A Guide to Business Insurance for UK Marine Trades

Introduction

Insurance solutions for businesses operating in the Marine Leisure Sector have been slow to evolve compared to other sectors. Until relatively recently, a boatyard owner could find him/herself having to source a suite of insurance products to cover buildings, contents, financial risks, vessels, pontoons and indemnity against a range of legal liabilities. Whilst the first Marine Traders “Combined” policy that provided cover for all these risks appeared in the late 1990s, the market did not rush to embrace the new paradigm. Some significant providers of insurance in this Sector did not release a “Combined” solution until as late as 2007 and others still only offer stand-alone covers.

Advantages of Combined Insurance Policies

There are numerous advantages to business owners of having a single insurance policy that combines cover in respect of the majority of their needs. First and foremost it streamlines administrative processes by reducing documentation considerably, thus saving business owners time and money. It also ensures the owner has a single renewal date to deal with. Probably the main benefit to businesses is the potential premium savings that can be made through this type of system: the more cover that can be placed on a single policy gives the provider more scope to reduce the overall insurance premium.

Marine Trades Insurance Providers

Combined Insurance policies for marine-related businesses are now available from a number of specialist providers. Whilst the majority of these providers will deal direct with the public, some will deal only through insurance brokers. An insurance provider that sells direct to the public will only offer their own product. Dealing directly with insurers not only restricts you in terms of available insurance options, it also means you have to invest valuable time in shopping around providers for competitive quotations. An independent specialist Marine Trades Insurance broker can potentially save you and your business time and money by conducting a full broking exercise across the market on your behalf.

Specialist brokers can also assist in arranging bespoke cover as opposed to a standard “off-the-peg” solution. This can give your business vital benefits where standard policy exclusions are amended or removed, widening the overall scope of protection. You may also benefit in the event of a claim:

Where a business buys direct from an insurer, in the event of a claim the owner is left to negotiate a settlement from the insurer. This can put the business at a disadvantage where there is a dispute over liability or settlement. Using an independent specialist broker to arrange cover provides the business owner with an experienced advocate in the event of suffering a claim. The broker is bound to act in the best interests of the client at all times and a specialist broker can often assist in instances where claims have initially been repudiated.
Structure of Marine Combined Insurance Policies

Before outlining the structure of a policy it is necessary to stress the importance of ensuring that the correct limits of indemnity form the basis of your insurance cover. It is tempting for businesses seeking to reduce their costs to deliberately underinsure their businesses. This can potentially prove catastrophic in the event of a loss, as an insurer will almost certainly invoke the principle of “Average” when underinsurance is discovered.

The Principle of Average: In the event of underinsurance any claim settlement will be based on the ratio of the sum insured to actual value. For example, where a business has insured stock worth £100,000 for only £50,000, the business has underinsured by 50%. In the event of a loss of £25,000, the insurer will apply average and only pay a settlement of £12,500.
The example above underlines the importance for businesses to establish the correct basis of cover with their provider and then negotiate a competitive premium. An independent specialist broker with access to a number of alternative markets will help you obtain the right solution at the best available premium.

Marine Trades Combined Insurance policies generally follow the same model, with the odd exception as to where a particular item may appear. For example, some policies will include pontoons in the Material Damage Section whilst others may bracket them in the Marine Section. Outlined below is a typical policy structure:

