In This Issue

• Captive Insurance: Benefits & Responsibilities
• Captives for Workers’ Compensation
• Litigation Expense Policies and Risk Retention Groups
• Stupid Captive Tricks
• Recent Case Update
• Report from Quatloosia

In this edition of Developments, we transition to our new publishing schedule, whereby new editions will come out only every other month.

This issue discusses perhaps the best asset protection and risk management tool available to businesses, which is that of captive in-surance. We examine the just-released Revenue Ruling 2005-40 which deals with insurance arrangements. Bill Campbell returns as a guest author to contribute a piece on workers’ compensation captives. Most people are not familiar with litigation expense policies, and so we give an overview of this type of policy, along with Risk Retention Groups. We also examine several new cases on fraudulent transfers, as well as one of the first cases to interpret the new Bankruptcy Act – and perhaps which raises more questions about the effect of that Act on state homestead exemption than it answers.

The Report from Quatloosia examines the phenomena of life settlements, and the potential benefits and pitfalls of such arrangements. Enjoy!

Editor

CAPTIVE INSURANCE:
Benefits and Responsibilities

by Jay Adkisson and Chris Riser

Asset protection is fundamentally about risk management. Insurance is the most basic risk management tool. Its purpose is to transfer certain risks at a fixed cost. When commercial insurance costs outweigh the benefits of transferring certain risks to a third party, self-insurance is an option. When commercial insurance for certain risks is simply unavailable, self-insurance is a necessity. If the costs of commercial insurance outweigh the benefits because the potential insured's loss history and risk profile is better than others in the pool of insureds, there is pricing inefficiency which benefits the insurance company, and usually not the insured. However, where the insurance company is owned by the insured or the owners of the insured (i.e., it is a "captive" insurance company), the insured and the insured's owners can benefit from the insureds favorable loss history. Why not retain those potentially large underwriting profits?

Captive insurance companies often are established as a sister company to its insureds, usually as a subsidiary of the parent holding company that owns the insureds. While contract and insurance law determines the insurance relationship between the parties, tax law determines the insurance relationship between the insureds and the IRS and the captive and the IRS. For the captive insurance arrangement to be respected as insurance for tax purposes, the insurance arrangements must be bona fide, must shift and distribute risks adequately, and the parent, the captive and the insureds must be separate entities for legal and tax purposes. Treatment as insurance for tax purposes can be important so that premiums may be deductible by the insureds and so that the captive will be treated as an insurance company for tax purposes.

A captive insurance company allows a business to take on favorable layers of insurance risk, and to administer their own claims when they desire. They are such efficient risk management (i.e., insurance cost management) tools that many major U.S. corporations have their own captive insurance companies.

This article will examine captive insurance companies, their advantages, and their limitations as risk management tools. A future article will address tax issues related to captive insurance companies.

You Already Insure Yourself - Whether You Realize It Or Not.

If a liability claim arises for which you and not a third party insurance company will pay your litigation expenses - and damages if you lose - you're self-insuring. In other words, if you're "naked" with respect to a particular risk, you're self-insuring for that risk whether you realize it or not.

Self-insurance is often deliberate. If a particular type of insurance coverage is so expensive that it is economically unreasonable to purchase the coverage, the person or business exposed to that risk will take on the risk rather than pay an insurance company to assume it.

Often, however, people and businesses are exposed to risks which they unwittingly assume. For example, if you breezed past (or didn't read at all) the section of your business's general liability policy that excludes coverage for sexual harassment claims, you may not realize that your business bears the risk of sexual harassment claims against you and its other employees. You're self-insuring for sexual harassment claims whether you know it or not. If a claim arises, the funds to defend - and potentially pay - the claim come out of your business's coffers. If you know you've assumed that risk and others, because you've decided that commercial insurance coverage is too expensive, perhaps you set aside a reserve of funds to cover these risks. Essentially, you're setting aside an insurance fund for yourself. Unfortunately, those funds are exposed to creditors and reserves set aside for such risks cannot be deducted from your business's taxable income for tax purposes.

A captive insurance company helps you to formalize and tailor your risk management program, and may allow you to reserve for these self-insured risks in a tax-advantaged way.

Claims Resolution

The captive insurance arrangement allows you to resolve your own claims. This gives you the ability to settle claims early if you desire, or to refuse to settle if you think that is in your better long-term interests. It also gives you the ability to select your own attorneys - attorneys who will look out for your best interests as opposed to those of a commercial insurance company. This means that you will have substantial control over the litigation process, letting you dictate the course of the litigation rather than standing by feeling helpless.

Draft Your Own Policies

A considerable advantage of using a captive is that it allows the business owner to custom-tailor the insurance to fit the business's needs, and to include or exclude certain risks as desired. For example, a property insurance policy might be drafted to cover losses due to terrorism or governmental action (such as changes in environmental laws).

Some smaller captives might issue policies that don't cover liability for damages to a third-party claimant, but rather provide coverage for litigation expenses (attorney fees, expert witness expenses, discovery expenses, etc.). This may make particularly good sense for a business exposed to the risk of frivolous litigation, where the likelihood of a plaintiff prevailing is low, but defense costs are high. With a litigation expense policy, the business can create a "war chest" to fund future defense litigation.

The effect of these policies is psychological as well as practical. A litigation expense policy effectively tells a plaintiff's attorney, "Our insurance policy will pay to fully litigate the claim, but won't provide anything for you to collect." Facing a fully-funded legal battle without the easy pickings of insurance funds is attractive to few plaintiffs and, more importantly perhaps, few plaintiffs' attorneys.

