David Kirkup and Mark Sims, of Captive Alternatives, outlay some of the key considerations when establishing a micro captive

Captive Review (CR): Why do risk pools require a closer look in the aftermath of the recent Avrahami and Reserve Mechanical tax court decisions?

David Kirkup (DK): Both cases hinge on a ‘bad’ pool with limited or no real risk and the appearance of circular funds. The cases do highlight what the courts consider to be bad facts on risk distribution.

Mark Sims (MS): Risk distribution is key in demonstrating that a captive is operating like a real insurance company. This is something the IRS is looking closely at in an attempt to invalidate whole portfolios of captives. Revenue Ruling 2002-89 states that a captive that receives 50% of its premiums from unrelated entities will achieve adequate risk distribution.

CR: In light of those decisions, what are considered ‘best practices’ for risk pools?

MS: Pool arrangement should be bench-marked against an industry standard Quota Share Reinsurance arrangement with genuine risk of loss, i.e. no backdoor
guarantees against loss; there should be significant third-party risk; insurance policies should be at least based on industry standards; premium pricing should be actuarially determined and arm’s-length to the client; there should be a history of legitimate claims; the pool should be adequately capitalised and adequate funds should be withheld until the end of the claims year; finally, exposure should be
from the first dollar – matching the original policy.

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