On January 4th, the U.S. Tax Court published an opinion denying a taxpayer’s deductions for premiums paid in connection with its affiliated captive insurance company. In Keating v. Commissioner, petitioners Terence Keating, Cheryl Doss, and Arthur Candland owned an S Corporation, Risk Management Solutions (“RMS”), and deducted $1.2MM in annual insurance expenses from 2012-2014. These funds were paid to a captive insurer, Risk Retention, Ltd., incorporated and licensed in Anguilla in 2008 (“Risk Retention”). The tax years at issue were 2012-2014.
For U.S. federal income tax purposes, Risk Retention made an election pursuant to IRC § 953(d) for treatment as a domestic corporation—an election only available to foreign entities meeting certain statutory requirements and whose operations constitute “insurance” as understood by the applicable U.S. federal income tax law. Risk Retention also made an election under IRC § 831(b) where underwriting profit is excluded from taxable income and tax is only paid on an insurer’s net investment income—among other requirements, this election is generally limited to insurers whose net written premiums do not exceed an inflation-adjusted amount of $2.2 million (during the years at issue, the written premium limitation was $1.2 MM—at the time of this writing, the written premium limitation is $2.8 MM ).
In summary, the Court determined that the transaction did not involve common notions of insurance for the following reasons:
1. Risk Retention was not operated like an insurance company
The Court found that Risk Retention’s operational functions were conducted in a manner “in which only unthinking insurance companies would operate.” In particular, the Court took issue with the general retrospective approach to issuing, renewing, and modifying Risk Retention’s coverages for RMS. For example, RMS’ workers’ compensation deductible coverage for 2012 was not modified until January 28, 2013 with an effective date of January 1, 2013.
The Tax Court’s opinion also focused on how premiums were priced and how RMS paid premiums. The Court expressed deep concern that RMS and its advisors unduly influenced the premium pricing to qualify Risk Retention for its IRC § 831(b) election and maximize RMS’s deduction for premiums paid to Risk Retention.
The Petitioners “treated Risk Retention as if it were a tax-free savings account,” did not conduct operations at arm’s length, and created a circular flow of funds. Risk Retention made undocumented and unsecured loans to fund life insurance policies of its owners and did not treat excess loan repayments as interest but as “extra” money that is “circled back out pretty quickly” for additional life insurance premium payments.
The utilization of a quota share reinsurance pool also supported the Service’s circular flow of funds argument because the reinsurance pool generally paid premium payments to Risk Retention almost immediately.
2. Risk Retention’s policies were not valid and binding
The Court found that the late delivery of claims-made policies cast doubt on their validity and binding effect. It was unclear whether the risk pool or Risk Retention was obligated to pay claims made between the coverage period inception and the policy issuance date. While the Court noted that the policies were not issued after the coverage period, it still found substantial doubt as to the policy’s validity and binding effect where Risk Retention’s policies were issued midway during the coverage period.
The Court also found that the policy language was unclear as to whether it was a claims-made policy or an occurrence policy which added to the Court’s concern that the policies were designed to be restrictive policies to quickly return premium payments to reinsurance pool participants.
Lastly, the claims adjudication process involved payment of claims not supported by any coverage and paid claims via board resolutions.
3. Risk Retention’s premiums were not reasonable
Because there was lack of commercial need for the Risk Retention coverage and the fact that the coverage was not actuarially supportable, the Court found the premiums were unreasonable.
The premium reasonability analysis began with RMS’s coverage needs and its procurement of coverage from the commercial marketplace. RMS did not replace any commercial coverage with Risk Retention’s coverage and did not have contractual obligations with its clients for the coverage it procured from Risk Retention. Because RMS agreed to certain insurance requirements with its clients, and passed on those insurance costs to its clients, the court took issue that Risk Retention’s coverage was not disclosed to RMS’ customers.
Finally, the Court noted the average rate-on-line for RMS’ captive coverage was ten times greater than comparable commercial coverage. The Court also noted in the record that RMS lacked historical loss history to support such a discrepancy. Instead, it seemed that Risk Retention’s policies were almost entirely underwritten without actuarial support and without any information relating to RMS and its historical loss history throughout the program.
4. Risk Retention’s Claim Adjudication Practices Were Abnormal
While Risk Retention and its reinsurance pool paid claims, how the claims were paid was in contravention of standard insurance practice. Specifically, board resolutions were used to pay claims that should have been denied under the terms of the policy. Risk Retention’s captive manager would also receive requests for claims approval after the claim was already paid.
Adding to the Court’s concerns around the circular flow of funds, the Court took issue with the low loss ratio of the program. In its analysis, the opinion looked to the general industry to note the low loss ratio “resulted in nearly a full round trip of premiums.”
Most concerning to the Court was the fact that policies were added or altered to retroactively provide claims coverage. Additionally, the prior-knowledge coverage limitation that prevents coverage for loss events known prior to policy issuance was not enforced in a consistent manner.
The Keating decision is the fifth successful case the Service has had in Tax Court with a micro-captive program that is inundated with very bad facts and represents an “easy win” for the Service and not necessarily an upset in their campaign against micro-captives. Generally speaking, no new ground was broken in the Keating decision.
As with any business operation, but especially in the context of a micro-captive arrangement, captive owner’s should ensure all transactions are properly documented and at arms-length. While some reasonable administrative efficiencies can, and do, likely exist in the context of an affiliated insurer, a captive program should otherwise conduct its operations like any other traditional unaffiliated insurance company.
It is likely the case that some of the analysis in the Keating decision would need further refinement if applied to an arrangement with fewer aggressively abusive facts. For example, a captive insurer may likely not have issues associated with loss ratios outperforming the traditional insurance market, if premiums are actuarially supported by data unique to the affiliated insured and claims adjudication comports with standard industry practice. Additionally, the importance of commercially available comparable policies and the existence of prior coverage is likely diluted where the arrangement otherwise satisfies other common notions of insurance.
If you or your business are considering a captive insurance program or if you would like to discuss the Keating decision’s impact on your current program, please reach out to your MarksNelson advisor or contact Eli Colmenero at firstname.lastname@example.org
 Terence J. Keating et al. v. Commissioner T.C. Memo 2024-2.