Reducing Overall Cost of Insurance

Another potentially useful function of a captive is to cover large commercial insurance deductibles. In that case, the business is retaining the risk - in the captive - of small claims and the first layer of larger claims, while shifting the "worst-case scenario" risk to a commercial insurer. Significantly increasing a deductible in a commercial policy will lower the cost of the commercial policy, so that a business with good risk management practices and few claims can capture the cost benefits by paying premiums for that first layer of risk to the captive, and retaining underwriting profits in the captive.

That leads to another benefit of captives. Captive insurance arrangements often are attractive because of pricing inefficiencies in the commercial insurance markets. If a business's loss histories have established that the anticipated cost of claims will be less than annual premiums in the long run, then moving to a captive insurance arrangement often makes sense. Likewise, where a business is unfavorably underwritten because it is grouped into a category of business with a bad loss history, the cost of a captive insurance program may beat the cost of a commercial insurance program. For a look at this phenomenon in the workers compensation insurance area, see the article by Bill Campbell in this issue of Developments.

A captive can also function as a reinsurance company - that is, as an insurance company for insurance companies. This is common where the insurance in the captive program is of a type that requires that the direct insurer be admitted (licensed, essentially) to issue insurance policies in the insured's state by the state's insurance commissioner. In a so-called (and perfectly legal) "fronting" arrangement, an admitted carrier will issue the policy to the insured, and the insured's captive insurer will reinsure some (or all) of the risk of the "fronting" insurer. This allows the captive to assume most of the risk and to earn most of the premium, less a fronting fee charged by the fronting insurer.

Tool for Value Shifting

From an asset protection perspective, the primary benefit to a captive insurance company is that it gives a mechanism to transfer value out of the operating business in a legitimate and a tax-efficient manner. Wealth that would have been accumulated in the business, distributed to the owners is removed from the reach of creditors. For example, assume that an operating business is able to justify the payment of $500,000 per year in insurance premiums to its captive, which holds those premiums as actuarially calculated reserves to pay future claims, or as surplus once it is no longer needed as reserves. Over ten years, that $5 million has been quietly moved out of the operating company. Of course, those funds don't sit in a safe as a pile of cash. The funds are invested to earn income and gains. If the business makes no claims over that ten year period, the captive may have considerably more than $5 million in assets. Although there are some restrictions placed by insurance commissioners on the investment of some or all of a captive insurer's reserves, capital and surplus, investment rules for captives are more relaxed than those for commercial insurers. The captive may be able to invest in the owners' related businesses and in new business ventures. From an asset protection perspective, the captive may also be able to function as a secured lender to strip equity from other valuable property of the owners.

Assuming that the premiums are reasonable and justified from an actuarial perspective, it will be very difficult for a subsequent creditor to prove that the transfers were not "for value" transfers for purposes of the Uniform Fraudulent Transfer Act. Moreover, the issue is unlikely to arise at all, because insurance premium payments made in the ordinary course of business are rarely a red flag to attract the attention of a court or a creditor.

Of course, the captive itself must be protected from the creditors of the captive's owners. At the very least, the captive should be owned through a limited partnership or limited liability company so as to give charging order protection to the stock in the captive.

Jurisdictions of Formation

Where to form a captive? Captive insurance companies often are formed offshore, in so called "debtor-haven" and "tax-haven" jurisdictions. No local taxes and lax regulation made life relatively easy for many captives before some of the offshore jurisdictions began to tighten up captive regulation.

Over the last few decades, U.S. states have slowly (and more rapidly in the last several years) enacted captive insurance company legislation, with Vermont leading the way in size of its captive insurance industry. Nearly half of the states have captive legislation, and several U.S. jurisdictions, including Vermont, Hawaii, South Carolina, Arizona, Montana, Utah, and the District of Columbia are aggressively pursuing and attracting new captive business.

As the captive market has matured and as offshore captive jurisdictions have increased captive regulatory oversight, offshore captive regulation in the larger offshore jurisdictions has become comparable to U.S. captive regulation. So, from a regulatory perspective, there may be little difference between using an offshore captive or a domestic captive. Rather, the choice of jurisdiction will depend on other factors, such as whether the captive primarily will be insuring risks within or outside the U.S., and other concerns.

Many who are newly considering a captive insurance program want to start with the question, "Where should we form the captive?" Though relatively important, the choice of captive jurisdiction is not nearly as important as a number of other factors in considering and designing a captive insurance program.

Forming and Managing a Captive

The term "captive formation" (often used by offshore service providers, in particular) is a very misleading in that it implies that forming the company is the beginning and end of the captive process. In fact, the process of putting together a captive insurance program involves considerably more than forming a corporation and filling out an insurance license application. The very first step is to investigate the economic feasibility of a captive program. The initial steps can be relatively informal, but if the initial inquiry leads to the preliminary conclusion that a captive makes economic sense, a formal feasibility study involving an actuarial firm should be undertaken. The study will examine the types of risks to be underwritten, the layers and levels of risk to be assumed by the captive, the layers and levels of risk to be shifted to reinsurers, the premiums and reserves that will be required, and an analysis of one or more potential captive jurisdictions. If the formal feasibility study validates the captive concept, a detailed application, including the feasibility study and a business plan, is submitted to the insurance commission in the jurisdiction where the captive is proposed to be formed. If the application is approved, the company is formed. After the company is formed and the required minimum reserves have been deposited in the company's bank account, the insurance commissioner issues the insurance license and the company can begin business.

Treatment of insurance contracts as insurance for tax purposes and treatment of a company as an insurance company for tax purposes has little to do with the company's insurance license. First, the insurance company must be operated as an insurance company. It truly must be in the business of insurance and must earn the majority of its revenue from insurance business. As a licensed insurance company and as a company legitimately in the business of insurance, the captive must employ or contract with auditors, attorneys, accountants, actuaries, insurance managers, claims managers and other supporting service providers. These services don't come cheap. However, in order that a captive has made it through the formation and licensing process, it already has been determined that it is economically feasible to bear these costs and still make a profit.

