Government Shutdown and Its Impact on Employee Benefits

As the federal government partial shutdown continues, employers who rely on government contracts or have business models that depend on a fully operational government are now forced to make difficult decisions regarding their workforce. Some employers are contemplating reductions in force, layoffs, or furloughs to weather the financial ramifications of the
shutdown. This leads to questions about employee benefits, and how benefits should be handled during these leaves of
trump maternity leaveabsence.

Employers contemplating a reduction in force, layoff, unpaid leaves of absence, or furloughs, should review the following:

  1. Review their employee handbook and plan document for eligibility provisions. How plan eligibility is determined will be critical in determining how benefits are or are not continued.
  2. Review their carrier contracts, including stop-loss or reinsurance provisions regarding eligibility.
  3. If they are an applicable large employer, review their obligations under the employer mandate
    play or pay provisions.
  4. Communicate process for benefit premium payments, if applicable.
  5. Provide COBRA notices appropriately, when necessary.

Eligibility Policies

Employers are obligated to follow the provisions put forth in their plan documents, and mirrored in their employee handbooks, for benefit eligibility. Employers whose handbooks do not contemplate layoffs, furloughs, or reductions in force, or who have conflicting language between documents, should consult with their legal counsel.

Carrier Contracts

Employers should work closely with their carriers, including stop loss and reinsurance carriers, to ensure that both parties agree about who is and who isn’t eligible for benefits. Conflicts between parties will require legal counsel.

Applicable Large Employers (ALE)

To comply with the ACA, applicable large employers must offer their full-time employees health coverage or pay one of two employer-shared responsibility/play or pay penalties. An applicable large employer has 50 or more full-time or full-time equivalent employees in the prior calendar year. Full-time employees are employees who are credited with 30 hours of service a week or more. A full-time equivalent employee is calculated by combining the number of hours of service of all non-full-time employees for the month (not including more than 120 hours of service per employee) and dividing the total by 120.

Under the ACA, any hour for which an employee is paid or entitled to payment must be counted as an hour of service. This includes:

  • An hour worked
  • Holiday
  • Incapacity (including disability)
  • Military duty
  • Vacation
  • Sick time
  • Layoff
  • Paid leave

This means that employees of applicable large employers will continue to accrue hours of service during a leave of absence due to the layoff provision if they are paid. If the employer is an ALE, and the employee is still considered full-time (e.g., due to being in a stability period), the employer will continue to be obligated to offer the full-time employees affordable, minimum value health coverage. Failure to do so would risk triggering ACA penalties (i.e., the “affordability” penalty, as the COBRA coverage offered due to the reduction in hours is likely to be “unaffordable”).

Employers are provided with two methods to determine an employee’s full-time status: the monthly method, and the measurement
and lookback method.

  • Under the monthly method, the employer looks at each employee’s actual hours of service each calendar month (an hour worked or an hour of paid time for vacation, holiday, sick time, incapacity including disability, layoff, jury duty, military duty, or other paid leave) each calendar month. An employee is full-time for the month if he or she works 130 hours, no matter how long or short the month is.
    • Under the look-back method, the employer looks at the number of hours the employee averaged during a look-back period called a “measurement period.” Once the employer determines whether the employee worked full-time during the measurement period, that determination generally will apply throughout the immediately following stability period regardless of the number of hours the employee actually works during the stability period (unless the employee’s employment ends).

Layoffs

If the employee is laid off during a stability period (not terminated) and is considered full-time, affordable coverage must be offered during the layoff to avoid exposure to potential penalties. Once the layoff is over, if the employee returns to work within 13 weeks (26 weeks for educational institutions), coverage must be reinstated by the first day of the month
following his return to work.

The time on layoff will not count as hours of service for purposes of the measurement period if the leave is unpaid. If coverage is terminated and the layoff exceeds 13 weeks, the employee can be treated as a new employee, with a new waiting period or initial measurement period, when he returns (of course, the plan may be designed to reinstate all returning employees immediately upon return). Generally, if the employee had coverage during the layoff (e.g., through COBRA or another extension of coverage), coverage will be reinstated upon return. There will be no hours of service to measure during unpaid leave (except for unpaid jury duty, FMLA or USERRA leave).

