3 August 2016USA analysis

Clubbing together

When is a captive not an insurance company? The answer is, more often—or certainly more easily—than you may think: your captive may have an insurance licence from a domicile but that does not necessarily qualify it as an insurance company in the eyes of the Internal Revenue Service.

To qualify, it is advisable for captives to spread their risk by participating in risk pools. If you can’t spread your risks, your captive is not seen as an insurance company, but simply as a vehicle that holds funds to pay potential insurable losses.

The primary difference between a captive and a risk pool relates to the retention of risk.

“Captives will retain measured levels of risk, while risk pools exist to take risk in, mix it up, package it and ship it back to the participants,” says Derek Martisus, small captives sales leader, Marsh.

Some risk pools are formed as captives and exist as separate entities; other times they are contractual arrangements. These differ from captives in that they are typically not designed to be insurers or bear risk but are generally designed to aggregate and distribute risk.

In essence, the concept is simple: a group of insurance companies have more risk or more concentrated risk than they are comfortable with so they pool their risks with each other and distribute them back to each other, using the risk pool.

“Risk pools perform two functions,” says Jeffrey Simpson, director of law firm Gordon, Fournaris & Mammarealla.

“One is an insurance and risk management function, and in that regard pools reduce your volatility, reduce the potential impact of a single large loss, help pure captives get access to a broader segment of the market and thereby start to get the effect of large numbers and get more predictable results and less volatility.

“That is an important insurance and risk management effect. The other part of it is that pools have become a means of accessing the risk distribution you need in order to be an insurance company for US tax purposes—so at same time as you are using the pool to manage your risk and control volatility you are also getting the distribution you need for tax purposes. The benefits are on parallel tracks,” he says.

Pooling facilities provide reinsurance and the accompanying financial smoothing that comes along with reinsuring specific risks and replacing them with a mixture of risk from other companies, industries and policy types.

“The assumption of other companies’ risks is always a hesitation for our clients,” says Martisus. “However, once they understand the financial benefits of replacing very volatile risk with more diversified risk, most gain comfort.”

Added benefits

A host of benefits are unlocked by being in a risk pool due to the fact that participation can allow a captive insurance company to satisfy the risk distribution requirements to qualify as an insurance company for tax purposes.

“In the absence of this status, the parent company cannot deduct premiums as a business expense and a captive cannot make the 831(b) election. Obviously, these benefits should not be overlooked,” says Martisus.

Risk pools have become more in vogue in recent years for captive owners who wish to avail themselves of tax deductibility of premiums paid to their captive, but aren’t able to achieve risk distribution on their own, says Anne-Marie Towle, senior vice president and senior consultant for the Global Captive Practice at Willis Towers Watson.

“Companies have selected risk pools as a mechanism to incorporate third party risk assumed into their single parent captive to achieve recognition as an insurance company for US income tax purposes,” she says.

Risk pools essentially incorporate risk typically at an excess or higher limits level and share the risk across multiple heterogeneous members.

“This sharing of certain types of coverage and limits has recently come under attack by the IRS for those companies accessing the risk pool strictly to achieve insurance company status for tax purposes,” says Towle.

“Some pools may have very limited chances of an actual loss, which concerns the IRS as to the validity of the transaction being considered insurance.”

Proceed with caution

Risk pools can be a beneficial way to spread risk across multiple members and provide insurance savings, Towle adds. However, it’s an arrangement you need to enter with your eyes open.

“Companies should conduct their due diligence early and understand the nuances and entry and exit requirements for the pools,” she says.

Sandra Fenters, president of Capterra Risk Solutions, agrees that a risk pool should be entered into only after careful research and consideration.

“What you’re essentially trying to do is diversify your risk portfolio on your balance sheet through sharing risk with similarly situated clients—so it is important to understand who you are sharing risk with and what types of risk you are sharing,” she says.

While the benefits are not in doubt, there are further reasons to proceed with caution.

“The IRS is currently auditing several risk pools, captives and managers who have facilitated and have accessed risk pools to achieve third party risk distribution,” says Towle.

“It may be some time yet before the IRS has developed its conclusions and releases guidance for the use of risk pools with regard to captives. Companies should exercise both caution and due diligence with exploring the use of a risk pool to validate risk distribution for their captive.”