Implementing a small captive insurance program usually involves first-year costs of about $100,000, including the legal and other professional work necessary to fit the captive into the owners' existing business and estate planning structures. Ongoing annual costs for management and professional fees usually are about $50,000. Obviously, these cost levels mean that captives don't make economic sense for many smaller businesses. This is one of the reasons that initial feasibility studies are particularly important.

A captive insurance program is one of the best risk management and asset protection tools available for many businesses and business owners, but it does not come without significant responsibilities and costs.

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CAPTIVES FOR WORKERS' COMPENSATION

by Bill Campbell

In today's volatile workers' compensation insurance market, many companies find themselves in untenable situations. Increasing premiums and claims abuse can drive costs to levels unheard of just a few years ago.

The good news is that many legislatures passed laws for relief. But, while the playing field may be leveling, insurance companies are typically slow to react.

Insurance companies by nature only have rearview mirrors, as they must look back to look forward. Actuarial data must be collected for an extended period of time in order for carriers to make predictions on the losses they can expect.

Even though insurers are in the business of covering risks, they are very averse to taking any risk at all. As a result, we have yet to see much downward movement in workers' compensation premiums. Even when we have seen reductions, there have been increases in other areas, such as classification rates, that result in no improvement at all.

With this environment of increasing premiums and costs, many firms are turning to the alternative funding arena for workers' compensation. Large deductible plans have become increasingly popular. These plans allow a company to elect to pay all claims up to an agreed amount. At the per claim cap, the insurance carrier takes over. Large deductible plans usually have an aggregate stop point to save a firm from catastrophic losses. For many firms, the use of a captive insurance company to pay the claims can be the tax break cherry on top of these plans.

This discussion, while specific to California, will apply to most programs across the US. Please check for any variations your state may have on the information presented here.

Components of a workers' compensation plan

There are several components to every workers' compensation policy that must be in place no matter what type of plan a firm elects to employ:

• Security- All workers' compensation policies must be fronted by an admitted carrier. This satisfies the Director of Industrial Relations as to the validity of the program. The admitted carrier in essence just lends its name to the program.

• Claims Administration- Usually supplied by the carrier or a third party administrator. Each will charge a per claim fee for the service. This provides labor code compliant claims management.

• Aggregate Stop Loss Re-Insurance- Low cost policies obtained from a large re-insurance company to limit the annual cost of the program. The attachment point for these policies is usually at $1,000,000 for all claims in a year.

• Specific Stop Loss- Used to provide capitation for large single claims. These policies usually attach at $250,000 on a per claim basis.

• Loss Fund- There must be a fund in place to pay all current and future claims. The fronting company will only accept a properly secured and maintained fund. A captive is often used here.

Captives

A "Captive" is a closely held insurance company whose insurance business is primarily supplied by and controlled by its owners, and in which the original insureds are the principal beneficiaries. In a captive, the shareholders-insureds actively participate in decisions influencing underwriting, operations and investments.

There are two types of captives generally used for workers' compensation. A company that wants to retain complete control over the operation, investment activity, and claims payments of the owned captive should seriously consider the single owner or pure captive.

The pure captive will cost more to set up and, depending on the level of involvement the firm elects, involves more hands on time for administrators. A company can operate its own insurance division to maintain complete control over the captive, but a TPA must be employed for claims management.

The other and by far more popular type used in the workers' compensation arena is the captive owned by an organization that is not one of the policy holders, commonly referred to as the rent-a-captive. These captives can be run by a broker, a re-insurer, or, more commonly, by a fronting insurance carrier.

The fees for this type of captive are usually much lower than the initial capital required to start a single owner captive. However, they do not offer nearly the same amount of flexibility. Investment opportunities are limited, and the managing company controls stock options and dividend payments.

Factors Prompting the Formation of a Captive

The major driving force in pushing companies to the captive market has been the high cost of premiums. Several other factors are also contributing to the movement.

There has been an overall lack of broad coverage availability as carriers leave the market, resulting in a loss of competition and a reduction of capacity, and thereby driving premiums up.

With the implementation of new rules, this flight is beginning to reverse itself. But, many firms have begun to realize that insurance is a very poor investment of company funds, and retaining at least some of the risk is a sound business practice.

There has also been a general lack of flexibility on the carrier's part. They are often unable to satisfy specialized needs for services and coverage. These needs encompass requirements, such as higher retention levels, more closely targeted loss control services, and greater control of claim settlements.

Company Profile for Workers' Compensation Captives

In order to seriously consider the formation of a captive, a company must be financially sound and ready for the commitment involved. Firms that succeed in the captive world will be forward thinking with a serious focus on loss control, safety, and risk management.

They will be willing to share the risks involved in compensation and have the organizational ability to deal with uncertainty. Their top managers will be committed to a long-term solution that will build a financial base to allow for a greater level of risk acceptance in the future.

The company's losses must be fairly predictable, and the total expected losses cannot be more than the anticipated premium. Last, but far from least, in order for the captive to work as a vehicle for tax savings, the firm must have a workers' compensation premium in excess of $1,000,000 and have a need for moving assets off the company's books.

Tax Advantages of Captives

A Captive is formed to allow a firm to place aside the funds needed to pay present and future claims. Why go to all the trouble and expense? Why not just open a bank account?

Placing funds aside or obtaining an LOC for current and future claims payments works well for a firm with low earnings, but leaving assets on the books can be detrimental to other companies.