Material Damage: This Section will cover all property other than vessels at your business premises. It is split into various sub-sections that vary from provider to provider, but the splitting of property into these sub-sections enables you to benefit from lower premium rates on the lower risk items to be covered. Typically, a Material Damage Section will be divided as follows:
Buildings (with or without subsidence cover)
Marine Installations (pontoons, slipways, wet/dry docks etc)
Computers and Associated Equipment (at the business’ premises)
Machinery and Equipment (at the business’ premises)
General Stock (at the business’ premises)
Valuable & Attractive Stock (at the business’ premises)
All Other Contents (at the business’ premises)
Glass: Some insurers will include Glass within the cover for Buildings. However, most Marine Trade insurers will not cover Glass unless specifically requested and will also levy an additional premium. Cover will be provided for external and internal glass with additional extensions available for items such as glass signage and sanitary ware.
All Risks Cover: Must be obtained for businesses wishing to insure items they remove from the business’ premises such as:
Tools & Machinery
Laptop Computers, Mobile ‘Phones etc
Trailers (thease can also be covered under the Marine Section)
Frozen Food: Covers loss or damage to fuel resulting from change in temperature in fridges or freezers resulting from breakdown or interruption to power supply.
Goods in Transit: Protects against loss of goods whilst in transit or whilst temporarily stored in the course of transit. Business owners need to beware of the variation in scope of cover from policy to policy and of the plethora of exclusions that each insurer applies to cover.
The premium for Goods in Transit insurance is based on a combination of the total sum insured per vehicle, the number of vehicles used and the estimated total annual carryings of the business.
This Section can also be extended to insure postal sendings and carriage by third parties.
Goods in Transit cover for vessels is excluded on many policies unless specifically mentioned. However, it is possible to include insurance for vessels whilst in transit by endorsing the Marine Section of the policy. Organising a policy in this way can save a business money if vessels are the only items to be insured whilst in transit.
Exhibitions: Covers exhibits, stands and other materials at exhibitions.
Whilst insurers include this Section within their policies, a business could reduce costs by having the Marine Section of their policy endorsed to cover vessels at exhibitions rather than pay their insurers an additional premium for the same benefit.
Business Interruption: Covers the loss of Gross Profit and/or the Additional Cost of Working in the event of the trading activities of a business being interrupted by an insured peril, such as fire or flood. Extensions can be purchased to cover losses arising from perils such as:
Breach of Canal
Damage in the vicinity of Premises or to Contract or Exhibition Sites
Denial of Access to the vicinity of Premises
Damage to Moulds, Patterns, Jigs, Dies, Tools, Plans, Designs, etc
Loss or Damage to Property stored in locations other than own premises
Loss or Damage to Property in Transit
Damage to Premises of Suppliers or Customers
Loss of Utilities
Disease & Illness
Just as it is essential to insure property on the correct basis to avoid insurers applying “Average” in the event of a claim, it is vital to ensure the correct level of Gross Profit is used to determine Business Interruption cover.
The definition of Gross Profit in insurance terminology differs from that of accountancy. A business should always check with its provider as to the exact terms of their Business Interruption policy but the procedure below provides a general system that should fit most insurers’ methodology:
Obtain the income statement for the last full operating month and locate the net profit amount.
Employers Liability Tracing Office
Review each individual expense line item on the income statement to identify costs of operation that are not directly related to production, also referred to as “standing charges.” For example, office rent is due whether the business is in operation or not, and the price does not fluctuate based on production, whereas some worker salaries (such as casual, seasonal labour) would cease when trading is interrupted.
Employers Liability Tracing Office
Add each standing expense identified in Step 2 to the net profit obtained in Step 1 to obtain gross profit, or the company’s loss from lack of operations.
Money: Provides insurance for cash, cheques etc whilst on premises, in transit or in bank night safes. Some policies will also provide extensions for money in directors’ homes and at exhibition or contract sites. Policies will usually provide a Personal Accident extension that offers nominal sums in the event of Death or Disability arising from assault during attempted robbery or theft.
Defective Title of Vessels: Reimburses the purchase price of a vessel bought or sold by a business in the event of the true owner of the vessel reclaiming it (or its value). It will also provide indemnity where a business has a valid claim brought against it as a result of being unable to provide good title for the vessel.
Employers Liability: It is a statutory requirement for all businesses to carry Employers Liability Insurance where they employ people be it on a paid or voluntary basis. It indemnifies the business in respect of its liabilities arising from death, injury or illness to its employees
Premium is based on the total annual wages of the business. Each occupation within a business’ workforce will attract its own premium rating based on the perceived hazards associated with that particular occupation. A rigger, for example, will attract a higher premium rating than an employee engaged in light yard work.
You should ensure you accurately declare your annual wageroll to insurers. Deliberately under-declaring could be construed as failing to disclose a material fact and may result in a claim being repudiated.
Labour only sub-contractors should be treated as Employees as far as insurance is concerned. Generally they work under the direction of the Insured and do not provide their own materials or tools (with the exception of small hand tools). Cover would therefore be arranged for such individuals by the hiring business under the Employers Liability Section of their policy.
There is a requirement that businesses must confirm their Employers Reference Number (ERN) or as it is commonly known Employers PAYE Reference to the insurer covering the Employers Liability which is recorded centrally with the Employers Liability Tracing Office (ELTO). This is to ensure that the correct insurer can be identified where claims are submitted by an individual, which can be years after their employment has ceased. It is not unusual, for example, for certain diseases or conditions such as respiratory disease, industrial deafness or repetitive strain injury to take many years to manifest.
The ERN is the unique reference which attaches to a business and does not change which means that it will identify the correct employer and then the insurer for any given time period from 2011 onwards.
Public Liability: Indemnifies your legal liabilities to third parties arising from your business activities that result in death or injury to any person or loss of or damage to property. The insurance only attaches to those activities disclosed to your insurer and noted on your schedule so it is essential that a full description of all your business activities is provided.
Premium is based on the estimated annual turnover of the business. Each activity will attract its own premium rating based on the perceived hazards associated with that particular activity. Paint Spraying, for example, will attract a higher premium rating than Chandlery Sales.

