COVID-19: the captive insurance fight-back begins

Hard times make hard people. For the captive insurance community, times have never been harder. Cash is lifeblood during this uncertain time. Large companies such as Boeing are cancelling dividends until further notice. Small companies are burning up as the quarantine drags on.

The night is always darkest just before dawn. The purpose of this missive is to remind that this too, shall pass, and the world will be radically different when the economy starts up again.

Any restart to the American economy will occur in fits and starts. The virus will pop up here and there. Until a cure or vaccine enters the mix, tough times will endure. That said, we endured 2008. We endured the Internal Revenue Service (IRS). We shall endure this and on the other side awaits a whole new world.

A new world comes with new paradigms. The first tectonic shift is that 831(b) captives are back. Ignore the case law. Ignore the IRS. Forget everything you thought you knew about IRS captive insurance compliance. Those days are gone.

The P&C industry is about to lose about 5 percent of its capacity across the planet—with the US-admitted carriers discussing a loss of 1 percent of capacity. That’s a game-changer.

That does not even account for the thousands of coverage cases looming in the federal court arguing that COVID-19 business interruption claims should be retroactively honoured by existing insurance policies. Those cases are likely to fail, but the costs of the litigation onslaught will affect every P&C carrier’s combined ratio.

Riding to the rescue

The idea of covering pandemic business interruption via traditional insurance is therefore a joke. It is not going to happen. Captives are here to save the day. Small and medium-sized businesses will be able to successfully argue that they need to self-insure for pandemic coverage via a captive insurance company.

Pandemic coverage in a captive is akin to the terrorism coverage offered by the purported captives in the Avrahami matter. The key difference is that the pandemic is real and affects literally every corner of the economy, and there is virtually no coverage for pandemic available in the market. The Avrahami argument that a terrorist could attack a jewellery store in Scottsdale, AZ was always a weak line. In addition, those types of managers frequently put together captives insuring laptops for a $1 million/$3 million coverage limit. Those types of captives remain illegal.

However, pandemic coverage is real. The pain is known. Can the IRS make an argument that pandemic coverage via captive insurance is fraudulent? Every federal judge will laugh that out of court, if it even gets that far. Tax courts are likely to see the writing on the wall. The reality is that we have a real risk that is basically uninsurable.

What does it all mean for those pesky risk pool cases, such as Avrahami and the rest? They’re still good case law, except that they are in no way meaningful. Yes, follow the guidance to the extent the guidance is there. But what guidance is there, specifically?

Each case addressing 831(b) captives has been narrowly tailored, with absolutely no room to argue for a ‘bright line’ rule. In other words, the Tax Court saw a scam and called out some bad actors. They did not generally prohibit risk pooling, as the concept is endemic to the concept of insurance.

Further, captive managers who have legitimate risks pooled in sufficiently large risk pools have remained in operation even after Notice 2016-66. The IRS has been picking its fights carefully.

Follow the rules

Take care to follow the rules. The general rules regarding ownership, and the general requirement of risk pooling, remain in effect. This is not a time to get sloppy. Use actuaries, capitalise the captives, have ISO forms and use professionalism.

But do not cower in front of the IRS any longer. Captives predicated on the concept of pandemic business interruption coverage will be the scene for resurgence in the captive insurance marketplace. To the extent the IRS overreached in Reserve or Syzygy, the time is now for competent captive managers to restart marketing 831(b) risk pools based on the realities of our quarantined world.

The IRS looks like Goliath. Captive managers are an army of Davids that can topple the regime. Risk pooling is fundamental to insurance. The 831(b) election is not a tax scam. Pandemic coverage is a legitimate insurable interest.

More than likely, the IRS will disagree with the general sentiment of this message. That’s fine. We do not operate our businesses for the benefit of the regulators. This is the place to fight. This is the place to reassert the legitimacy of the 831(b) risk pool.

Matthew Queen is US claims vendor manager at Hiscox. He can be contacted at: matthewqueen@gmail.com