Formation of a captive will basically allow a company to pay premiums to itself. The IRS allows these premiums to be deducted as expenses. And, while the captive must file a tax return and recognize income, the IRS allows insurance companies to deduct for reserves placed aside for claims. The IRS also allows for reserves to be placed aside for claims that are "incurred but not reported". These are reserves placed aside for claims per industry standard that will probably happen, but you do not know about yet. IBNR reserves are also deducted.

The captive will accrue interest, and, with careful planning, investment income. But, accounting principles for insurance companies allow for deducting claims reserves. Therefore, unlike the bank account, reserves set aside for future claims payments are deducted immediately. Alternatively, if a firm sets aside cash to pay claims, it must pay tax on those funds before paying the claim.

These deductions, along with other normal expenses, will drive up the amount of cash a firm can place in the captive. For a large firm, the amount of capital set aside can be substantial. This is the reason many Fortune 500 firms have entered the captive market and taken on their own risk.

Benefits of a Captive

The primary benefit of a captive is tax control and is not just the fact that a company can set aside capital. A firm with a captive insurance company has taken positive steps in setting aside funds for inevitable expenses in a tax-reduced environment.

There is also a greater incentive for management to implement effective loss control and return to work programs. Coordination with claims administrators to reduce or eliminate loses becomes paramount. In this way, senior management will develop a greater understanding of insurance, risk management, and the risk financing process.

A captive operates more efficiently for the parent than conventional insurance and can apply a higher percentage of the premium dollar to claims. This, along with accrued investment income, will result in a reduction of the overall cost of insurance.

As an insurance company, the captive has direct access to the wholesale insurance market. This will not only lower costs, but it will allow for additional negotiating leverage in dealing with underwriters.

There are fewer regulatory restrictions for captives than there are for normal insurers. This is due to the simple fact that captives are generally not dealing with the public, and Departments of Insurance in the captive domiciles feel that a captive will try very hard to "do no harm" to the parent company.

When a captive formulates coverage for the parent company, it is generally very favorable. There are some limits, of course. A firm participating in a rent-a-captive has limited control over the insurance form, whereas the owner of a pure captive can cover almost any risk.

Disadvantages of a Captive

When the captive is funded, the company must allocate funds into an area of operation that is not part of the mainstream activities. It is entirely possible that these funds will be needed to cover underwriting losses, albeit on a controlled basis.

When a company decides to use a captive, there must be a firm commitment to a long-term goal of lowering costs and absorbing new administration costs. The captive is in no way a short-term price fix. Without a senior management commitment, the firm may face unintended tax consequences as well as unforeseen legal exposure.

In Conclusion

While captives are not right for every company, the tax advantages can be substantial. Captive programs can be funded as needed throughout the year. These funds are considered premium payments by the IRS and are therefore tax exempt, saving the company 38% to 40% up front.

A reputable Risk Management firm, in conjunction with a good CPA, should perform a thorough evaluation of your company's insurance needs and financial situation. Orion Risk Management has the experience and knowledge to evaluate your position and advise you on available avenues of coverage that will suit your particular needs. We work closely with our clients to form the type of coverage best suited to their specific situation.

Bill Campbell works in conjunction with the risk management team of Orion Risk Management, Inc. Orion is a leader in alternative risk plans that allow their clients the opportunity to more closely control costs and coverage. http://orionrisk.com

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ALTERNATIVE INSURANCE
Litigation Expense Policies and Risk Retention Groups

by Jay Adkisson and Chris Riser

The relationship between asset protection and insurance is rarely discussed and is generally poorly understood. Some asset protection planners advise their clients to get rid of their insurance coverage altogether. The rationale is that the existence of an insurance policy creates a target for plaintiffs' attorneys. The money saved by eliminating insurance coverage can be utilized, of course, to pay the planner's fees in setting up the expensive asset protection plan that will render insurance coverage unnecessary.

Of course, this is ridiculous - and dangerous to boot. A client has little or no financial stake in whether an insurance company pays a plaintiff's claim other than the possibility of future premium increases. It also does not recognize that plaintiffs' attorneys focus closely on reaching settlements with insurance companies and moving on to the next case, instead of wasting money, and more importantly, time that could be applied to getting their next big insurance settlement. Similarly, the asset protection client's main motivation should be to get rid of a lawsuit and get back to making money, and not to spend years dodging creditors.

Insurance then, is an incredibly useful and often relatively inexpensive asset protection tool.  It is specifically designed to transfer the risk of loss away from the client and to the insurance company. To the extent that it makes economic sense to cover a particular risk and insurance is available, insurance always should be the primary risk management method and asset protection should play only a secondary role.

Thus, a client should purchase as much insurance coverage as is economically practical.  The client's asset protection planning should be integrated with that coverage. The goal is to create a scenario where a plaintiff and his attorney are very likely to accept the limits of the client's insurance coverage in settlement of a claim, even if the plaintiff's potential recovery is greater than the insurance coverage limits.  When insurance coverage is available to meet a plaintiff's claim, the plaintiff's attention becomes focused on the insurer, because the insurance company has the proverbial deep pockets. Where an insurance company is on the hook for at least a portion of the liability to a creditor, every attempt should be made to transfer the onus of non-payment to the insurance company and away from the client.  At the very least, every business should have a general liability insurance policy, and every household should have umbrella coverage in addition to homeowner's and auto policies.

Litigation Expense Policies

A litigation expense policy is simply an insurance policy that pays for the costs of defending a lawsuit. If a defendant's only insurance is a litigation expense policy and the insured loses at trial, the litigation expense policy will not pay the plaintiff or indemnify the insured for its losses. It only covers litigation expenses.

In the mid-1990s, with the emergence of the modern captive markets, litigation expense policies resurfaced as a flexible and sophisticated asset protection tool. These instruments now play an important role in advanced asset protection planning.

