1 August 2019

Tax collectors will continue to eye captives, experts tell AM Best

Regulators should check risk retention groups (RRG) have a long term view of the risks of their members, and the ability to serve them long term, before allowing them to launch, according to Pamela Davis, president and CEO of the Nonprofits Insurance Alliance (NIA).

Speaking on a webinar hosted by AM Best on the state of the captives market, Davis said regulators had a responsibility to ensure RRGs are fit for purpose before they launch. This is preferable to allowing bad actors to launch companies that will fail to serve their members and undermine the reputation of the broader captives industry, she said.

It has been a year in which the reputation of the industry has been in the spotlight, with the IRS going after 831(b) captives and putting the structures on its dirty dozen list of the worst tax scams.

But Joel Chansky, consulting actuary at Milliman, pointed out that the US Congress has taken a friendlier stance towards them. In any tax years in which captives make premiums of $2.3 million or less they are not subject to federal income taxes on underwriting gains, up from a threshold of $1.2 million in 2016. This shows the government is not united against the industry, he said.

Still, captives must be prepared for aggressive actions from tax collectors and regulators, as evidenced by the Microsoft case in the State of Washington last year. The case saw Microsoft’s captive Cypress Insurance forced to pay the state $573,905 in unpaid premium taxes and $302,915 in interest and penalties. This could be the tip of the iceberg for the captive industry, warned Chansky.

“It is a big issue for the industry and creates the spectre of other states taking similar steps to tax captive premiums,” added Chansky.

However, none of this will undermine the business case for captives. Susan Molineux, director at AM Best, said its rated captive composite consistently outperformed the commercial composite because captives understand the risks of their owners better than commercial insurers do of the risks of their clients.

Davis said some commercial carriers are cancelling whole books of business, while increasing prices significantly for others, because they do not fully understand the risks involved.

“RRGs know their industries very well so they do not have to take this sledgehammer approach,” she said. “We don’t want to cut whole lines, we want to better understand risks and find other ways to manage them,” she said.

Davis said: “RRGs can’t insure every risk. But they can at least differentiate between a poorly priced risk and a bad business.”

They can do this because captives, and RRGs in particular, are the original innovators, said Davis. “They only exist because they felt there was a need, they were forced to get into the insurance business for self preservation,” she said.

She admitted the cost of technology remains a challenge for captives, but noted that NIA’s experience proved that even small companies can develop their own software if they put their minds to it. “The cost of investing in new technology is great but the cost of not keeping up with technology will be even greater,” she said.