Unpaid Leave

If the employee is on an unpaid leave of absence (except FMLA) and in a stability period as full-time, the employee must be offered affordable coverage through the stability period to avoid potential penalties. When the employee’s hours are calculated during the measurement period, the leave of absence (except FMLA) will count as zero hours of service. Employers that are ALEs should seek experienced legal counsel to ensure that their plan documents reflect their practices during any furlough, layoff, reduction in force, or leave of absence to mitigate risk under the ACA.

Payment of Premiums

Employers who continue offering benefits during a furlough, layoff, or reduction in force will need to establish a process for premium payment.

Employers that already have an established process for premium payment during unpaid FMLA leave or during a pay shortage (for example, for tipped employees) should utilize those policies. The IRS has not provided guidance or regulation for handling pay shortages without a loss of benefit eligibility. Employers often refer to the rules provided for handling employee contributions during an employee’s unpaid Family Medical Leave Act (FMLA) leave. There are three options that employers have during unpaid FMLA leave:

  • Pre-payment
  • Pay-as-you-go on an after-tax basis
  • Catch-up salary reduction upon return from leave

During the government shutdown, it is likely that only the second two options would be feasible. The premium payment policy should be uniformly enforced for all employees. Employers may set a time limit for the employee to catch up on contributions before terminating coverage, as well as a maximum period of time over which employees may spread payments. Employees should be allowed uniform periods of time to pay back missed contributions; for instance, management should not be given three months to pay back missed contributions when other employees are only given one month.

COBRA

The Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA) allows qualified beneficiaries who lose health benefits due to a qualifying event to continue group health benefits.COBRA

COBRA qualifying events include what is called a “reduction in hours.” A reduction of hours commonly occurs when an employee goes from full-time to part-time, when an employee is temporarily laid off or furloughed, or when an employee goes on a leave of absence. The IRS COBRA regulations provide that a reduction of hours in a covered employee’s employment “occurs whenever there is a decrease in the hours that a covered employee is required to work or actually works, but only if the decrease is not accompanied by an immediate termination of employment.”

In this event, employers who are subject to COBRA should timely provide affected employees with their COBRA election notice if their reduction in hours results in a loss of coverage under the plan.

COBRA Strategy for ACA Compliance or Culture Concerns

In the event that a plan document, employee handbook, or carrier policy determines a furloughed or laid off employee is no longer a benefits eligible full-time employee, employers who are subject to COBRA could offer impacted employees COBRA coverage and assist the employee with premium payment.

Under the ACA play or pay provisions, an offer of COBRA coverage is considered an “offer of coverage” and if an employer assists in premium payments, COBRA coverage could potentially be made affordable to ensure the employer was not triggering ACA penalties for failing to offer affordable, minimum value coverage.

Spring to Speak at World Captive Forum 2019

We’ll be packing our bags for sunny Florida soon enough! Spring’s Managing Partner, Karin Landry, will be speaking on three different panels at this year’s World Captive Forum.

The three-day event will run from January 30th to February 1st in Turnberry Isles, Florida and we expect a great turnout of employers, regulators and service providers alike, all there to share their experiences and perspectives.World Captive Forum 2019

Karin will lead the following sessions:

  • State Regulation Again! Time for a Fresh Look! from 10:45-11:45 AM on January 31st. She will be speaking alongside Joseph Holahan, Attorney at Morris, Manning & Martin, LLP about the varied regulatory issues facing the captive industry today. They’ll be looking at Washington state and others who have passed recent tax regulations related to captives, and fleshing out how captive professionals can move forward.
  • US Benefits – It’s a Better Year from 1PM to 2PM on January 31st. Karin and David Slenn, Partner at Shumaker Loop & Kendrick LLP, will discuss benefits captives – where they stand today and where they’re headed. They will specifically address updates from the Department of Labor (DOL) and share a case study to bring the topic to light.
  • Stop-Loss in Captives from 2:15-3:15PM on January 31st. In this session, Karin will be joined by Steve Kroll of International Capital Investment Company and Tom DeNoma of Nationwide to discuss the growing trend of stop-loss captives and best practices in doing so. They will represent the employer, insurer and consultant viewpoints.

