty made large loans to its owners, 9 while Swift's captive bought and sold real estate. 10
None of these contain appropriate investment examples.
Premium Calculations
An insurance premium prefunds four expenses for the policy period.
- Projected losses
- Allocated loss expenses
- Unallocated loss expenses
- Profit
For example, a $500,000 premium would be comprised of $250,000 of potential claims, $200,000 of premium, and $50,000 of profit. 11
Data for these calculations comes from a variety of sources. The insured's loss information is combined with the loss experience of similar companies to arrive at a class rate. Industry and actuarial databases provide expense information, while the profit margin is considered a reasonable return on the insurer's capital.
The preceding assumes the data is available. All large actuarial firms have proprietary databases comprised of loss data from clients. But in some situations, such data is not available. The risk may be new, or there may be insufficient claims for a credible data set to exist. When this happens, an actuary can use their best judgment to determine an acceptable rate. The number may be based entirely on the underwriter's judgment, or it could be from a model such as the Monte Carlo method. The primary requirement for these nontraditional methods is that the actuary performing the analysis must leave a sufficient paper trail to allow another actuary to duplicate their work.
The micro-captive cases contain many examples of poor pricing methodology. Perhaps the most egregious is several captives either targeted a high premium amount or had total premiums right around the $1.2 million limit of the section 831(b) deduction. Other bad facts included actuaries who continually skewed premium amounts higher, poor record-keeping, and a lack of adequate work to justify total expenses.
Valid and Binding Contracts
Important public policy considerations support the use of cookie-cutter insurance policies. If every insured negotiated its own contract, the cost would quickly become prohibitive. Policies contain triggering clauses, terms and conditions outlining the parties' duties and responsibilities, policy-specific definitions, valuation clauses, and state-mandated requirements. If each were individually negotiated and drafted, the legal cost alone would quickly dwarf the premium.
The use of forms standardizes common policy terms as understood by market participants. For example, insurance producers, claims adjusters, and coverage lawyers are equally aware of the term "occurrence" as used in a commercial general liability policy. This understanding has been further solidified by state and federal cases. Finally, universally understood contract provisions allow actuaries to more accurately price coverage.
The most common policies are written by Insurance Services Office, Inc. This organization submits forms to state regulators for approval, and the approved forms are then used throughout the state. Because a policy's provisions must apply to many situations in a state (for example, it must be applicable to most negligence cases), it is broadly drafted, creating an industry-understood shortcoming of policy ambiguity.
Before the micro-captive cases, the captive case law regarding the requirements for valid and binding policies was limited. The court in R.V.I. Guar. Co. v. Commissioner, 145 T.C. 209 (2015), stated that claims payments were a requirement, while the court in Securitas Holdings, Inc. & Subsidiaries v. Commissioner, T.C. Memo. 2014-225 (2014), held that the information contained in a standard declarations page was sufficient. Some micro-captive cases had clear failures such as policies issued after the end of the policy year or no policies issued, period. But several cases found the policies invalid simply because they were ambiguous, which exists with all insurance contracts.
The Syzygy court conceded that insurance policies were ambiguous and acknowledged this was a major source of litigation, only to then rule against the taxpayer. The Tax Court's understanding of policies was clearly lacking.
Conclusion
So, after nearly 40 cases in the captive insurance case law timeline, the industry still has remarkably little certainty for a transaction that has profound macroeconomic benefits. It is far past time for a clear and certain path to emerge.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.
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