The alternative risk market has always been creative and responsive to “uninsurable” events, but the COVID-19 pandemic is revealing risk in unexpected places, and challenging old notions about what does or does not constitute insurance. Captives have a real opportunity to step up and help businesses navigate the changing risk landscape, says Gary Osborne of Risk Partners.
While the Internal Revenue Service (IRS) has been on a winning streak with some egregious wealth planning cases, it has more recently made some statements and taken positions that should—and hopefully will—be challenged. One such position was to ask insureds whether they have ever had a claim that would have been covered by a policy and, if the answer was no, arguing that meant the policy was not really insurance.
This makes no sense. Many people have never made a claim on their home insurance, but that does not invalidate it as insurance. The policies that led to this line of attack were captives that wrote coverages for some low (sometimes very low) frequency but high severity risks, such as terrorism. These captives were charging premiums that were multiples of what the commercial market would have charged.
The other problem was coverage that was not commercially available, such as crisis management or regulatory action. The IRS challenged this, on the basis of what could have generated a claim.
The COVID-19 pandemic has certainly created massive business losses from both crisis management and regulatory action. It will be hard for the IRS to challenge policies addressing these types of risks going forward. In fact, these unprecedented business impacts may drive companies to look at captives as a way to prepare, in a small way, for the possibility of such events happening again in the future. They may also encourage businesses to consider other forms of enterprise risk management that have seemed unlikely in the past.
Captives currently fighting the IRS over allowable premiums will be able to point to these losses as evidence that unlikely events do happen. They can now show that they were, in fact, acting as prudent stewards of their businesses, by purchasing insurance to cover unlikely but damaging events.
Captive owners and their managers need to do a better job of writing the policies to address these unusual scenarios, and backing that up with actuarially determined premiums, and considering the level of capitalisation for their portfolio of risks. When we fail in these basic steps we help the IRS.
While the upcoming case between CIC Services and the IRS at the Supreme Court is a real opportunity for our industry to push back at blatant intimidation by the IRS, it is not expected to help in the determination of what constitutes insurance risk as opposed to business risk, or what is an appropriate methodology for premium and capital determination.
Writing polices to address ‘black swan’ events
Crisis management was written by some captives based on some actual historical issues. One policy, for real estate management companies, was designed to address costs incurred from bed bug infestations. It was based on an incident in which one building out of 20 had a bed bug issue, where the company felt compelled to treat every building to address the adverse publicity and ensure it could still attract tenants. The commercial policy covered only the one building that actually had the infestation.
Another policy was designed to address lost revenue in a complex that was identified as having had a resident with Ebola. Its occupancy level dropped substantially for a lengthy period. In both cases there were verifiable costs or losses that were not covered by their commercial insurance policies.
Regulatory action coverage was designed around the concept of the Securities and Exchange Commission (SEC) investigation policy that is commercially available. To address the moral hazard, the coverage was to indemnify a policyholder against expenses of defending and mitigating the costs of a regulatory action or a regulatory policy change. It should not cover penalties and fines. This coverage can demonstrate prior losses to many companies or demonstrate if there is plenty of available evidence of potential losses.
In many cases, the current iterations of these policies are not responding to the current pandemic.
Crisis management sought to respond to adverse events hitting one location, not every location. Real estate managers have not had loss of tenants because of the pandemic but have been prohibited from evicting, which could cause losses from bad receivables.
Managers have the opportunity to sit down with their clients and figure out what has caused the most financial stress during this lockdown period and design coverage that would respond in a financially responsible way. They take into account premium and capital needs, and whether they see a second wave problem causing further pain in the near future.
It could be, if there is a reasonable surplus built up in a captive, that writing a crisis policy now could provide coverage if a second wave of infections were to hit, while still pricing premium appropriately. Of course, premium pricing currently could be challenging because the possibility of a second wave remains high. Assessment will involve input from actuaries who can look at previous, less serious, pandemics, as well as historical information from the more serious Spanish ’flu after World War 1 and Hong Kong ’flu in 1968.
Regulatory action policy wording did not necessarily foresee this kind of mandated closure, so most policy wordings were not written broadly enough, or aimed at business interruption scenarios driven by government action. Regulatory action policy wording addressing a government mandated lockdown would not normally trigger a business interruption claim under standard commercial policies. Amending this coverage may be the better option for many businesses, if they have seen their financial position eroded by the government lockdown. Wording addressing a lockdown scenario, along with the original regulatory action coverage element of defense costs, could be the easier terminology to amend, rather than the crisis management policy, if we have a repeat of the business losses created by government intervention.
It is also worth noting that the US government is considering a Pandemic Risk Insurance Act (PRIA) that would be voluntary, as opposed to the mandatory aspects of the Terrorism Risk Insurance Act. Captives are currently included and if this act progresses, captives may see an opportunity for themselves to fund for the future. It is too soon in the process to tell, but this is a developing story worth watching.
This pandemic has caused untold damage to the global economy. Captives can be a great tool to help businesses rebuild, while helping to prepare them for any recurrence. It remains to be seen whether the IRS will recognise this, and back off on its harassment of properly regulated and capitalised captive insurance companies.
Gary Osborne is vice president at Risk Partners. He can be contacted at: firstname.lastname@example.org
Gary Osborne, Risk Partners, COVID-19, PRIA