Lyft demonstrates unintended consequences of new SEC captives rules

The Securities and Exchange Commission (SEC) now requires companies who report earnings on an EBITDA basis and who also possess captive insurance companies to reduce their adjusted EBITDA by the amount adjusted for captive insurance reserves. In the case of Lyft, this meant that their $126.7 million of adjusted EBITDA profit was negatively adjusted by $375 million. This resulted in a negative $248.3 million adjusted EBITDA. Lyft’s stock tanked by 36%.

Many public companies leverage captive insurance. If they are mandated to reduce EBITDA by the amount of adjusted reserves held by their captive, then every single public company with a captive would recognize a materially negative impact to its value when the captive takes up reserves. However, this opens the door to improving the adjusted EBITDA earnings if the captive’s reserves are taken down due to good claims performance. The SEC’s change of non-GAAP disclosure rules creates new issues and opportunities for public companies leveraging captive insurance solutions.

This disclosure gamesmanship does not affect every public company. The rules appear to limit this gamesmanship to companies whose captives directly relate to the value of the business. The updated SEC Compliance and Disclosure Interpretations (C&DI) provide:

Question 100.01

Question: Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?

Answer: Yes. Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. Whether or not an adjustment results in a misleading non-GAAP measure depends on a company’s individual facts and circumstances.

Presenting a non-GAAP performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business is one example of a measure that could be misleading.

When evaluating what is a normal, operating expense, the staff considers the nature and effect of the non-GAAP adjustment and how it relates to the company’s operations, revenue generating activities, business strategy, industry and regulatory environment.

The staff would view an operating expense that occurs repeatedly or occasionally, including at irregular intervals, as recurring. [December 13, 2022]

The language suggests that the captive insurance EBITDA adjustment is limited to situations where the captive’s reserves relate to “normal, recurring… expenses,” within the broader context of the company’s “operations, revenue generating activities, business strategy, industry and regulatory environment.”

As an example, if Microsoft leverages a captive to fund its general liability insurance, then those reserves are unlikely to be required to offset EBITDA since there is no reasonable relationship between its general liability exposure and its core business. For Lyft, and ridesharing in general, this is a different story. Ridesharing firms need to have captive insurance for their drivers and without captive insurance there is not enough capacity in the marketplace to provide coverage for these firms. Thus, the ridesharing industry’s existence mandates captive insurance companies capable of paying claims.

For the captive insurance industry, this means that claims reserving for public companies is a greater issue than in the past. While these reserves were reported, they were excluded from EBITDA calculations. That exclusion was critical because equity analysts regard EBITDA as one of the most important metrics of financial health. This captive industry needs to wrestle with an incredible incentive from public companies’ leadership to weigh in on claims reserving in order to manage investors’ expectations.

Lyft’s captive insurance problem

The issue started in December of 2022. Until last December, almost all public companies excluded captive insurance reserves from their adjusted EBITDA since captive insurance companies are deemed non-GAAP financial metrics by the SEC. However, the SEC amended its regulations to require EBITDA adjustments to reflect “recurring cash operating expenses necessary to operate a public company.” This includes expenses relating to “company operations, revenue generating activities, business strategy, industry, and regulatory cost…”

Lyft is a rideshare company that uses a blend of captive insurance and commercial insurance solutions to provide coverage for its network of drivers. Ridesharing companies are difficult to insure, and captive insurance has been an integral part of the insurance solution for the industry.

The SEC’s position is that since Lyft’s platform needs to include insurance for its drivers, and since captive insurance is a critical component of that insurance solution, captive insurance constitutes a material component of the parent company’s operations and revenue generating activities. This is because if there were no captive insurance company then Lyft would not be able to provide insurance and would cease operations.

This accounting change radically reduced the apparent profitability of Lyft. Instead of reporting $126.7 million in EBITDA adjusted earnings, it was forced to recognize the $375 million increase in insurance reserves. Recognition of these non-GAAP liabilities resulted in adjusted earnings of negative $248.3 million. The stock dropped a record-setting 36% in one day.

Lyft maintains that exclusion of captive insurance reserves is a better view of the company’s overall performance. Its position is that it establishes insurance reserves for claims incurred but not yet paid as well as incurred but not yet reported and any related estimable expenses.

The company evaluates these actuarial assumptions as new information is learned. Changes in the insurance reserves balance, including both the adjustment to prior periods as well as the current period, are recorded as a change in estimate on the income statement for the current period. For example, if in the first quarter of a given year, the cost of claims grew by $1m for claims related to the prior fiscal year or earlier, then the expense would be recorded for GAAP purposes within the 1st quarter instead of in the results of the prior period.

Investors need to know how the company is performing regarding its core operations. Lyft maintains that previous years’ insurance claims do not relate to the quality of the app, the number of drivers, the price per trip, or other relevant metrics of ridesharing.

Lyft has a point; however, it overstates its position. Its 10-K notes that Lyft uses a blend of captive insurance and commercial insurance solutions to cover its requirement to provide insurance. Over the years it has transferred more risk to the commercial markets as underwriters grew more comfortable with ridesharing risks. Further, the company recently executed a loss portfolio transfer to reduce liabilities on Lyft’s balance sheet.

Alas, the reality is that ridesharing companies generate large losses. Neither the admitted nor E&S markets possess enough capacity interested in insuring Lyft, Uber, and similar companies. Thus, without a captive insurance solution the ridesharing industry is effectively precluded from operating. Therefore, the ability to manage these losses directly impacts the ability for the companies to operate. Ridesharing companies are only a going concern if their drivers have insurance coverage.

Unfortunately, inclusion of insurance reserves into public companies EBITDA opens another area of gamesmanship. Insurance reserves reduce the apparent profitability of a company. This creates an incentive to understate reserves. If the captive insurance company minimizes its reserves under an unduly optimistic picture of claims development, then the investors end up with another unrealistic portrayal of the profitability of the parent company.

Insurance reserves manipulation is nothing new. However, the incentive to manipulate reserves within a captive insurance company for public companies’ financials is a novel problem unintentionally created by the SEC. Reserving claims is more art than science and the captive managers’ actuaries possess dozens of means by which to express claims data in a manner befitting the needs of the public company’s executives.

The SEC has a great point that ridesharing companies’ captive insurance operations directly bear on the profitability of the company. However, disclosure of these reserves creates an enormous incentive to depress the value of reserves to maximize EBITDA for the markets. Since insurance reserves are not objective, expect manipulation of insurance reserves in response to this.

In other words, the SEC has the right idea, but their approach lacks the nuance necessary to control the inevitable manipulation via sophisticated professionals working with the claims.

Conclusion

The SEC’s regulation makes sense. This regulation lacks the nuance to preclude gamesmanship, so expect controversy regarding reserving philosophy within captive insurance companies in the foreseeable future. Inclusion of non-GAAP reserves is limited to companies whose captives directly relate to the value of the underlying company. This opens the door to litigation as to whose captive programs directly relate to operations. For Lyft and Uber, this appears obvious because of the need for insurance. For REITs focusing on skilled nursing, there may be interest from the SEC to disclose reserving adjustments because of the nature of the professional liability market. Further, private equity roll ups in the commercial trucking space face similar risks from an overly aggressive SEC.

Thus, the ultimate lesson is that good regulation is difficult. While the SEC’s regulation is logical, the application is arbitrary and lacks nuance. There is room for disagreement as to whom this regulation applies and there is likely to be litigation on this topic in the future.