You should ensure you accurately declare your annual turnover. Deliberately under-declaring could be construed as failing to disclose a material fact and may result in a claim being repudiated.
Exclusions and Extensions to Public Liability Insurance vary from insurer to insurer. For example, some policies will automatically provide Yachtyard Liability Insurance as a standard extension to their Public Liability cover. Others will charge an additional premium for Yachtyard Liability.
Liability in respect of hiring-in of cranes is normally excluded on most Marine Trade policies unless specifically requested. The additional premium for this cover is based on your estimated annual hiring-in costs. Standard cover is usually £100,000 which may not be adequate to replace the crane you hire. Find out what your exposures are and get your cover topped-up if necessary.
Yachtyard Liability: Protects your liabilities in respect of moving vessels on water for reasons such as testing, demonstration and deliveries. Like most policy sections, scope of cover will vary from insurer to insurer. For example, policies will restrict your permitted range, but distance you are permitted will vary greatly.
Not all insurers provide this cover under the “Yachtyard Liability” heading. Some insurers will provide “General Liability” that will automatically encompass the Yachtyard Liability element of other policies.
Products Liability: Insures your legal liabilities in respect of the products you manufacture and/or supply.
Whether you are manufacturing or distributing (wholesale or retail), you need to make sure the products you supply are safe. Failing to meet your responsibilities can have serious consequences. You could face legal action with possible fines or even imprisonment. You could also be sued by anyone who has been injured or has suffered damage to personal property as a result of using your product.
Products Efficacy Insurance: Designed to cover the failure of an item to perform its intended function Efficacy Insurance is often excluded from the Public & Products Liability Sections of Marine Trade policies. If your business is involved in the manufacture, supply or installation of performance critical products you need to check with your insurance provider to ensure you and your business have the right scope of Liability Insurance.
Marine Risks: Non-Marine Commercial policies have virtually no insurance provision for vessels. They are specifically excluded, with the odd exception such as rowing boats. The Marine Section of a specialist Trader’s policy is divide into 3 distinct parts:
1. Vessels: This part of the Marine Section will cover all vessels not undergoing construction and includes Stock Vessels, Work Boats, your Private Craft and Charter Vessels. It can also be extended to cover other types of Marine Stock such as engines and parts.
Sums Insured for vessels are usually determined on an “Agreed Value” basis. This can be the price you paid for the vessel plus the cost of any improvements, or it can be a depreciated or written-down value.
The cruising range of your vessels will be clearly defined in this Section of your policy. You should check to ensure that you and your hirers are actually insured to sail or cruise to your intended destinations. For example, an insurer may assume that, if you are based on the Thames, you are only on the non-tidal stretch and will endorse your policy for”Inland Waterways” use only.
The are several extensions that can be purchased for this part of your policy such as:
Social use of vessels by Directors, Employees, Family Members.
Racing Risks (Sails, Masts, Spars & Rigging).
Water Skiing, Towing of Toys.
Angling and/or Diving Parties.
Personal Possessions
Exclusions in respect of vessels will vary from policy to policy. You should ask your provider to go over any exclusions with you in detail in case you require a special endorsement or extension.
2. Builders Risks: Whilst scope and definitions may differ from one insurer to another, Builders Risks insurance will usually cover your vessel at the yard or dock where it is being constructed, including the yard or premises of a subcontractor. It may also cover the vessel whilst in transit between your yard and your subcontractor’s yard. Extensions can also be obtained to cover:
Movement of the vessel on water around the dock where it is being built.
Sea Trials
Delivery voyages under own power
If the vessel in build is being towed on the water a special extension is usually required to insure this activity.
The premium for this Section is based on a combination of the maximum completion value of an in-build vessel and the maximum value of vessels in-build at any one time.
3. Marine Third Party Liability: This insurance is an extension of the Vessels Section and covers your legal liabilities in respect of your interest in or use of your vessels by your skipper and crew. The usual limit of indemnity provided is £3,000,000 but higher levels of cover can be purchased where required.
Policy Conditions, Exclusions and Warranties