The primary value of a litigation expense policy is that it pays the legal costs of defending certain claims without making a pot of money available to a plaintiff who is able to obtain a judgment. The issuing insurance company - but not the insured - retains the right to settle the claim within remaining policy limits, meaning that the longer the litigation lasts the less money will be available for settlement, all the way down to nothing. For plaintiffs' attorneys, this is a tremendous incentive to settle the case early and within the limits of the LEP policy.

But litigation expense policies can cover more than just litigation expenses. Litigation expense policies can be negotiated to cover a broad range of risks, including paying for the lost work time of the insured in responding to discovery requests and travel expenses to and from key depositions and trial.

Litigation expense policies may also be used to strengthen the effectiveness of existing insurance. One way in which they can do this is by providing counsel in addition to the attorney provided by the primary liability insurer in order to ensure that the insured's interests are well covered, and in order to provide additional assistance in the litigation.  Similarly, litigation expense policies also provide "bad faith" coverage to challenge the primary insurance company's failure to defend a claim or to cover a judgment. A comprehensive litigation expense policy will pay for the cost of hiring an attorney to write demand letters to the primary insurance company insisting that they aggressively defend the case, or settle, if that is in the client's best interests, and to pay claims to the fullest limits of the policy in the event of a judgment. The presence of a watchdog may keep the primary insurance company from abandoning interests of the client, or at least position the client to bring a bad faith case against the insurance company should it fail to honor the terms of its policy.

Another feature of litigation expense policies is the concept of the "dedicated reserve", which is a segregated reserve account set aside specifically for the particular policy for which the premium is paid (after the insurance company's deduction for its fees). The dedicated reserve ensures that regardless of what happens to the insurance company, funds will be available to meet claims.

Litigation expense policies can contain a number of other useful features, limited only by the imaginations of the parties negotiating the policy's terms.  Because litigation expense policies of the type described here are sold exclusively by small offshore insurance companies, their policy provisions can be quite flexible without the risk of interference from the local insurance commissioner.

Although a creditor may challenge the payment of premiums to an insurance company for a litigation expense policy as a fraudulent transfer, that challenge is unlikely to be effective. The transfer of the premium is "for value", i.e., the insured receives valuable policy benefits in exchange for the premiums paid. Also, if the insurance company is offshore it will be unlikely to refund the premium depending on the terms and services already provided, including, presumably, funding the fraudulent transfer litigation. Thus, litigation expense policies can be useful tools even for a debtor involved in a current lawsuit.

Like any other sophisticated products, litigation expense policies are subject to abuse. In particular, beware of refund policies which are pitched as an asset protection tool but are little more than a dubious tax shelter. Marketed primarily to physicians, these products promise that the insured can pay a premium to the insurance company, take a business deduction for it, and then at the end of the policy term recapture the premium inside a cash-value life insurance product, Roth IRA or some other tax advantaged investment vehicle, allegedly allowing the insured to deduct the substantial premium then to receive the funds back tax-free without recapturing the income tax deduction.  These schemes are clearly questionable and aggressive tax shelters.

Furthermore, the insurance policies usually do not stand up to scrutiny as insurance policies. For example, coverage limits may be identical to premiums paid, or the policy may require the payment of additional premiums if claims exceed the initial premiums paid.  Many such policies require the transfer of money offshore, which of course raises serious concerns about the potential loss of the money to embezzlement and tax or financial transactions reporting requirements that could compromise the supposed tax and asset protection benefits. The IRS is examining some of the more heavily-marketed arrangements and we would not be surprised to see them soon specifically designated as illegal tax shelters.

Litigation expense policies are really not designed to be tax products, although they have occasionally been used that way. The problem with using them as tax products is that litigation expense policies are meant to be last-ditch products that create powerful asset protection weapons in the event a determined creditor comes along. Litigation expense policies which are also designed to be tax shelters may compromise the insurance coverage, for if the IRS says that for tax purposes, the policy reserves really belong to the policyholder, the creditor might have an opening to convince a court that the policy reserves really belong to the policyholder for legal purposes as well.  A truism of asset protection applies here: that which attempts to accomplish everything often will accomplish nothing.

When considering a litigation expense policy, a U.S. attorney familiar with onshore and offshore property and casualty policies in general as well as with litigation expense policies should always be employed to negotiate the terms of the policy and to investigate the issuing insurance company and the totality of the arrangement.

LEPs are ideal policies to be issued by captive insurance companies.

Risk Retention Groups

A Risk Retention Group (RRG) is a member-owned business association that is formed specifically for the purpose of pooling and sharing similar business risks. RRGs must be licensed in at least one state or the District of Columbia, but once licensed are allowed under the federal Liability Risk Retention Act of 1986 (which specifically preempts contrary state laws) to underwrite the insurance risks of its members nationwide, including giving preferential rates, terms and conditions to groups seeking liability insurance coverage.

The members of an RRG must be engaged in the same or similar businesses, at least so far as the liability exposures are concerned. Interestingly, insurance companies are forbidden from being members of an RRG unless all the other members are insurance companies. RRGs are exempt from federal and state securities registration, but must make full disclosures of all their operations to their members.

RRGs are effectively exempt from state law except that the states can still collect premium and surplus taxes, force compliance with unfair claim settlement practices, and follow a few other requirements common to insurance companies. The states may not, however, dictate rates, coverages, forms, methods of operations or investment activities, loss control or claims, etc. RRGs can thus underwrite most types of general liability policies, such as Errors & Omissions and Products Liability insurance, etc., but  RRGs are not allowed to underwrite insurance relating to employees, such as workers' compensation, property insurance, and personal lines insurance such as auto insurance.