Spring has been to the World Captive Forum several times and always finds it to be a strong indicator of industry hot topics. Karin is excited to learn and share her knowledge. Not to mention she’ll get to escape from the Boston cold! If you’ll be in Florida too, don’t forget to catch a session (or two or three) or Karin’s and say hello.

Spring to Exhibit at Yankee Dental Congress 2019

Our team is excited to head to the Yankee Dental Congress in Boston’s Seaport from January 30th to February 2nd. As a long-time broker and partner for hundreds of Massachusetts Dental Society (MDS) members, this event has always been a rewarding way to meet with small business owners and vendors in the dental arena. In fact, this will be Spring’s 10th year in a row being involved with the Yankee Dental conference, and we are thrilled!

Captive Insurance

The four-day event is sure to bring the best and brightest in the field, drawing a crowd of almost 20,000. We look forward, as always, to this networking and learning opportunity. If you will be at the conference – which takes place at the Boston Convention and Exhibition Center – please stop by booth 2234 and say hello! We will have plenty of fun giveaways, as well as information about the services we offer to so many of the area’s dentists (among others).

The 4 Biggest Themes from the 2018 Cayman Captive Forum

As we unpack our suitcases from another successful appearance at the Cayman Captive Forum – our 11th one attended as a company! – I’m also taking the time to unpack my thoughts on the event.

As a sponsor and exhibitor at the conference, which ran from November 27th to the 29th in the Grand Cayman Islands, our team had the pleasure of meeting a range of new faces and familiar colleagues. This is an event that we look forward to each year, and not just because it gives us a break from the cold weather. Drawing over 1,000 attendees, this is a top-notch event catered to captive professionals of all kinds, whether they are seasoned experts or newcomers.Cayman Captive Forum

The Cayman Captive Forum is one of many ways that we keep up with trends, priorities and news. So between ice cream socials and poolside receptions, I noted the four most prevalent categories from this year’s educational sessions.

1  –  Taxes
No surprise here, as taxes and captives go hand-in-hand. This year, audience members learned about captive considerations for taxable and tax-exempt entities. Further, a group of accountants and lawyers covered US tax reform in detail, highlighting how it all affects captives (i.e. CFC rules, changes to attribution rules, etc.).

2  –  Current Events
Naturally, any modern conference would take inspiration from current events, but I noticed quite a few sessions at Cayman that were focused on unrelated topics frequently seen in the headlines.

First, there was “Ridesharing in Healthcare”, which explored the role of transportation in population health management. Then, a panel explained the impact of the “#MeToo” movement on the healthcare industry – addressing harassment, bias and recommended solutions. Thirdly, a team from CHRISTUS Health told audiences of their experiences with Hurricane Harvey and its consequences, arming listeners with suggestions for future catastrophic events. Another session dealt with workplace violence, something we hear about far too often, and, finally, some healthcare specialists provided a defense strategy for an Ebola outbreak.

3  –  Blockchain
Blockchain is another hot topic, so it got some spotlight at Cayman this year. In “Blockchain Technology Global Trends”, we learned about blockchain regulations and issues pertinent to insurance and healthcare. Then a panel of accountants discussed the opportunities and challenges presented by blockchain as it relates to insurance.

4  –  Cyber
Cyber has been top-of-mind for risk professionals for several years. Unfortunately there has been no magical solution, so the subject remained front-and-center once again this year at Cayman. Charles Kolodkin and Rebecca Cady explained how to use Miscellaneous Professional Liability (MPL) to strategize for cyber risk. Their lessons learned included, “hone the ability to manage the claim” and “work with operational leadership and board”. Another session discussed how to control for vendor cyber risks, highlighting the increased interconnectivity between areas like big data, social media, cloud computing and the Internet of Things (IoT) and the role it all plays on cybersecurity.

 

All in all, the 2018 Cayman Captive Forum was an event to remember. Myself and my Spring team members enjoyed all of the networking and learning opportunities that the event brought about, and are already looking forward to next year’s!

Captive Insurance

Spring to Sponsor 2018 Cayman Captive Forum

The Spring team is delighted to announce that we will be sponsoring the Cayman Captive Forum which runs from November 27th to the 29th in the Cayman Islands.