As detailed above, policy conditions and exclusions will vary from insurer to insurer. Even if you are purchasing your policy by telephone you should always ask your provider to go through them with you in addition to any warranties that will have been imposed. There are significant differences between each of these:

Conditions: Policy conditions basically set out a code of conduct you’re your business and also outline duties and obligations required for cover to be in effect. If policy conditions are not met, the insurer can deny a claim specific to that condition.
Eg. A theft from a business premises is discovered and not reported to the insurer for a month. If there is a policy condition that all losses must be reported within 7 days, the insurer could refuse to pay the claim.
Exclusions: An exclusion actually removes cover from the insurance policy.
Eg. Boats are excluded from the Goods in Transit Section of a Marine Trades Policy unless an endorsement is put into effect.
Warranties: A policy warranty is an instruction by the insurer that must be carried out by the insured. For example, the business may be warranted to work on vessels worth no more than £500,000. In such a case, if the business worked on a more valuable vessel then it would be in breach of warranty.
The breach of a warranty by a business would enable an insurer to void the whole policy. In the above example, if the business owner suffered a theft of outboard engines, the insurer could void the policy on the grounds that the business had breached a warranty – even though that warranty was totally unrelated to the theft.
As you can see, warranties can potentially have a huge impact on your business. You should ensure your insurance provider goes through each warranty with you and explains what it means. Insurers can impose a warranty for just about anything – some common examples are below (the list is by no means comprehensive):
Compliance with Flammable Liquids & LPG Regulations.
No paint or GRP Spraying.
Automatic fire alarms to be tested weekly.
Fire extinguishers to be professionally inspected annually.
Fireproof doors to remain closed during working hours.
All stock to be kept at least 15cm off floor
Waste & dirty cloths to be kept in metal bins.
Waste bins to be kept outside premises out of working hours.
Intruder alarm to be set whenever premises is unoccupied.
Electrical circuits to be inspected within 30 days of policy inception.
Cash registers to be left empty & open when premises closed.
Vehicles to be fitted with immobilisers and alarms.
Premises to be inspected daily.
No artificial heating to be used on premises.
Machinery only to be running when premises is occupied.
No flammable liquids to be kept on premises.
Moorings to be lifted & inspected at least annually.
Terms of trade to incorporate BMF Terms of Business.
No work carried out on commercial vessels
Trailers to be secured with a wheelclamp whilst unattended.
Vessel not be let out for hire or reward.
Vessel will not tow or be towed
British Marine Federation (BMF) Terms of Business
Most Marine Trade policies warrant that you operate under BMF Terms of Business. You do not have to be a member of the BMF to use their terms. The essential point from an insurance aspect is that you ensure all your customers insure their own boats. This is a crucial factor that defines the mechanics of how your Public Liability insurance works and how it differs from non-Marine commercial insurance policies.
If you have a customer’s boat, outboard etc in your custody or control and it is lost or damaged due to your negligence, your legal liabilities in respect of the property are covered under the Public Liability Section of your Marine Trade policy.
This cover would not be provided on a non-Marine policy as legal liability in respect of goods in custody or control is specifically excluded. To insure these items you would have to procure specific insurance which, as leisurecraft and associated equipment are very expensive, would be financially prohibitive for a business to purchase.

