The third prong of the Harper Test is “whether the arrangement was for “insurance” in its commonly accepted sense.” The case provides further guidance in this paragraph:

Rampart was both organized and operated as an insurance company. It was regulated by the Insurance Registry of Hong Kong. The adequacy of Rampart’s capitalization is not in dispute. The premiums charged by Rampart to its affiliates, as well as to its shippers, were the result of arm’s-length transactions. The policies issued by Rampart were valid and binding. In sum, such policies were insurance policies, and the arrangements between the Harper domestic subsidiaries and Rampart constituted insurance, in the commonly accepted sense.

Several other cases have added clarification to this definition. From the Ocean Drilling Case:

Several factors contribute to recognizing Mentor as a valid insurance company. The parties that insured with Mentor, both plaintiff and unrelated parties, truly faced hazards. Events such as hurricanes and accidents were real possibilities and could result in losses to the insured parties. The business underwritten by Mentor was understood to be insurance provided by Mentor. Insurance contracts were written and premiums were paid. Unrelated parties purchased reinsurance from Mentor. Unrelated parties co-insured a portion of the direct insurance Mentor wrote for plaintiff. Unrelated parties reinsured policies that Mentor wrote for plaintiff. Premiums charged to plaintiff and unrelated parties were based on the commercial rates in London. The validity of claims was established before payments were made on them. Claims were paid from funds of Mentor that were maintained separately from plaintiff’s funds. Mentor’s capitalization was adequate, and the policies it entered into were valid and binding. Mentor’s business operations were separate from plaintiff’s. Cumulatively, these facts indicate that Mentor’s existence as an insurance company was valid and not a sham.

From the Malone Case:

Eastland was adequately capitalized according to Bermuda’s insurance law. The record establishes that Eastland was formed for legitimate business purposes. We have found that Eastland operated in the same manner as other insurance companies. It established reserve accounts, paid claimed losses only after the validity of those claims had been established, and was profitable, much in accordance with industry standards. The policies into which it entered were valid and binding. All of these factors cumulatively indicate that Eastland was a valid insurance company.

…..

As discussed above, Eastland was both organized and operated as a valid insurance company and was not a sham corporation. It was regulated by the authorities of Bermuda, and its capitalization was adequate under Bermuda law. The insurance agreements between Malone & Hyde and Northwestern and the reinsurance agreements between Northwestern and Eastland were the result of arm’s-length negotiations and were properly evidenced by written policies and endorsements. The reinsurance policies issued by Eastland were valid and binding. Eastland operated as a separate and viable entity, financially capable of meeting its obligations. In sum, the arrangements among Malone & Hyde, its subsidiaries, Northwestern, and Eastland constituted insurance in the commonly accepted sense.

Several elements stand out in the above excerpts;

1.) The importance of adequate capital. A captive is a stand-alone insurance company. Central to this idea is the importance of the ability to pay claims and, to do that, it must have money. An under-capitalized captive will create a red flag.

2.) Forming the captive for a legitimate business purpose. If there is one key takeaway from looking at the case law history, it’s that a captive — first and foremost — is about risk. That must be clearly demonstrated from the beginning of the transaction. If someone says, “we need to find a business purpose for the captive,” they’re missing the point.

3.) The importance of valid insurance policies. An insurance policy is a contract between the insured and the insurer. The existence of a policy indicates there are two parties, each with enforceable rights under the contract.

4.) The importance of being subject to a regulator: while I understand the reason for this, I personally think it’s a bit of a misnomer for this simple reason: practically every jurisdiction has some kind of regulatory authority.

Let me add a few other points which I think are worth mentioning, all of which revolve around the idea of corporate substance. On an ongoing basis, it’s imperative to demonstrate the captive is a separate, viable entity. There are many ways to do this, but I believe the best method is to regularly hold and document company meetings. Most statutory codes for corporations have a detailed set of rules and requirements for annual meetings (here is a link to Delaware’s corporate code on shareholder meetings to give you an idea for what’s involved). The reason for these meetings is simple: to discuss important matters related to the corporation and formulate a direction for the company. In doing this, the board of directors demonstrates the captive is indeed a separate and viable business entity.

In addition, there is the concept of alter ego, which is defined by the law.com law dictionary as, “a corporation, organization or other entity set up to provide a legal shield for the person actually controlling the operation.” The best way to think about this concept is that an individual uses the corporation not as a separate, viable company, but instead utilizes the corporation to essentially act as or for the individual with the benefit of limited liability. This is something we most definitely want to avoid. According to AMJUR, here are the factors the court will look at to determine if an alter ego exists:

In determining whether to pierce corporation veil, courts will consider whether there was (1) majority ownership and pervasive control of the affairs of the corporation, (2) thin capitalization, (3) nonobservance of corporate formalities or absence of corporate records, (4) no payment of dividends, (5) nonfunctioning of officers and directors, (6) insolvency of the corporation at the time of the litigated transaction, (7) siphoning of corporate funds or intermingling of corporate and personal funds by the dominant shareholder(s), (8) use of the corporation for transactions of the dominant shareholder(s), (9) use of the corporation in promoting fraud, 1 (10) the authorized diversion of an entity’s funds, (11) failure to issue stock ownership, (12) ownership of the entity by one person or one family, (13) the use of the same address for the individual and entity, (14) concealment of the entity’s ownership, (15) attempts to segregate liabilities to the corporation, (16) whether there was a failure to collect paid-in capital, (17) employment of the same attorneys and employees, (18) use of the entity as a subterfuge in an illegal transaction, (19) formation and use of entity to transfer to it the existing liability of another person or entity, and (20) the failure to maintain arm’s length relationship between related entities.

Taking the above in combination with the third Harper fact, we see the need to make sure the captive operates as a separate and stand alone insurance company.

In accordance with Circular 230 Disclosure