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21 December 2020Accounting & tax analysis

The captives year in review


What are the main factors that have impacted the captive insurance industry this year? And what, if we will allow ourselves a quick look into the crystal ball, will this mean for 2021 and beyond?

Let’s look at the five main factors in the alternative risk world in 2020: COVID-19; the Internal Revenue Service (IRS); the hard market; the captives conference circuit; and Washington State.

The pandemic

COVID-19 has thrown the US and the world’s economies into a major reset. The long-term impact is still uncertain but a return to “normal” seems unlikely. The working remotely movement has been accelerated dramatically and workers have proved they can do their jobs effectively from home.

“A Difference In Conditions policy could respond for an employer when commercial or personal coverage denies a claim.”

Will these workers want to lose the home and family time they have gained from no longer facing commutes into major city centres? What impact will this have on cities such as New York and San Francisco, commercial centres that attracted people because that was where the work was, even though that involved long commutes, high housing costs and high taxes?

If San Francisco workers can now do their jobs from rural Idaho or Montana what does that do the current economy? Which industries are going to be severely hit: commercial real estate, restaurants, ride-sharing and, as a side-effect, insurance? We have already seen the claim frequency for commercial and personal auto drop as the mileage driven has reduced dramatically.

How will workers’ compensation be impacted to address accidents when employees are at home? How will cyber insurance be changed with the additional internet activity and is the capacity now in the wrong place?

Captive insurance will once again be a solution for potential coverage gaps that may arise out of these changes. When are you working and when are you on your own time? A Difference In Conditions policy could respond for an employer when commercial or personal coverage denies a claim due to the uncertainty of the applicable coverage for a claim.

If you slip and twist your ankle making lunch at home, is that a workers’ compensation claim? If you are surfing the web at midnight and you are hacked and there is company information on your computer, will the commercial cyber policy cover it?

This uncertainty exists now but does not seem to have been addressed in policy discussions yet as it is still seen as “temporary”. The commercial insurance market is not known for its speed in dealing with changed circumstances, so I expect that captives will lead the way in helping companies fund for these emerging exposures.

The disease itself is driving much discussion about the role of captives, as most insurance policies have a virus or pandemic exclusion. There has been consideration about including COVID-19 in captives but it has not been included in our client base yet since we are still in the middle of the pandemic, and it may be difficult to argue it is insurance as it is a “known” risk currently.

However, if widespread vaccination successfully improves the current situation, it will then make sense to evaluate losses from the pandemic, losses from regulatory actions, changes in workforce utilisation and design insurance coverage that can respond in an appropriate fashion for future events. This capturing of economic impact will be vital in pricing the coverage and being able to respond to some of the inappropriate court decisions from 831(b) cases, such as “have you ever had a loss that would have been covered by this policy”?

The IRS

IRS activity in the captive insurance world remains a dampener on activity levels as there is still caution due to aggressive and intimidating tactics from the IRS towards existing captives owners. The abusive structures should be shut down but the lack of guidance, and moreover the current threats from the IRS, are scaring businesses from adopting 831(b) structures right when they could be a real asset to companies trying to deal with a hardening insurance market and difficult economic conditions.

The 831(b) election is available to insurance companies with annual premiums less than $2.3 million. By making the election, the taxpayer choses to be taxed only on its investment income and excludes underwriting profits from taxation. The downside is that underwriting losses are not deductible.

“The attempts at networking virtually were, to put it kindly, ineffective.”

The challenge to Notice 2016-66 by CIC Services has made it all the way to the Supreme Court. The hearing there, while not addressing the nuances of captive insurance, may be beneficial for the captives industry in reducing the burden of duplicative reporting and perhaps encouraging the IRS to issue guidance on their position on what they consider acceptable practices, such as actuarially supported premiums or solvency tests. This would be preferable to threats to enforce penalties against captives that have made the election for risk financing and risk management reasons.

Practitioners currently can advise against factors that have appeared in several captive court decisions, such as (1) pooling structures with low or zero claims payouts; (2) unusual investments including excessive loan backs or intercompany loans or illiquid life insurance; (3) policy pricing that bears no resemblance to commercial market options; and (4) coverages that veer to close to covering business risk. While there is little certainty on this topic, it is clear that in order to be considered insurance a loss must be “fortuitous”.

The IRS has a long history of antagonism to the captive insurance industry. If a captive owner structures its programme around known standards of risk transfer and risk distribution and avoids the pitfalls listed above, it should be able to take the 831(b) election and use the benefits to help it build funding for critical business risks it may face.