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A Brief Introduction to Captive Insurance

Over the past 20 years, many small businesses have begun to insure their own risks through a product called “Captive Insurance.” Small captives (also known as single-parent captives) are insurance companies established by the owners of closely held businesses looking to insure risks that are either too costly or too difficult to insure through the traditional insurance marketplace. Brad Barros, an expert in the field of captive insurance, explains how “all captives are treated as corporations and must be managed in a method consistent with rules established with both the IRS and the appropriate insurance regulator.”

According to Barros, often single parent captives are owned by a trust, partnership or other structure established by the premium payer or his family. When properly designed and administered, a business can make tax-deductible premium payments to their related-party insurance company. Depending on circumstances, underwriting profits, if any, can be paid out to the owners as dividends, and profits from liquidation of the company may be taxed at capital gains.

Premium payers and their captives may garner tax benefits only when the captive operates as a real insurance company. Alternatively, advisers and business owners who use captives as estate planning tools, asset protection vehicles, tax deferral or other benefits not related to the true business purpose of an insurance company may face grave regulatory and tax consequences.

Many captive insurance companies are often formed by US businesses in jurisdictions outside of the United States. The reason for this is that foreign jurisdictions offer lower costs and greater flexibility than their US counterparts. As a rule, US businesses can use foreign-based insurance companies so long as the jurisdiction meets the insurance regulatory standards required by the Internal Revenue Service (IRS).

There are several notable foreign jurisdictions whose insurance regulations are recognized as safe and effective. These include Bermuda and St. Lucia. Bermuda, while more expensive than other jurisdictions, is home to many of the largest insurance companies in the world. St. Lucia, a more reasonably priced location for smaller captives, is noteworthy for statutes that are both progressive and compliant. St. Lucia is also acclaimed for recently passing “Incorporated Cell” legislation, modeled after similar statutes in Washington, DC.

Common Captive Insurance Abuses; While captives remain highly beneficial to many businesses, some industry professionals have begun to improperly market and misuse these structures for purposes other than those intended by Congress. The abuses include the following:

1. Improper risk shifting and risk distribution, aka “Bogus Risk Pools”

2. High deductibles in captive-pooled arrangements; Re insuring captives through private placement variable life insurance schemes

3. Improper marketing

4. Inappropriate life insurance integration

Meeting the high standards imposed by the IRS and local insurance regulators can be a complex and expensive proposition and should only be done with the assistance of competent and experienced counsel. The ramifications of failing to be an insurance company can be devastating and may include the following penalties:

1. Loss of all deductions on premiums received by the insurance company

2. Loss of all deductions from the premium payer

3. Forced distribution or liquidation of all assets from the insurance company effectuating additional taxes for capital gains or dividends

4. Potential adverse tax treatment as a Controlled Foreign Corporation

5. Potential adverse tax treatment as a Personal Foreign Holding Company (PFHC)

6. Potential regulatory penalties imposed by the insuring jurisdiction

7. Potential penalties and interest imposed by the IRS.

All in all, the tax consequences may be greater than 100% of the premiums paid to the captive. In addition, attorneys, CPA’s wealth advisors and their clients may be treated as tax shelter promoters by the IRS, causing fines as great as $100,000 or more per transaction.

Clearly, establishing a captive insurance company is not something that should be taken lightly. It is critical that businesses seeking to establish a captive work with competent attorneys and accountants who have the requisite knowledge and experience necessary to avoid the pitfalls associated with abusive or poorly designed insurance structures. A general rule of thumb is that a captive insurance product should have a legal opinion covering the essential elements of the program. It is well recognized that the opinion should be provided by an independent, regional or national law firm.

Risk Shifting and Risk Distribution Abuses; Two key elements of insurance are those of shifting risk from the insured party to others (risk shifting) and subsequently allocating risk amongst a large pool of insured’s (risk distribution). After many years of litigation, in 2005 the IRS released a Revenue Ruling (2005-40) describing the essential elements required in order to meet risk shifting and distribution requirements.