A key benefit to the use of RRGs is that, because each policyholder is also a member who participates in profits, each policyholder has substantial incentive to engage in proactive risk management to try to avoid claims, instead of just "let the insurance company take care of it." The members also can adopt better loss-control and more quickly identify other members whose risk-management is lax, and either assist them in upgrading their risk management or else invite them to take their insurance business elsewhere. Indeed, it is the fact that the members of an RRG know their business better than anybody else that often give the RRG an underwriting edge over insurance companies.

RRGs are commonly used in conjunction with its members' captive insurance companies. The idea is that the RRGs pool a certain layer of risk, and then each member's captive reinsures the RRG for the remaining layers. Captives are also used to reinsure the particular risks of the members who own the captives. This arrangement is often necessary since the member's captive insurance company for cost and asset protection reasons is probably domiciled outside the United States, and is not admitted to underwrite business in the states where the RRG is operating. When used in this fashion, the RRG effectively becomes, quite legally, the fronting company for the members' captives.

For example, assume that Members A, B, and C form a Risk Retention Group to offer products liability insurance coverage of up to $1 million for each of the members. Historically, the losses of each member have averaged about $50,000 per year. Members A, B, and C each also have captive insurance companies, and their captives reinsure the RRG for their own annual claims exceeding $100,000 per member. Thus, the members have pooled their risks for their first $100,000 losses each per member, and have accepted the risks of losses exceeding this amount. Members B and C now need not worry if Member A has losses of $1 million in a given year, since their exposure as to Member A's liability is capped at $100,000 by the reinsurance policy given by Member A's captive.

While the formation of a Risk Retention Group is a major undertaking, requiring licensing by at least one state, it is one of the strongest risk management tools available for like businesses. It can also be a very good investment for the original owners to form the RRG and manage it.

IRS ISSUES NEW REVENUE RULING 2005-40

Finally giving insurance practitioners some long-needed guidance on what constitutes "insurance", the IRS has released Revenue Ruling 2005-40 which discusses in some detail what does and does not constitute risk-sharing and risk-shifting for federal tax purposes.

In our next issue of Developments, Chris Riser will give a detailed overview of captive insurance company taxation. For the moment, however, we are attaching Rev.Ruling 2005-40 to the end of this Developments so that you can read for yourself what the Service has to say.

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STUPID CAPTIVE TRICKS

by Jay Adkisson

There are a lot of people who try to put together their own captive and mess it up pretty badly which exposes themselves and their businesses to both tax liability and sometimes even criminal penalties. Sadly, there are also many advisors out there who try to form captives but don't really understand what they are doing and end up botching it pretty badly. This article reviews some of the bad practices that we see when people bring us their captives to review.

Didn't Get the News About 501(c)(15)?

For whatever reasons, there still seem to be a few people who have not yet received the news the 501(c)(15) captive is effectively no more. While Congress did not abolish 501(c)(15) insurance companies outright, Congress instead created a $600,000 maximum limit for gross receipts of both the insurance company and other companies held by the same control group.

In other words, if the both the insurance company's income and the income of the owners exceeds $600,000 in a given year, then the 501(c)(15) limit has been busted and that exception can no longer apply. Since probably no business that would even consider a captive would have less than $600,000 in income by itself, the effect of Congress' change - which became effective as of December 31 of 2003 - is to have eliminated the provisions for anybody who actually needs it.

Some tax professionals apparently did not get the news about this change, and have been blissfully advising their clients that 501(c)(15) is alive and well, although their clients are about to wake up to a horrible tax nightmare. Worse, some of these professionals have misconstrued the Determination Letter given to them by the IRS to allow in some way an "exception" to the gross receipts test, which is absolutely not the case. To the contrary, such letters only say that the captive is exempt only so long as it complies with 501(c)(15), which is no longer practically feasible. Malpractice per se.

The Single-Insured Captive

Another common error is the person who sets up an insurance company but then only uses it to underwrite the risks of his own company. Since there is no risk-spreading or risk-shifting, there is little chance that the IRS will consider the insurance company's activities to be that of insurance, and thus little chance that the IRS will consider the insurance company to be an insurance company for tax purposes - even if it holds a nice, shiny license from somewhere.

Where people run adrift of this mud bar is where they have received bad advice from their Property-Casualty broker, and set up a captive to underwrite their business needs, thinking that because they have 11 or more single-member LLCs as subsidiaries, they meet the test for risk-sharing and risk-shifting. To the contrary, as the IRS recently announced in Rev.Ruling 2005-40 (which is appended to this newsletter), the IRS simply disregards the single-member LLCs and thus there is just one policyholder - and no risk-sharing or risk-shifting.

There is one major Property-Casualty insurance broker who has (crazily) been advising its clients to set up these arrangements, and we would not be surprised to see significant litigation against this broker and some of its accommodating advisors who only thought that they understood the federal tax treatment of insurance companies.

The Sham Segregated-Cell Captive

This is a strategy being sold to doctors, whereby they act like they are making payments of medical malpractice premiums or disability income premiums to an offshore segregated-cell insurance company, but the insurance company after some period of time ends up paying out those premiums as "profits" to an offshore trust or similar arrangement that is controlled (directly or indirectly) by the physician. Sometimes these arrangements are designed so that they appear as offshore deferred compensation arrangements.

At any rate, what happens is about the same in all these schemes: The physician makes his premium payment to the segregated-cell captive, takes a deduction for it, and then gets his money back tax-free offshore.

There are four words which are applicable to this structure: Don't drop the soap. This is amazingly blatant criminal tax evasion, and the physician who doesn't fess up before being caught by the IRS will get to spend some quality time at Club Fed. This will be in addition to the huge fines and penalties that the physician will get to pay, in addition to the back taxes and interest.