While the conference’s location and weather (especially in November) are certainly a treat, we swear that’s not the only reason we’re going. In fact, Spring has been involved with the Insurance Managers Association of Cayman (IMAC, the host group) for over a decade, and its events and resources have never let us down. This year we will be joining over 1,400 otherCayman Captive Forum industry professionals to network and share our experiences and best practices. Attending conferences is one of the strongest ways that we keep our pulse on trends, and with such a large captive market in the Cayman Islands, this is one of the best.

A group of impressive speakers will present on topics like:

  • Risk distribution
  • Tax considerations
  • Regulatory updates
  • Cyber risk
  • Telemedicine

And much more!

If you are heading to the Cayman Captive Forum too, please stop by booth #7 to say hello to our team. We’ll be giving out a great raffle prize!

5 Questions to Answer Before Renewing Your Health Insurance Plan

Whether you’re an office manager, business owner, or a human resource or benefits professional, renewing your company’s health insurance plan may become automatic. Considering alternatives is a daunting task that many feel they lack the bandwidth to handle. However, at a time when healthcare costs are rising, the market is in flux, and employees are expecting more and unique benefits, choosing the most convenient option is probably not your best bet.

It’s imperative to routinely review your package, your results and rethink your strategies to make sure you’re minimizing your costs while giving employees the best coverage at a reasonable rate. You may think you’ve considered everything, but you probably haven’t. Before your renewal date, make sure to address the following questions.

  1. Does your medical trend align with market standards?

Before you renew, take a hard look at the medical trend being used this year for next year’s renewal. The market has been seeing downward trends, so you’ll want to make sure you’re seeing that in your rates.  For 2019, renewals are in the low single digits.

  1. If you’re self-insured, have you considered medical stop-loss?

While advantages of self-insurance include flexibility and savings opportunities, self-insured companies are also exposed to an extra level of risk – unexpected, catastrophic loss that they’re expected to cover themselves. Stop-loss insurance, sometimes called catastrophic insurance, can help mitigate this risk. Medical stop-loss is coverage specific to healthcare spenEmployee Benefits Communicationd, and involves the establishment of a threshold by the employer over which they have external coverage for.

With an uncertain future for US healthcare, medical stop-loss is something all self-insured organizations should include in their program. Employers will need to consider where the stop-loss program attaches to make sure you don’t over or under purchase coverage.  Also, captive stop-loss solutions should be considered to maximize your savings, providing a savings of 10% or more on your stop loss spend.

  1. Do you have the right tools in place to support and communicate benefits with your employees?

You may have an impressive health plan and competitive benefits offerings, but if your employees aren’t aware of them, don’t know how to utilize them, or find them irrelevant, you’re not going to see the results you’re hoping for.

It might be time to give these questions some thought:

  • How and when are you telling employees about what’s available to them?
  • Do they truly understand their options?
  • Do you know what benefits your workforce finds most valuable? Are you giving them what they want, or what you think they want? Think about your demographics here.
  • Do you have streamlined processes for benefits administration, claims filing, etc.?

Consider a formal or informal survey of employees to find out what is working and not working. Further, there are a number of administrative tools, such as Bswift, that you may want to evaluate. For compliance and HR initiatives, ThinkHR and like platforms may be appropriate.

  1. Is it time to consider an actuary?

An actuary is a certified professional that measures and predicts insurance risks and premium rates. They are math-based risk experts and can help organizations with insurance policy development, forecasting, valuations, audits, and more.

Most small businesses believe they have no need for actuarial services. However as organizations grow and consider more advanced and varying insurance options, the greater the need for an actuary becomes. While the work of an underwriter is crucial, actuaries take a deeper look at the numbers. They are a neutral third party, and can offer crucial information such as how much volatility you can expect over a one and five-year period. These insights allow you to make smarter insurance decisions.

  1. Could your organization benefit from alternative funding strategies?

If you’re fully-insured, have you thought about aiming for a self-funded structure? If you’re self-insured, have you thought about a captive insurance company? If you’re a small businesses, have you thought about an Association Health Plan (AHP)?Employee Benefits Funding

We recommend thinking about these alternatives every couple of years. As businesses change and grow, along with market regulations and options, what once made sense for an organization may no longer be the best fit.

Captives provide unparalleled transparency of and control over an insurance program, which helps with cost savings and customization. Once only an option for jumbo-sized employers, more and more smaller organizations are utilizing a captive structure, either as a standalone captive or part of a cell or group captive.