For those who are self-insured, the use of the captive structure approved in Rev. Ruling 2005-40 has two advantages. First, the parent does not have to share risks with any other parties. In Ruling 2005-40, the IRS announced that the risks can be shared within the same economic family as long as the separate subsidiary companies ( a minimum of 7 are required) are formed for non-tax business reasons, and that the separateness of these subsidiaries also has a business reason. Furthermore, “risk distribution” is afforded so long as no insured subsidiary has provided more than 15% or less than 5% of the premiums held by the captive. Second, the special provisions of insurance law allowing captives to take a current deduction for an estimate of future losses, and in some circumstances shelter the income earned on the investment of the reserves, reduces the cash flow needed to fund future claims from about 25% to nearly 50%. In other words, a well-designed captive that meets the requirements of 2005-40 can bring about a cost savings of 25% or more.

While some businesses can meet the requirements of 2005-40 within their own pool of related entities, most privately held companies cannot. Therefore, it is common for captives to purchase “third party risk” from other insurance companies, often spending 4% to 8% per year on the amount of coverage necessary to meet the IRS requirements.

One of the essential elements of the purchased risk is that there is a reasonable likelihood of loss. Because of this exposure, some promoters have attempted to circumvent the intention of Revenue Ruling 2005-40 by directing their clients into “bogus risk pools.” In this somewhat common scenario, an attorney or other promoter will have 10 or more of their clients’ captives enter into a collective risk-sharing agreement. Included in the agreement is a written or unwritten agreement not to make claims on the pool. The clients like this arrangement because they get all of the tax benefits of owning a captive insurance company without the risk associated with insurance. Unfortunately for these businesses, the IRS views these types of arrangements as something other than insurance.

Risk sharing agreements such as these are considered without merit and should be avoided at all costs. They amount to nothing more than a glorified pretax savings account. If it can be shown that a risk pool is bogus, the protective tax status of the captive can be denied and the severe tax ramifications described above will be enforced.

It is well known that the IRS looks at arrangements between owners of captives with great suspicion. The gold standard in the industry is to purchase third party risk from an insurance company. Anything less opens the door to potentially catastrophic consequences.

Abusively High Deductibles; Some promoters sell captives, and then have their captives participate in a large risk pool with a high deductible. Most losses fall within the deductible and are paid by the captive, not the risk pool.

These promoters may advise their clients that since the deductible is so high, there is no real likelihood of third party claims. The problem with this type of arrangement is that the deductible is so high that the captive fails to meet the standards set forth by the IRS. The captive looks more like a sophisticated pre tax savings account: not an insurance company.

A separate concern is that the clients may be advised that they can deduct all their premiums paid into the risk pool. In the case where the risk pool has few or no claims (compared to the losses retained by the participating captives using a high deductible), the premiums allocated to the risk pool are simply too high. If claims don’t occur, then premiums should be reduced. In this scenario, if challenged, the IRS will disallow the deduction made by the captive for unnecessary premiums ceded to the risk pool. The IRS may also treat the captive as something other than an insurance company because it did not meet the standards set forth in 2005-40 and previous related rulings.

Private Placement Variable Life Reinsurance Schemes; Over the years promoters have attempted to create captive solutions designed to provide abusive tax free benefits or “exit strategies” from captives. One of the more popular schemes is where a business establishes or works with a captive insurance company, and then remits to a Reinsurance Company that portion of the premium commensurate with the portion of the risk re-insured.

Typically, the Reinsurance Company is wholly-owned by a foreign life insurance company. The legal owner of the reinsurance cell is a foreign property and casualty insurance company that is not subject to U.S. income taxation. Practically, ownership of the Reinsurance Company can be traced to the cash value of a life insurance policy a foreign life insurance company issued to the principal owner of the Business, or a related party, and which insures the principle owner or a related party.

1. The IRS may apply the sham-transaction doctrine.

2. The IRS may challenge the use of a reinsurance agreement as an improper attempt to divert income from a taxable entity to a tax-exempt entity and will reallocate income.

3. The life insurance policy issued to the Company may not qualify as life insurance for U.S. Federal income tax purposes because it violates the investor control restrictions.

Investor Control; The IRS has reiterated in its published revenue rulings, its private letter rulings, and its other administrative pronouncements, that the owner of a life insurance policy will be considered the income tax owner of the assets legally owned by the life insurance policy if the policy owner possesses “incidents of ownership” in those assets. Generally, in order for the life insurance company to be considered the owner of the assets in a separate account, control over individual investment decisions must not be in the hands of the policy owner.

