A privately held insurance company should only be implemented when it makes economic and business sense. There must be an inherent need to cover uninsured risk in a business before considering a captive insurance company.<\/p>\n
The IRS has issued multiple Revenue Rulings, Procedures, Notices and Bulletins addressing various issues associated with the use of privately held insurance companies. Recently issued IRS publications include:<\/p>\n
Revenue Ruling 2001-31<\/a> \u2013 IRS Gives Up on \u201cEconomic Family Theory\u201d<\/p>\n Revenue Procedure 2002-75<\/a> \u2013 Private Letter Rulings on Insurance Co. Issues<\/p>\n Revenue Ruling 2002-89<\/a> \u2013 50 Third Party Insurance Risk<\/p>\n Revenue Ruling 2002-90<\/a> \u2013 12 Brother \/ Sister Subsidiary Requirement<\/p>\n Revenue Ruling 2002-91<\/a> \u2013 Spreading of Risk in Captive Group<\/p>\n Notice 2003-34<\/a> \u2013 Use of Insurance Companies \/ Hedge Funds<\/p>\n Revenue Ruling 2005-40<\/a> \u2013 Tax deduction not applicable if entity is \u201csole client\u201d of captive<\/p>\n Notice 2005-49<\/a> \u2013 IRS asks for comments on qualification of certain arrangements as insurance<\/p>\n CICAcomments_IRSnotice2005-49<\/a> \u2013 The Captive Insurance Company Association\u2019s comments on IRS notice 2005-49<\/p>\n Revenue Ruling 2001-31<\/a>, issued June 4, 2001: With this ruling, the Internal Revenue Service has acknowledged that it will no longer invoke and follow the \u201ceconomic family theory\u201d with respect to captive insurance transactions. The judicially accepted definition of insurance involves the following elements of risk:<\/p>\n Risk Shifting<\/strong>-the transferring of the financial consequences of the potential loss to the insurer, and Risk Distribution<\/strong>-allowing the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as premiums and set aside for the payment of such a claim.<\/p>\n The sharing and distribution of the insurance risk by all the parties insured is essential to the concept of true insurance. The \u201ceconomic family theory\u201d argues that where insurance risk has not been shifted or distributed outside the \u201ceconomic family\u201d there cannot be valid or bona-fide insurance contracts. Valid and bona-fide insurance contracts are essential in obtaining deductions for premiums paid to a related party insurer.<\/p>\n As an alternative to the \u201ceconomic family theory,\u201d the courts have historically employed a balance sheet test to determine if bona-fide insurance exists. Thus, where the risk of loss has been removed from the insured\u2019s balance sheet, shift of risk has occurred. Although the IRS has indicated that it will no longer invoke the \u201ceconomic family theory\u201d as an argument that risk has not shifted between related parties, the Service has indicated that it will continue to scrutinize each entity involved in an insurance transaction on many levels to determine if bona-fide insurance contracts exist. These areas may include:<\/p>\n <\/p>\n Revenue Ruling 2002-89<\/a>, issued December 11, 2002: This ruling discusses two scenarios involving the payment of premiums by a parent to its two wholly-owned captive subsidiaries.<\/p>\n In the first scenario, the premiums paid by the parent to its wholly owned subsidiary accounted for 90% of the subsidiary\u2019s income for the year. In the second scenario, the premiums paid accounted for 50% of the second subsidiary\u2019s income for the year. In determining whether these scenarios represented valid insurance arrangements, the IRS noted that:<\/p>\n -Both insurance captives were adequately capitalized,<\/p>\n -Both insurance captives were properly regulated,<\/p>\n The companies transacted their insurance business in a manner consistent with the standards applicable to an insurance arrangement between unrelated parties.<\/p>\n The IRS again focused on the concepts of adequate risk shift and risk distribution and concluded that the arrangement in scenario 1 did not provide sufficient risk shift or distribution while the facts in scenario 2 did. Thus, where 50% of the subsidiaries risk is with unrelated third parties, the IRS has concluded that sufficient shift and distribution of risk has passed to the subsidiary to constitute a valid and bona-fide insurance arrangement for the parent.<\/p>\n Although Revenue Ruling 2002-89 appears to definitively state that 50% of an insurance company\u2019s business must be with unrelated parties in order for the related party insurance arrangement to constitute bona-fide insurance, judicial precedent exists in the 9th Circuit\u2019s Harper Group decision that this third party element may be as little as 29 to constitute a valid and bona-fide arrangement between related parties.<\/p>\n Revenue Ruling 2002-90<\/a>, issued December 11, 2002: The IRS concluded that the premiums paid by 12 operating subsidiaries to a captive insurance subsidiary owned by a common parent are deductible. The facts in Revenue Ruling 2002-90 are similar to the brother-sister subsidiary arrangement as outlined in the 5th Circuit\u2019s ruling in Humana. The IRS concluded that the transaction contained adequate risk shift and risk distribution and that the amounts paid for insurance by domestic operating subsidiaries to an insurance subsidiary of a common parent are deductible as \u201cinsurance premiums.\u201d The IRS also based their position on several facts as follows:<\/p>\n -The premiums of the operating subsidiaries were determined at arms-length.<\/p>\n -The premiums were pooled such that a loss by one operating subsidiary is borne, in substantial part, by the premiums paid by others.<\/p>\n It is important to note that the IRS analyzed each of the subsidiaries to ascertain:<\/p>\n If they conducted themselves in all respects as would unrelated parties to a traditional relationship; If the insurance company was able to pay claims;<\/p>\n The adequacy of the insurance company\u2019s financial performance; and<\/p>\n If separate financial reporting was maintained on behalf of the insurance company.<\/p>\n Revenue Ruling 2002-91<\/a>, issued December 11, 2002: The IRS concluded that a group captive arrangement, which was formed by fewer than 31 unrelated insured\u2019s, with each insured having no more than 15% of the total risk, was a bona-fide insurance arrangement. The ruling also outlines other factors that the IRS will consider in determining whether a transaction constitutes a bona-fide insurance arrangement. These factors include:<\/p>\n Whether the insured parties truly face hazards; Whether the risks are shifted and distributed to the insurance company, since the entities are commercially and economically related;<\/p>\n Whether the policies contain provisions such that the covered risks may exceed the amount of premiums charged and paid;<\/p>\n Whether the validity of claims were established before payments are made; The IRS again focuses on risk shifting and risk distribution in determining whether the transactions are considered deductible \u201cinsurance premiums”.<\/p>\n Revenue Procedure 2002-75, issued December 11, 2002: This revenue procedure discusses certain insurance transactions whereby the IRS will now contemplate issuing private letter rulings regarding whether a valid and bona-fide insurance arrangement exists between related parties. The IRS has indicated that taxpayer\u2019s seeking a ruling should contact the appropriate department at the IRS to determine whether the facts in each case will be considered by the IRS for a ruling before preparing the ruling request.<\/p>\n\n
\nWhether the insurance company is regulated as an insurance company in the jurisdiction(s) where it does business;
\nWhether an adequate amount of capital was present within the insurance company;<\/p>\n
\nWhether premiums charged by the captive are based on commercial rates;<\/p>\n
\nWhether the captive\u2019s business operations and assets are kept separate from the business operations and assets of its shareholders.<\/p>\n