Further, the AHP market is expanding quickly, due in part to new regulations passed earlier this year. This is a great avenue for a small business to benefit from economies of scale and get the same rates as a large employer. For more information about how to set up or join an AHP, please get in touch.

 

Healthcare is complicated, but with that complexity comes new and exciting opportunities. Before you decide to maintain the status quo and renew your plan, take some time to think about what’s truly best for your organization and its workforce.

7 Ways Captives Provide Clients a Competitive Edge

A recent report from AM Best concluded that, based on their ratings, captive insurance companies outperformed commercial market carriers yet again in 2017. This finding was based on a hard look at balance sheet strength, operating performance, and business profiles of captives as compared to their commercial counterparts.

As long-time captive consultants, we’ve seen a range of clients benefit from a captive structure and are well-versed in their advantages. The AM Best report is a testimony to the positive role captives can play and how they’re able to provide a competitive edge to the organizations using them.  Some of the key advantages include:

  1. Homogeneous Risks

Whether a Single Parent Captive or a Risk Retention Group (RRG), the insureds of a captive are going to have similar risk profiles and diversity. A Single Parent Captive insures the parent company, so all its risks belong to one entity. RRGs are made up of like companies with similar missions and business products/services, such as a group of universities. In both cases, the homogeneity of risk will benefit the captive by establishing a certain level of predictability which helps with the consistency of rates and an unsurprising loss ratio.

 

  1. Underwriting Profit/Results

According to AM Best, the Captive Insurance Composite (CIC) experienced a 86.4% five-year combined ratio, while the Commercial Casualty Composite (CCC) had a 99.9% five-year combined ratio. Captives enjoy such underwriting profits for a number of reasons, primarily the fact that risk management, control, prevention and mitigation are all at the heart of the captive’s purpose. Organizations are able to benefit from their own good experience. Captives facilitate transparency and more access to data. This allows organizations to act in a proactive manner and implement risk mitigation and control protocols in an almost real time basis. Comparatively, a fully insured commercial market policy may result in a delayed information transition – most commercial insurance arrangements provide reports a quarter after year-end.  In addition, frictional costs are lowered with a captive.Captive Insurance Advantages

 

  1. Return on Investment

A major advantage that organizations with captives have over commercial carriers is the opportunity to recapture part of the premiums. Captives require capital infusion to start and get off the ground. The profits/savings from the insurance carrier accumulate in the captive and can, over time, begin to yield impressive returns on investment. Most feasibility studies use an internal rate of return or a hurdle rate to help visualize potential savings. This makes captives a great alternative for deploying capital and earning a consistently positive return on income, in addition to being able to use it strategically for reinsurance purposes.

Another pro of captives is the ability to evaluate their ROI evaluated against  their hurdle rate as their internal rate of return. A company can determine if an investment will give them adequate benefit or savings over a given timeframe based on their rate of return, and then decide if that investment is worth following through with, or if another solution is more economically sound.

These factors combined allow captives a healthy sum of capital and positive balance sheets.

 

  1. Competitiveness

Commercial carriers are sometimes unable to understand the true needs of the insureds and are limited in their offerings. Captives create competitiveness in the market and can compel commercial carriers to offer better terms and costs by virtue of a captive’s existence. In many instances, commercial carriers are threatened by the captive’s ability to take on all the risk and become willing to create quota share arrangements. Captives are a unique, tailored solution for the insured(s) and offer an unbeatable level of customization and very little changes in premiums. They have the ability to insure unique risks and are able to fill in the gaps of coverage where commercial markets are unable to do so.

 

  1. Enterprise Risk Management

AM Best defines Enterprise Risk Management (ERM) as, “establishing a risk-aware culture and using tools to consistently identify and manage, as well as measure risk and risk correlations.” An organization that utilizes a captive is likely to have a stronger ERM system in place, when compared to its captiveless peers, since it is partaking in its own experience and thus is more motivated to better manage its risks. In most cases, the captive is a vital cog in the ERM wheel. This close alignment allows for better results for both parties, and a lower total cost of risk for the captive.

