The swinging pendulum
Following a third loss in the US Tax Court for risk-pooled 831(b) captives, small and medium-sized enterprises looking to transfer business risks and obtain the benefits of captive insurance are questioning whether there’s truly a space for them in the alternative risk market.
Even after three high-profile decisions, definitive guidance for structuring and operating smaller captives remains lacking. While the cases are clearly “bad” captives carefully curated by the Internal Revenue Service (IRS), and target practices that are almost a decade old, there is no question they are causing dismay in the risk management community.
In an initiative to provide industry support, the Self Insurance Institute of America (SIIA) has developed a Captive Manager Code of Conduct, designed to ensure that captive managers observe high standards of ethical conduct.
Similarly, the Captive Insurance Companies Association (CICA) has issued guidance on commonly accepted practices for risk pools in response to recent Tax Court decisions.
Certain groups and individuals have used the 831(b) election for the wrong reasons and it is therefore unsurprising that the IRS would scrutinise this tax election and similar structures. However, as the market matures, as unscrupulous promoters are weeded out, and as the IRS gains a better understanding of the risk management needs of many smaller businesses, there is hope that the swinging pendulum will reach a place of equilibrium.
When structured properly and operated as legitimate insurance companies, there’s no reason captive risk management structures should not continue to expand for the middle market.
Companies of all sizes face existential risks that are commonly ignored or underinsured. While the need for advanced risk management strategies—such as private insurance structures—is obvious, the guidelines for actually implementing a programme are less so.
Despite the lack of clear regulations, we can look to precedent established in the Tax Court cases so far and borrow from the best practices of larger captives and commercial insurers, to establish a solid foundation for structuring and operating programmes that demonstrate the legitimacy of captive insurance. Some of the key components of best practice are described below.
Professional management
Ideally, a licensed insurance company should be used to underwrite and issue policies. Although many captives issue policies themselves, a direct writer more clearly demonstrates that a structure is operating as a true insurance company.
Arguably, a premium paid to a licensed insurance carrier—that has been developed by independent actuaries with due regard for market conditions—is a lot easier to defend as a deductible expense under IRS Code Section 162. While undoubtedly more complex or onerous to operate, a good risk management firm can provide this service on behalf of its clients.
Adequate capitalisation
Although minimum required capital and surplus can vary widely among various jurisdictions, adequate capitalisation can signify sufficient regulatory oversight and good faith effort to ensure solvency. Capitalisation should be at least 33 percent of premium to ensure sufficient reserves to pay claims.
Actuarially determined pricing
To operate like a true insurance structure, premiums must be actuarially credible. To ensure pricing is established at arm’s length, an independent professional actuarial firm should be used to determine coverages and pricing.
A lack of actuarial experience, and inappropriate or inexplicable pricing or methodology, have made for some very damaging testimony in the Tax Court cases we’ve seen. Common underwriting methodology by a professional actuary who has the ability to view the entire portfolio of risk—and exclude atypical or unusual risks—is essential.
Sufficient risk distribution
Risk distribution is perhaps the most fundamental feature of a true insurance structure. Owners and managers should ensure that a fixed percentage of total risk is transferred, that the risk transferred is unchanged from the originally priced risk, and that the percentage of premium transferred parallels the percentage of risk transferred.
To achieve risk distribution, a traditional quota share-style reinsurance treaty can be implemented, with a focus on pricing, on treaty risks assumed and avoiding artificial layering or loss limits. The pool should consist of similar risks with diverse coverages.
Professional claims process
Legitimate programmes will have claims, so a professional claims manager is essential. Hands-off claim adjudication will help to demonstrate that all legitimate claims are considered and managed in a competent manner.
Emilie Gastley is director of marketing at Captive Alternatives. She can be contacted at: egastley@captivealternatives.com
Reinventing captives with private insurance
David Kirkup, COO and CFO, writes: Captive Alternatives (CapAlt) has been providing risk management solutions for more than 20 years but never before has our name been quite so appropriate. That’s because we are actively providing a real alternative to the traditional captive market.
CapAlt has operated a true insurance model since its inception and Puerto Rico has proved to be a sophisticated international insurance jurisdiction for our pioneering private insurance structure.
CapAlt has built a highly compliant private insurance structure that no longer has to rely on the 831(b) election, thus avoiding the current concerns about that process. We comply with all of the suggested best practices including pricing, risk sharing, and claims management. Our growth demonstrates the interest in legitimate risk management structures for smaller companies, and we expect more to come.
CapAlt is a risk management and insurance consulting firm that helps business owners develop effective risk management programmes. CapAlt’s pioneering business strategy—private insurance—enables businesses and organisations to self-insure business risks, and participate in the underwriting profit arising from effective risk management.
As a result, CapAlt clients build wealth to help protect and assure their corporate futures. CapAlt manages the operations of more than 175 segregated asset plans from its offices in Puerto Rico and Atlanta.
