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CAPTIVE INSURANCE • The captive does not loan funds to its owner or to any policyholder. • Capitalization is adequate. • A valid non-tax purpose motivates the formation of captive. • The captive's business operations and assets are kept separate from the business operations and assets of its owner(s). Conformity with Commonly Accepted Notions of Insurance • Premiums are priced at arm's length and are established according to customary insurance-industry rating formulas. • The conduct of interaction between the captive and policyholders is consistent with the standards applicable to an insurance arrangement between unrelated parties. • The captive properly investigates and establishes the validity of claims before paying them. • The captive either performs all necessary administrative tasks using its own personnel or it outsources those tasks at prevailing commercial market rates. • The policyholders truly face insurable hazards. • The transaction is of a type that involves insurance in the commonly accepted sense. • The captive holds all required licenses to conduct insurance business in the jurisdictions in which it operates. Risk Distribution Characteristics or Pooled Risk • In a brother-sister insurance arrangement, i.e., one that involves related entities under the same corporate parent, there must be at least 12 affiliated corporate policyholders that pool their risk. In an association captive arrangement, there must be at least seven policyholders. (For mines, separate policyholders traditionally own different properties. A group of owners would pool corporate risks, however, such as associated with closure and reclamation of mills, tailings facilities or certain existing environmental conditions associated with groundwater or waste rock piles, etc.) • No single policyholder's risk accounts for more than 15% of the captive's aggregate maximum exposure to loss. In other words, there is a true pooling of risk. • The volume of potential loss events is significant. Presumably, "significant" volume means volume that is significant from a statistical standpoint; i.e., the statistics are sufficient to enable an actuary to assign probabilities to the 42 E&MJ; • FEBRUARY 2013 insurance company's potential under writing losses. • Potential loss events are independent. • Pooled risk is essentially homogeneous in character. • A net underwriting loss generated by one policyholder is borne in substantial part by premiums paid by other policyholders. • There is a real possibility that a policyholder will sustain a covered loss in excess of the premium it pays. (Mine operations can vary considerably and catastrophic events do not always lend themselves to actuarial certainty, nonetheless there are plenty of operational, health and environmental risks associated with mining. By more effectively managing risks that may not have previously been addressed, it may be possible to safeguard life and property better while saving on taxes.) • Premiums are not experience-rated. That is, a policyholder is not obligated to pay additional premiums if its actual losses exceed its premium during any period of coverage, nor will a policyholder be entitled to a refund if its premium exceeds its actual losses during any period of coverage. The 20 conditions in Rev. Ruls. 200289, –90 and –91 constitute the comprehensive approach utilized by the IRS to evaluate captive insurance arrangements. Essential Element of Risk Transfer It is worth elucidating the specific test implied in the risk transfer analysis. Per Rev. Rul. 2002-89, a policyholder may not, in significant part, pay for its own risks. This notion holds that "true insurance…must rid the insured of any economic stake in whether the loss occurs."2 In FSA 200202002, the IRS traced this notion back to testimony in the Humana case:3 …the essential element of an insurance transaction from the point of view of the insured (e.g., Humana and its hospital network) is that no matter what insured perils occur, the financial consequences are known in advance. Expressed another way, once an insured pays a premium, 1 2 3 4 See Kidde Industries v. U.S., 81 A.F.T.R. 2d 98-326 (40 Fed. Cl. 42) (1997). Clougherty Packing v. Commissioner, 811 F.2d 1297 (9th Cir. 1987). Humana Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989). For example, see IRS Rev. Ruling 2005-40. in the true insurance situation, the insured is neutral as to whether the loss event occurs. The foregoing statement is the essence of whether risk transfer is deemed to exist. It is fundamental that for a captive to be treated as an insurance company under the federal tax code both risk transfer and risk distribution must exist. It is also important, however, to note that while risk transfer is and has been the subject of much IRS scrutiny, at the present time, the IRS seems more concerned with actual risk distribution at the captive operational level.4 Conclusion The foregoing is a general summary of captive insurance concepts, including an overview relating to domicile choice and tax planning. The regulatory rules of a particular jurisdiction in terms of taxes, environmental operations and financial insurance requirements, as well as the thinking of the IRS regarding captives, continually evolve. Forthcoming promulgation of financial assurance requirements for mines under CERCLA § 108(b) is one example of this potential evolution. Accordingly, prior to the implementation of a captive program, as noted above, contact with any specific proposed domicile must be part of any analysis of its suitability. In addition, a captive program must be sensitive to the possibility of changing IRS and other regulatory (EPA, MSHA, OSHA, etc.) trends. The starting point is preparation of a detailed feasibility study and business plan which is consistent with the mine-operation plan, and specifically tailors the captive arrangement accordingly in order to ensure that a captive proposal addresses the above issues and makes fundamental business sense. The authors are shareholders at Anderson Kill & Olick, P.C. Nevius is chair of the firm's environmental law group and England is chair of the firm's captive insurance group. Anderson Kill routinely represents mining operations with respect to various environmental risk-management matters, including financial assurance and the establishment of captive insurance companies. The authors emphasize that this article is for informational purposes only and is not a substitute for specific legal advice. Please contact the authors before taking steps to implement a captive insurance program. www.e-mj.com