 

  1. Retention

Many rated captives have a retention rate of 90% or higher. This is, in part, because policyholders are routinely rewarded through dividend payments from the captive that are significantly higher than any seen in the commercial market. These profits can be used in a multitude of ways to further benefit the captive. For example, policyholders could underwrite additional lines of coverage without the need for more capital, or provide premium holidays on programs, or fund FTEs.Innovative Insurance Strategy

This, combined with the lack of competition means that captives don’t need to shop around for business each year, creating savings in acquisition costs which can then be returned to the captive (e.g. in the form of loss control) to further benefit the insureds.

 

  1. Ability to Identify Emerging Risks

A captive’s structure and foundation in ERM gives it an added advantage of foreseeing emerging risks. Typically, all key stakeholders and the entire risk team of an organization will be involved in the captive’s management and activity. Having a strong alignment between the parent company, the captive, the IT team, the risk experts, the actuaries and other main players means that everyone is on the same page. A captive can make long-term assessments while also flagging and resolving issues quickly. There is no fragmentation of knowledge in a captive setup, and all stakeholders have the same interests. In sum, captives allow organizations to be nimble and react to changing market conditions quicker than commercial market carriers.

 

Conclusion

As AM Best states, captives performed well in 2017, as did RRGs, and it’s projected that success will continue into 2018 and beyond. The US captive market has grown substantially over the past few years, with domiciles like North Carolina and Hawaii experiencing an uptick in captive formation. Further, we’re seeing captives being used more frequently for nontraditional lines of coverage, such as cyber and medical stop-loss, adding to the list of use cases.

Captives are a great tool for insureds to create unique, custom-made solution in partnership with the commercial markets. They facilitate better management of claims – their expenses and adjustments – through accurate estimations.

Lastly, one of a captive’s most important attributes is its flexibility and ability to be swift and proactive, without the typical issues in a commercial insurance relationship.

Continued Pressure from the IRS on Bad Fact Patterns – How to Avoid Trouble

The Courts recently made a decision regarding the Reserve case for the IRS. This is the second case of late that has been decided against a captive owner in an effort to crack down on captives the IRS perceives to have a poor fact pattern, and therefore cannot meet insurance tax treatment standards. For example, captives that have been set up to undertake sham transactions or undertaking transactions that do not meet the bona fide insurance company characteristics would fall into this category.

According to the Avarhami v. Commissioner (“Avrahami”) judgement, the court provided four criteria that result in an arrangement constituting insurance.  These four criteria were also addressed in the Reserve Mechanical Corp (“Reserve”) v. Commissioner case, and are as follows:

  • The arrangement must involve insurable risk
  • The arrangement must shift the risk of loss to the insurer
  • The insurer must distribute the risk among its policy holdersIRS captives
  • The arrangement is insurance in the commonly accepted sense

Reserve outlined these four non-exclusive criteria to establish a framework for determining the existence of insurance for federal income tax purposes.  The court’s opinion focused on the idea of risk distribution, which led to investigating PoolRe Insurance Corp. (“PoolRe”), the stop loss insurer for Reserve. The judgement discusses the transaction in detail and stated there was a circularity of funds that invalidated the pooling arrangement.

To determine if a captive insurer has met the risk distribution criteria as a standalone captive without stop-loss or reinsurance protection, the courts looked at the total number of insureds and the total number of independent risk exposures. It has long been believed that the “law of large numbers” allows an insurer to minimize its total risk and reduce the likelihood of a single claim exceeding the premium received. In the Avrahami and Rent-A-Center court cases, risk distribution passing and failing thresholds have been observed as follows:

  • Rent-A-Center ultimately showed distribution of its risk by insuring the risk for 14,000 employees (workers’ compensation), 7,100 vehicles (auto coverage), and 2,600 stores (general liability coverage) in 50 states
  • Avrahami didn’t show distribution of risk by insuring 3 jewelry stores, 2 key employees, and 35 total employees. Further, one of the stores had 5 low frequency coverages and the other 2 stores had 2 low frequency coverages

Reserve, an Anguilla-domiciled captive, wrote 11 to 13 policies over the three tax years in question and had direct policies for 3 insureds.  Peak Mechanical & Components, Inc. (“Peak”), an S Corp for Federal income tax purposes, was owned in equal 50% shares by two individuals and was the primary insured under all policies. The policies were also issued to two other subsidiaries, although the operations were not significant. Peak operated two facilities and had a max of 17 employees. Reserve did not meet risk distribution based on this exposure profile alone; its exposures were similar in scale to the Avrahami’s.  Reserve contended that it still met the risk distribution safe harbor requirements, by having 30% of its gross premium for each of the tax years for unrelated parties via the reinsurance agreement with PoolRe.  A similar argument was made in the Avrahami case with their reinsurance pool.