The hard market

Nothing spurs captive insurance activity more than the recurring phenomenon of the commercial market rediscovering pricing discipline. The current marketplace is hardening as insurers’ investment positions face declining returns as their portfolios lose the longer-term bonds with better yields and have to reinvest them at today’s historically low yields.

“I have missed interacting with friends, clients, and other service professionals and look forward to meeting up again in person.”

This gets underwriters and executives to focus on underwriting profits, but they unreasonably enforce the rate increase across the board to all their customers and do not recognise the nonsensical pricing that can result. Using a client example from open lot coverage: the premium for a $5 million excess layer increased from $700,000 a year to $1.5 million a year, and this was for a company whose largest loss under this cover was $3 million.

This client took a 50 percent quota share position in this layer through its captive so the carrier, while in theory reducing its risk profile, did not increase its premium income. Furthermore, the client, by using its captive, kept the funds in-house and, with no claims (as historically had been the case) to this layer, built surplus and improved its ability to retain more risk and rely less on commercial insurance over time.

The pricing surge is spreading from commercial property and commercial auto to now include umbrella (where price increases and reduced limits are the new normal), professional liability lines and directors and officers.

The greater acceptance of captive cell structures and the lower costs and capitalisation involved could see the surge in formations we have seen in 2020 continue in 2021.
The captive conference circuit

There were many captive insurance professionals already on planes and at the hotel in Palm Springs, CA, when Captive Insurance Companies Association (CICA) cancelled its annual conference in March, starting a domino effect that has seen only Alabama (to my knowledge) hold an in-person conference this year.

The need for associations to be seen and heard and spread their message resulted in multiple virtual events being held throughout the year by many of the leading domiciles and associations and to a great degree they were all, in my opinion, terrible.

The educational content was strong and well thought-out but sitting at a desk or in an office eliminated the focus on the event. On many days, I forgot there were sessions going on. The attempts at networking virtually were, to put it kindly, ineffective. However, the bigger threat to these events is the greater acceptance of videoconferencing and using it for short and effective communication with prospects and clients.

Will Vermont return to needing an in-person meeting in the state for prospective new client owners? Will South Carolina still require an annual meeting in state? Will brokers and prospects still require captive managers to jump on a plane and make their pitch/presentation to them in their office?

Unfortunately, I see the larger captive insurance conference events (Cayman, Vermont, CICA) becoming more dominant due to the “everyone is there” effect (and what I see as the sledgehammer to the travel budget that will follow from this year’s lowered expenses) and the ability to fill your calendar with client and vendor meetings.
Smaller state association meetings are going to be scrutinised to see (1) why are you going; (2) if there are prospects there; and (3) what is different over the large events that justifies going.

As a 35-year professional in this most collegiate of industries, I will truly say I have missed interacting with friends, clients, and other service professionals and look forward to meeting up again in person. I recognise that 2020 has proved that captive sales can happen without jumping on a plane three or four times a month. Captive insurance associations are going to have to consider some kind of consolidation or innovation of their events to stay relevant.

Washington State

A look back at 2020 would not be complete without considering the threat to the captive insurance industry that the actions of Washington State have caused.
Washington State has taken the position that captives writing premiums on risk situated in the state are violating its insurance law. Washington does not have a self-procurement statute nor does it have any kind of captive insurance statute currently.

“If Washington is successful in this action it could encourage other cash-strapped states to see captives as a cash cow.”

Washington has decided that captives are operating illegally in the state and has imposed fines and penalties as well as surplus lines taxes on several companies. Unfortunately, several large corporations felt it was easier to just pay the taxes and fines than fight this overreach. However, at least two companies have demanded court hearings on this topic and, of course, COVID-19 and 2020 have delayed these actions.

The concern is that if Washington is successful in this action it could encourage other cash-strapped states to see captives as a cash cow to go after and start a tsunami of similar tax-fishing expeditions. This could reduce the efficiencies of using a captive with added administration and taxes (see the Insurance Premium Tax regime in the EU) and further the “home state” movement to the detriment of the traditional strong captive domiciles as such as Vermont, Hawaii, Bermuda, and Cayman. Expect some court and legislative clarity on this in 2021.

The captive insurance market has been through crazy years before (2002) and even with these five curveballs in 2020, it has thrived and continued to serve the risk-financing needs of the business world. The old chestnut comes to mind: “When you have seen one captive, you have seen one captive”, and our innovative and evolving marketplace continues to show great adaptability to the world. Our little industry is poised to shine again in 2021.

Gary Osborne is vice president of alternative risk at Risk Partners. He can be contacted at: gosborne@riskpartners.com