831(b) Captive Owners File Lawsuit Against Gallagher and Artex

Arthur J. Gallagher & Co. and its captive management unit, Artex Risk Solutions Inc., are being sued by a group of small employers alleging they have had to pay back taxes and other penalties to the Internal Revenue Service (IRS), involving their participation in 831(b) captives.

Filed in US District Court for the District of Arizona, the suit, Dimitri Shivkov, et al. v. Artex Risk Solutions Inc. et al., alleges that Artex moved its customers into 831(b) transactions to collect big fees.

"The receipt of those fees was the primary, if not sole, motive in the development and execution of the captive insurance strategies," according to the suit.

The suit, which is seeking class action status, alleges that Artex "should have known that these purported tax-advantaged captive insurance strategies were, in reality, nothing more than illegal and abusive tax shelters."

In a statement, Gallagher, which is based in Rolling Meadows, Illinois, denies the allegations. "Gallagher and Artex are aware of the recent filing of a class action lawsuit relating to our 831(b) captive business. We have disclosed the ongoing IRS audit and related customer litigation involving our 831(b) captive management business in our SEC [securities and exchange commission] filings and to our clients," Gallagher said.

"This class action lawsuit appears to be related to the IRS audit, and we believe it has no merit and will deal with it accordingly. Gallagher and Artex have successfully defended individual claims involving similar allegations. We have been disappointed with the IRS's position on 831(b) captives. 831(b) captives are important insurance vehicles that have been provided for by Congress for decades. Gallagher and Artex have diligently and consistently striven to comply with 831(b) in forming and managing captive insurance companies," the statement added.

Small employers have been the biggest participants in 831(b) captives. A significant attraction is the tax advantages the captives provide. Specifically, 831(b) captive owners can receive tax deductions for their contributions to the captives. While investment income earned by the captives is taxable, underwriting income is not. As a result, 831(b) captives can build up sizable assets, especially if the captives are designed in such a way to have minimal exposure to losses. That can occur, for example, if risks covered have little, if any, likelihood to result in losses.

The suit alleges, "According to its website, Artex provides, and has provided at all relevant times, 'middle market risk solutions' to 'closely-held, profitable business[es] looking to transfer uninsured business enterprise risks to captives for financial benefits.' " Per Artex, this solution "usually does not impact existing P&C [property-casualty] insurance."

According to the suit, some of the businesses worked with Tribeca Strategic Advisors LLC, a brokerage that Gallagher acquired through Artex.

Those businesses—small firms—received certain insurance coverages through Provincial Insurance PCC, owned by Karl Huish. Provincial transferred the risks to the 831(b)s owned by the insureds through a reinsurance arrangement.

As part of the arrangement, "Provincial remitted the net ceded premium back to the captive for the facultative reinsurance. The facultative reinsurance premiums were generally paid to the captive within a few weeks of the insured's premium payment to Provincial," the suit notes.

"Provincial issued a reinsurance contract with regard to the facultative reinsurance. It specified that the captive was liable to contribute 100 percent of its related insured's claims and loss adjustment expenses for losses in the facultative reinsurance," according to the suit.

Under the reinsurance arrangement, "the facultative reinsurance certificate showed the captive's maximum liability for each policy listed and specified the amounts of the reinsurance premiums by coverage line. In almost all instances, the facultative reinsurance premiums equaled 49 percent of the net premium for the insured of the captive insurance company," the suit noted.

In addition, a quota share layer was set up, in which risks were pooled among the 831(b) captives and equaled 51 percent of the reinsured premiums.

"In addition to being liable for its related insured's claims, a captive participating in Provincial's pool was also purportedly liable for claims by unrelated insureds whose captives also participated in the pool," according to the suit.

"By allocating 51 percent of reinsurance premiums to quota share and 49 percent to primary, Provincial and Artex suggested that more than half of the risks were for quota share claims. This is an important benchmark for Artex, as anything short of this allocation would cause Artex's captive policies to fail risk-distribution rules. Notwithstanding the 51 percent allocation of reinsurance premiums to the quota share layer, the overpriced, vague, and defective policies carried little possibility of potential coverage for any valid claims," the suit said.

As a result, the IRS said that "deductions for purported captive insurance premiums were disallowed because the transactions, among other things, lacked economic substance," the suit said.