COMPLIANCE

The loss ratio is the primary metric the IRS uses to determine if a captive is operating like a real insurance company. A legitimate insurer expects to pay out a reasonable portion of the premiums it collects as claims over time.

The Formula:

• (Losses + Loss Adjustment Expenses) / (Premiums − Policyholder Dividends)

The Thresholds:

• Transaction of Interest: A 10-year average loss ratio of less than 60%.21

• Listed Transaction: A 10-year average loss ratio of less than 30% (and the Financing Factor must also be met).

Work with independent actuaries to design a balanced portfolio of insurance policies for the captive. This includes not only low-frequency, high-severity risks but also policies for risks with more frequent, smaller claims. This balanced approach should produce a sustainable, long-term loss ratio that is projected to remain comfortably above the 60% threshold, thereby avoiding reportable transaction status based on this factor. 

The IRS is intensely focused on preventing what it calls a "circular flow of funds," where money is deducted as a premium, received tax-free by the captive, and then loaned or transferred back to the business owner without being taxed.

• The Prohibited Activity: The Financing Factor is met if, within the last five years, the captive has provided a loan, guarantee, or other non-taxable transfer of its capital back to the operating practice or its owners.

The governance documents for captive structures must contain strict prohibitions against any such related-party financing to neutralize the Financing Factor as a source of regulatory risk. 

The IRS's current regulations are built upon the lessons learned from years of litigation. Tax Court cases, such as Avrahami v. Commissioner, Syzygy Insurance. Co. v. Commissioner, and Swift v. Commissioner provide a clear judicial roadmap of what constitutes a non-compliant captive.19 The courts have consistently ruled against arrangements that:

• Lacked economic substance and were motivated solely by tax benefits.

• Insured implausible or commercially duplicated risks.

• Charged premiums that were not actuarially sound or determined at arm's length.

• Failed to achieve adequate risk distribution.

• Engaged in circular flows of funds through related-party loans.

Your captive framework should incorporate these judicial "red flags" as a foundational checklist of practices to avoid, ensuring that every structure is built not only to the letter of the new regulations but also in the spirit of established case law.