One of these programs is being marketed by a law firm in the Bahamas, which has aggressively approached property-casualty brokers in the U.S. and even some financial planners to help them sell this scheme.  Don't believe it. The Bahamas law firm claims that they have opinion letters and other stuff that will keep the physician out of jail when the time comes, but this scheme is so detached from tax reality that the physician caught up in it will not have a prayer when the IRS criminal investigation agents come knocking.

Offshore planning in general is a flame to which physician moths flock to and get burned. This segregated cell scheme is just another in a long line of abusive offshore strategies that will keep many physicians awake at night wondering whether they will be indicted, just as the abusive Irish or Barbados employee leasing schemes are doing to hundreds of physicians nationwide now.

The Lesson

Captive insurance company taxation is complex and changing. It is very easy to screw up and hit one of the many deadly tax landmines, leading to the entire captive arrangement being disregarded. While captive insurance is a very powerful tool, it must be accompanied by quality tax advice and counsel. If an arrangement sounds too easy or too good to be true, seek a second independent opinion from a qualified tax professional who has experience with insurance company taxation.

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RECENT CASE UPDATE

Christopher v. Gonzalez, 2005 Cal. App. Unpub. LEXIS 4569 (May 25, 2005)

The California Court of Appeals held proof of the existence of one or more factors used to test "actual intent to hinder, delay, or defraud" a creditor for the purposes of a claim pursuant to the Uniform Fraudulent Transfer Act do not create a presumption that the debtor has made a fraudulent transfer.  The court affirmed the trial court's decision to grant summary judgment in favor of the defendant debtor, even though the trial court erroneously concluded that actual intent is required to bring a cause of action for fraudulent transfer. 

Erik Christopher sued Omar Gonzalez and his company, Omar's Exotic Birds, Inc., pursuant to the Uniform Fraudulent Transfer Act.  Christopher was a judgment creditor of one of Gonzalez's other companies, Neon.  Christopher alleged that Gonzalez fraudulently transferred Neon's assets to himself and Omar's.  At trial, Gonzalez testified that the transfers were made in satisfaction of debts of Neon owed to Gonzalez and Omar's.  The trial court granted summary judgment in favor of Gonzalez and Omar's, and Christopher appealed.

The appellate court affirmed the trial court's decision, ruling that, even if the evidence shows factors such as insolvency of the debtor after the transfer or failure to receive reasonably equivalent value for the transfer, such factors are not presumptive of fraudulent intent.  The court found that there was sufficient evidence that Gonzalez made the transfers in satisfaction of debts owed by Neon to Gonzalez and to Omar.

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Filip v. Bucurenciu, 2005 Cal. App. LEXIS 841 (May 24, 2005)

The California Court of Appeals affirmed the trial court's decision, ruling that property transactions associated with a marital dissolution and property settlement agreement may be subject to the Uniform Fraudulent Transfer Act. The court affirmed a finding of fraudulent transfer and conspiracy to commit fraudulent transfer.

Marin Filip obtained a judgment against Petru Bucurenciu for $366,388.77. Subsequently, Petru and his wife, Marioara Bucurenciu, filed for divorce.  The Bucurencius owned four parcels of real property in the Bucurenciu Family Trust.  After the settlement agreement, Marioara formed Loomis Land, Inc. (LLI), in which she and her daughter, Roxanne, were sole shareholders.   Pursuant to a settlement agreement between Petru and Marioara, one of the properties was transferred to LLI, as Marioara's property. Even though a second property was allocated to Petru in the settlement agreement, this property was also transferred to LLI.   A third property was transferred to Titus and Slyvia Bujdei in exchange for a $400,000 promissory note.

Filip brought suit against the Bucurencius, the Bujdeis, LLI, and the Bucurenciu Family Trust, alleging violation of the UFTA. The trial court entered judgment in favor of Filip, holding that the Bucurencius and the Bujdeis engaged in conspiracy to defraud Filip as defined under the UFTA.  The court held the transfers and sales of the properties were fraudulent and set aside the transfers.  The court allowed the properties to be seized or foreclosed in order to satisfy Filip's judgment against the defendants.  Further, the court held that the property settlement pursuant to the Bucurencius' divorce decree did not protect Marioara from Filip's fraudulent transfer claim. 

The appellate court agreed with the trial court, ruling that the evidence was substantial enough to satisfy the UFTA's requirement that a transfer was made with "actual intent to hinder, delay, or defraud any creditor of the debtor."  The court noted that intent is proved by factors that indicate "badges of fraud," such as retaining control after the property is transferred, insider transfers, whether the debtor has been sued prior to the transfer, and whether the value received by the debtor was reasonably equivalent to the value of the transferred asset. 

The court observed that the sale of one parcel of property to the Bujdeis indicated fraudulent intent to hinder Filip because it was sold for less than fair market value.  The property was appraised at $530,000, and the Bucurencius sold it to the Bujdeis for no money down and a $400,000 promissory note. Further, the court stated that the trial court properly concluded based on the evidence, that the other transfers to LLI were fraudulent.  Thus, the court used the finding of fraudulent transfer as the underlying tort for civil conspiracy.

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Baillie Lumber Company v. Thompson, 2005 Ga. Lexis 300 (April 26, 2005).

The Supreme Court of Georgia held a debtor corporation may bring an alter ego claim against the corporation's former principal, even if the corporation is protected under a Chapter 11 bankruptcy stay. 