Before it is determined whether Reserve distributed risk through the agreement with PoolRe, they evaluated whether PoolRe was a bona fide insurance company. In the eyes of the court, a captive should be able to answer “yes” to each of these questions and provide adequate support to:

  1. Is there no circularity to the flow of funds?
  2. Are the policies developed in an arm’s length approach?
  3. Did the captive charge actuarially-determined premiums?
  4. Does the captive face actual exposures and insurance versus business risk?
  5. Is the captive subject to regulatory control, and did it meet minimum statutory requirements?
  6. Was the captive created for non-tax business reason?
  7. Was a comparable coverage in the market place more expensive, or even available?
  8. Was it adequately capitalized?
  9. Were claims paid from a separately maintained account?

The court’s conclusion in Reserve’s case provided details of the concerns with evidence in support of the first six questions listed above, and concluded that the PoolRe quota share arrangement provided the appearance of risk distribution without actual risk distribution.  The court summary also highlighted the following:

  • Circularity of funds was exhibited with PoolRe receiving and distributing the same amount of money to Reserve
  • There was no evidence that the premium payments to PoolRe by Reserve and the other participants were determined by actuaries
  • Contracts were not determined in a like manner, nor using objective criteria

One of the major concerns the IRS addresses with the Avrahami and Reserve cases is that a one-size-fits-all rate for all participants in the pool/reinsurance agreement isn’t valid.  The court also addressed an alternative ground for the case, which would have been to evaluate “Insurance in the Commonly Accepted Sense”. To determine if an insurance arrangement exists, the following factors come into play:

  • Was the insurance company organized, operated and regulated as an insurance company?
  • Was it was adequately capitalized?
  • Were the policies valid and binding?Captive Checklist
  • Were the premiums reasonable and a result of an arm’s-length transaction?

The court summary pointed out several issues in Reserve’s support for answering the above questions, such as:

  • Reserve had no employees of its own performing services and the board members did not know how claims were made or handled.
  • There’s no evidence that activities were performed in its domicile.
  • Claims must have supporting documentation, yet there was no addendum for the program until after the policy date. An employee from the insured signed the checks as opposed to the insurer.
  • Binding and valid policies – policies must, at a minimum, identify the insured.
  • There were peak paid commercial market premiums of $95,828 in 2007 versus $412,089 to Reserve in 2008. This is a 330% increase in insurance premiums. In addition, Peaks premiums vary from year to year with no explanation.
    • Note, the Avrahamis similarly had significant increases in premium spend, with almost an 800% increase over a several year period.

These cases provide us and other captive professionals with guidance and clarity. As the industry grows, cases like these will form the cornerstones of how to properly operate and conduct business as a captive insurance company.

Key Takeaways

The IRS clearly has problems with some of the pooling structures used to qualify captives as meeting the risk distribution safe harbor tests. They are concerned that the premiums ceded to the pool and the transfer of risk into the insurance pool are not commensurate with one another, and that the pools are only being utilized to circle premiums to the captive participants, with each assuming no or minimal losses from the pool.

There should be clear documentation of premium determination by an actuary, illustrating why premiums are reasonable and that sufficient risk transfer exists.  Over time, if the total loss experience and premium ceded to the pool doesn’t produce a long-term average loss ratio consistent with the commercial marker, then the pool’s support in having arm’s-length contracts with each of the participants becomes weak and difficult to defend.  Long term average commercial market loss and loss adjustment expense (“LAE”) ratios for most lines of business generally fall in the range of 50% to 75%, hence the 70% loss and LAE ratio threshold in IRS Notice 2016-66 used to identify captive transactions of interest.

Finally, it is important to show sufficient support in a captive’s business plan, policies, and feasibility studies to address the questions above about an insurer/pool being a bona fide insurance company.