The IRS prohibits the policy owner, or a party related to the policy holder, from having any right, either directly or indirectly, to require the insurance company, or the separate account, to acquire any particular asset with the funds in the separate account. In effect, the policy owner cannot tell the life insurance company what particular assets to invest in. And, the IRS has announced that there cannot be any prearranged plan or oral understanding as to what specific assets can be invested in by the separate account (commonly referred to as “indirect investor control”). And, in a continuing series of private letter rulings, the IRS consistently applies a look-through approach with respect to investments made by separate accounts of life insurance policies to find indirect investor control. Recently, the IRS issued published guidelines on when the investor control restriction is violated. This guidance discusses reasonable and unreasonable levels of policy owner participation, thereby establishing safe harbors and impermissible levels of investor control.

The ultimate factual determination is straight-forward. Any court will ask whether there was an understanding, be it orally communicated or tacitly understood, that the separate account of the life insurance policy will invest its funds in a reinsurance company that issued reinsurance for a property and casualty policy that insured the risks of a business where the life insurance policy owner and the person insured under the life insurance policy are related to or are the same person as the owner of the business deducting the payment of the property and casualty insurance premiums?

If this can be answered in the affirmative, then the IRS should be able to successfully convince the Tax Court that the investor control restriction is violated. It then follows that the income earned by the life insurance policy is taxable to the life insurance policy owner as it is earned.

The investor control restriction is violated in the structure described above as these schemes generally provide that the Reinsurance Company will be owned by the segregated account of a life insurance policy insuring the life of the owner of the Business of a person related to the owner of the Business. If one draws a circle, all of the monies paid as premiums by the Business cannot become available for unrelated, third-parties. Therefore, any court looking at this structure could easily conclude that each step in the structure was prearranged, and that the investor control restriction is violated.

Suffice it to say that the IRS announced in Notice 2002-70, 2002-2 C.B. 765, that it would apply both the sham transaction doctrine and §§ 482 or 845 to reallocate income from a non-taxable entity to a taxable entity to situations involving property and casualty reinsurance arrangements similar to the described reinsurance structure.

Even if the property and casualty premiums are reasonable and satisfy the risk sharing and risk distribution requirements so that the payment of these premiums is deductible in full for U.S. income tax purposes, the ability of the Business to currently deduct its premium payments on its U.S. income tax returns is entirely separate from the question of whether the life insurance policy qualifies as life insurance for U.S. income tax purposes.

Inappropriate Marketing; One of the ways in which captives are sold is through aggressive marketing designed to highlight benefits other than real business purpose. Captives are corporations. As such, they can offer valuable planning opportunities to shareholders. However, any potential benefits, including asset protection, estate planning, tax advantaged investing, etc., must be secondary to the real business purpose of the insurance company.

Recently, a large regional bank began offering “business and estate planning captives” to customers of their trust department. Again, a rule of thumb with captives is that they must operate as real insurance companies. Real insurance companies sell insurance, not “estate planning” benefits. The IRS may use abusive sales promotion materials from a promoter to deny the compliance and subsequent deductions related to a captive. Given the substantial risks associated with improper promotion, a safe bet is to only work with captive promoters whose sales materials focus on captive insurance company ownership; not estate, asset protection and investment planning benefits. Better still would be for a promoter to have a large and independent regional or national law firm review their materials for compliance and confirm in writing that the materials meet the standards set forth by the IRS.

The IRS can look back several years to abusive materials, and then suspecting that a promoter is marketing an abusive tax shelter, begin a costly and potentially devastating examination of the insured’s and marketers.

Abusive Life Insurance Arrangements; A recent concern is the integration of small captives with life insurance policies. Small captives treated under section 831(b) have no statutory authority to deduct life premiums. Also, if a small captive uses life insurance as an investment, the cash value of the life policy can be taxable to the captive, and then be taxable again when distributed to the ultimate beneficial owner. The consequence of this double taxation is to devastate the efficacy of the life insurance and, it extends serious levels of liability to any accountant recommends the plan or even signs the tax return of the business that pays premiums to the captive.

The IRS is aware that several large insurance companies are promoting their life insurance policies as investments with small captives. The outcome looks eerily like that of the thousands of 419 and 412(I) plans that are currently under audit.

All in all Captive insurance arrangements can be tremendously beneficial. Unlike in the past, there are now

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