Incubators of innovation

There are many takeaways from the recent US Tax Court cases reviewing captive insurance programmes. For example, discussions regarding pricing and claims management have helped the industry understand the court’s expectations regarding a captive’s operations.

Perhaps more importantly, the tone of the opinions suggests that one of the greatest challenges facing the captive insurance industry is in articulating the non-tax business reasons for forming a captive.

The Internal Revenue Service (IRS) has spent years crafting a narrative that places tax planning at the forefront. In its annual Dirty Dozen list, and in Notice 2016-66, the IRS links qualification as a small captive insurance company with promoters that persuade clients to “participate in schemes”, and targets “micro captives” specifically as having potential for tax avoidance or evasion.

Ultimately these depictions of captives pay only lip service to the risk management benefits of captive insurance, and focus intensely on the perceived abuses.

This narrative framing has consequences in the courtroom. In the Syzygy and Reserve Mechanical opinions, there was very little discussion of the non-tax reasons that the insureds had for forming captives, and the discussion was dismissive at that. Contrast this with the opening pages of the opinion in Rent-A-Center (a taxpayer victory), which describes Rent-A-Center’s difficulties with the commercial market for directors and officers, worker’s compensation, general liability and commercial automobile insurance.

The effort to control the narrative is more than a tactical issue. The focus on tax planning does a terrible disservice to the dedicated and respected managers, underwriters, actuaries, and other practitioners who service smaller captives. It is also wrong. Captive insurance companies for privately or closely held businesses take part in a long tradition of innovation in insurance products, and that is the context in which they should be viewed.

Risk strategies
Nowhere is this more apparent than in the incorporation of enterprise risk management (ERM) principles into captive insurance programmes. ERM is a concept that has been in circulation since the 1990s, although strategies associated with ERM were being used long before that.

The Casualty Actuarial Society defines ERM as: “The discipline by which an organisation in any industry assesses, controls, exploits, finances, and monitors risks from all sources for the purpose of increasing the organisation’s short- and long-term value to its stakeholders.”

ERM differs from traditional risk management in that it is applied across the organisation, is predictive rather than reactive, and utilises an analysis of all of the risks that face the enterprise, often applying portfolio theory to risk management.

It has been adopted by financial regulators in the US and in Europe and is reflected in risk management frameworks adopted by the International Standards Organization (ISO) and the Committee of Sponsoring Organizations (COSO).

In part due to the incorporation of risk management requirements in regulations such as the Dodd-Frank Act, many larger organisations have adopted ERM strategies. These strategies focus on converting risk management problems into opportunities, which can not only reduce costs but also create value for the enterprise.

A quick illustration using the ISO 31000 framework demonstrates how captive insurance can support an ERM programme. ISO 31000 calls for the organisation to undergo a risk assessment, which includes risk identification, risk analysis, and risk evaluation. This involves three steps: identifying as many risks as possible; prioritising key risks; and then determining the potential impact of those risks on the organisation.

This process should be familiar to every practitioner in the captive insurance space. Captive managers, underwriters and actuaries have developed expertise in helping business owners identify and prioritise risks. Some of these risks fall into the traditional category—general liability, property damage, injury to workers—which are covered under commercial insurance programmes.

Where ERM shines is in identifying the exposures for which insurance is unaffordable or unavailable in the commercial market. These are often the risks that keep the business owner up at night: supply chain interruptions, legislative or regulatory changes, or litigation that is outside the scope of an errors and omissions or general liability policy.

Following risk assessment is risk treatment: the process of determining which risks to avoid; which risks to retain; and which risks to transfer (all or in part). If a significant risk cannot be transferred in the commercial market, then a captive insurance programme may be an appropriate solution.

A captive programme not only fulfils the ERM goal of finding opportunities to build value in the organisation (by creating a potentially valuable financial asset for the enterprise), but can also help the business focus on risk monitoring, another integral part of the ISO 31000 framework. In this way, the captive’s loss experience can create a feedback loop for the business to track the changes in its risk profile and refine its risk management programme.

A new paradigm
In the last few decades, captive insurance companies have played an integral role in bringing ERM to the middle market. Recognising this trend, in 2014 the Self-Insurance Institute of America (SIIA) established an enterprise risk captives (ERCs) working group under the Alternative Risk Transfer Committee. In addition, SIIA proposed the term ERC as a better name for the small captive insurance companies that are used by privately or closely held businesses that seek to manage risks not often addressed by traditional insurance.

SIIA and the ERC working group’s efforts are crucial in that they help establish a paradigm for analysing how ERCs operate. This paradigm explains how the risks that are covered by ERCs are selected, evaluated and priced. It also explains how claims experience within the ERC creates the feedback loop that can drive development of new coverages.

This paradigm should also help us appreciate the ways in which ERCs have fostered innovation, not only in the design of insurance products but also in the delivery of those products to the market. For example, turnkey captive management models enable a business owner to hand over the day-to-day operations of the ERC to experienced professionals, allowing him or her to maintain control over the strategic direction of the ERC.

Series and protected cell structures have enabled ERCs to realise cost and administrative efficiencies, making them more accessible and affordable. Working on ERCs has given many actuarial firms the opportunity to develop expertise in pricing unique risks. As a result of these developments, more businesses are able to finance an unprecedented variety of risks.

That ERCs would serve as incubators of innovation should be no surprise. ERM represents the cutting edge of risk management, and ERCs are the obvious and logical extension of applying ERM principles to the middle market. What remains is to continue to tell this story until ERCs are fully recognised for the value they provide.

Andrew Rennick is a partner at Womble Bond Dickinson. He can be contacted at:  andrew.rennick@wbd-us.com