Bert Thompson was the manager and sole shareholder of Piedmont Hardwood Flooring, Inc, when he misappropriated Piedmont's assets for his own use and relinquished his control of the company.  Baillie Lumber is an unsecured creditor of Piedmont. After Thompson relinquished his control, Piedmont filed for bankruptcy under Chapter 11 and was allowed to operate as a debtor in possession.  Icarus Holding LLC was formed to wind up and to be held as a suable entity for Piedmont.

This opinion is in response to two certified questions from the Eleventh Circuit Court of Appeals to the Supreme Court of Georgia.  The questions are:  (1)  Under Georgia law, may the representative of a debtor corporation bring an alter ego claim against the corporation's formal principal?  (2)  If so, what is the measure of recovery? 

The procedural history is as follows.  Icarus filed a complaint in bankruptcy court to recover assets that it alleged Thompson fraudulently transferred and misappropriated.  Subsequently, Baillie filed suit in state court against Thompson, alleging that Thompson was the alter ego of Icarus and seeking to pierce the corporate veil and hold Thompson personally liable for the debts of Icarus. 

Thompson moved for injunctive relief in the bankruptcy court, seeking to stop Icarus' state law suit on the basis that the alter ego claim against Thompson is property of the bankruptcy estate, and only Icarus has standing to bring the suit.  The bankruptcy court ruled that any alter ego claim against the principal of the corporation is property of the bankruptcy estate and subject to the automatic stay.  The court explained that allowing an unsecured creditor to make an alter ego claim against the principal of the debtor corporation circumvents the bankruptcy law by depriving other unsecured creditors of their pro rata share of recovery.  The district court adopted the bankruptcy court's opinion, and Baillie appealed to the circuit court.

In answering the circuit court's certified questions, the highest state court answered in the affirmative to the question of whether a corporation may bring suit against its former principal on an alter ego claim. As to the second question, the court answered that the corporation may seek the remedies of disregarding the corporate entity and holding the former principal liable for the corporation's debt.  The court reasoned that an alter ego or "piercing the corporate veil" claim has the purpose of remedying abuse of the corporate form, and confining the doctrine to third-parties thwarts the equitable principles behind piercing the corporate veil.  In other words, the court stated that the relationship between the corporation and the party who is suing the corporation is not as important as the equitable principles behind the veil piercing doctrine.  Further, the court noted that it is unlikely a corporation, outside of a bankruptcy context, would institute an alter ego action, and the veil piercing doctrine is only allowed when there is a lack of adequate remedies.

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In re Robin Bruce McNabb, 326 B.R. 785 (Bankr. D. Ariz 06/23/2005).

In one of the first cases to interpret the new Bankruptcy Act, discussed in our May 2005 edition of Developments, a federal bankruptcy judge in Arizona has held to the effect that federal limitations on homestead exemption, where the homestead had not yet been owned for 40 months, were not applicable where Arizona had "opted-out" of federal exemptions. Instead, Arizona's homestead cap would apply, and not the federal cap.

Creditors argued that because McNabb had not lived in his Arizona home for 40 months, the California homestead exemption would apply. Because the California exemption was much lower than the $150,000 exemption provided under Arizona law, McNabb argued that Arizona law would apply since Arizona had opted-out of the federal bankruptcy exemptions.

In allowing McNabb to assert the Arizona protections, the court went out of its way to criticize this aspect of the new Bankruptcy Act:

". it makes little sense to limit the cap to the few remaining non-opt out states . . . Until Congress does fix it, however, the Court must apply the unambiguous statute as written . . . The cap applies only 'as a result of electing'. Where there is no election, the cap cannot be the result."

The court then ordered an evidentiary hearing to determine other issues in the case, presumably including whether McNabb's transfer of residency from California to Arizona was meant to "hinder, delay or defraud" creditors, meaning that many more statutory cans of worms remain for the court to open in attempting to interpret the new Act.

The vague rumors floating around include those that Congress may attempt to pass certain technical amendments this Fall to clear up certain issues as have arisen in McNabb. Whether or not that happens, this case shows that the new Bankruptcy Act has already started to generate intense surprises for debtors and creditors alike, and this will of course continue at least until we have a few circuit-level cases interpreting the Act.

Keep your seatbelt fastened, tight.

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REPORT FROM QUATLOOSIA

By Tony-the-Wonder-Llama

Seems like people will figure out how to make a buck out of anything. Lately, this includes death. Don't get me wrong: Since the dawn of man a lot of people have been making a lot of money on death. Death sells, for the reason that it is the big unavoidable. Morticians and those who sell burial plots are getting ready to go through their biggest up cycle ever as the baby boomers start cashing it in. And life insurance has always been a very lucrative business, though the trouble with life insurance is that you actually have to die to reap the benefit of it.

Not anymore. Seems like some very bright people have figured out a way for you to make money on your life insurance before you die. No, it does not involve being placed into a time machine and being teleported to some future date right after you've been lowered into the ground where you collect on your own policy and then get zapped back to the present where you can spend it. It doesn't involve you faking your death, either.

Nope, these very bright people have figured out a way for you to make money on your own death before you die, in a way that doesn't involve fraud or teleporting. To the contrary, they will show you how to create vast amounts of cash - hundreds of thousands of dollars if not more - seemingly out of thin air without you having to do much than take a medical, signs some forms, receive the check, and then of course at some future date die at your leisure.

The one sure thing about anything this good is that it is sure to get a bunch of other folks all riled up, and indeed this strategy has of late come under some serious scrutiny with some other very bright people claiming that there are some significant and hidden downsides to the strategy. What? You can't get something for nothing? If it is too good then it is not true?

Somewhere between the very bright people who claim that you can make money off your death before you die, and the very bright people who claim that you can't, lies the truth. To find that truth you must first understand the concept of a "life settlement", and to understand that, you must understand what its immediate predecessor, the "viatical settlement" are all about.