Risk Distribution and the Middle Market

In recent tax law cases involving captives serving middle market businesses risk distribution was an aspect that proved detrimental to the taxpayer’s case. In each of the cases the insurance manager had introduced the captive to a risk pool that did not provide risk distribution as was hoped. In this blog I wish to look at risk distribution so that those with a captive or those considering a captive have a basic understanding of the concept of risk distribution for captive insurance companies.

Risk distribution is a fundamental component of an insurance company. It is the law of large numbers that allows the insurer to withstand unexpected adverse losses over a large portfolio of insurance policies. Another way to consider it is that given a large enough number of risks within a portfolio and a set period of time the underwriting results will trend towards what is actuarially predicted. As well as being the basis of a successful insurance company the courts have also considered that risk distribution to be central, at least in part, to the argument as to what, in terms of taxation, is an insurance company.

Whilst we can discuss what constitutes sufficient risk distribution, and certain actuarial studies have looked to establish models, the courts have not provided solid guidance although multiple independent risk units seem to be a developing focus.

While the courts have not provided specific expectations the IRS has been more forthcoming with safe harbors in the form of Revenue Ruling 2002-89 & 90. These rulings relate to having more than 50% of third-party business and multiple entities that are geographically diverse as a way to have sufficient risk distribution.

Prior to these revenue rulings many captive practitioners, especially those serving the middle market, would look to the Harpers case to determine the amount of third-party business, that was required to meet risk distribution needs. In that case between 28% and 33% of business was derived from third parties. However, many simplified the ruling in Harpers to solely focus on third party business and ignored the other facts in the case that included thousands of independent risk exposures; Some insurance managers still do.

Risk Pools

Post 2002-89 many middle market captive managers developed risk pools as a way to provide clients a way to meet that safe harbor. The idea was simple: get different clients to insure certain risks of other clients. On the face of it that may work, however, for some managers form was far more important than substance.

Most middle market managers will rely on risk pools to convince a business to establish a captive. They will often be convincing that the risk pool meets safe harbors or case law expectations for risk distribution. By now, the message should be clear: Do not take the tax advice from your insurance manager. If you are going to be part of a risk pool, seek independent tax advice as to whether it is likely to provide sufficient risk distribution.

I have come across many risk pools in my time serving the middle market. In recent middle market captive case law there were issues with the pool arrangements and there was no or insufficient risk distribution. Here are a few of the issues that I have seen:

• Premiums. Premiums must be determined at arms-length and ideally be supported with an actuarial pricing report. Remember that risk distribution is there to help underwriting result trend to expected losses. If your actuary is pricing your policies with a 60% or 70% expected loss ratio how can the pool loss ratio keep being single figures? It seems a good argument that premiums may be overstated. Find out how the premiums are established, both initially and as part of the renewal process, and always ask to see your actuarial pricing reports. If you don’t understand anything, make sure to ask your insurance manager to explain.

• Actuarial support. Historically very few risk pools had substantive actuarial support for their structure. Reinsurance splits seemed to be more designed with an outcome in mind rather than an equitable sharing. Make sure you review the actuarial support for the pooling structure and ask your insurance manager to explain everything.

• Equality. Every pool member must be treated the same in terms of standards. Typically, that means a definitive list of policies, limits and policy periods that may be considered. I have seen pools where premiums are seemingly established in multiple ways e.g. influenced by the policy holder, by non-insurance personnel and by different actuaries. That is not how commercial insurers operate and it should not be how a captive and pooling structure should work. Consistency of approach is essential so that everyone in the pool is treated equally. A captive client should expect one actuary to oversee all pool participants.

• Limits. I have seen pools writing risks such as deductible reimbursement where the captive is responsible for the first layer of risk, e.g., $25,000 of each and every loss, before the pool reinsurance kicks in. That isn’t a good structure where the deductible on the commercial policies that form the subject matter have deductibles of $25,000 or lower. I have also seen pool structures where premium allocation for pooled layers are close to the limits they offer negating risk transfer.

• Unneeded policies. A captive should only be used for risks that are part of your risk management needs. However, some captive owners take out policies that are not needed because of the benefit (other than coverage) they can bring, especially where premiums are, shall we say, enhanced. This helps the pool because there is more risk seemingly placed into the pool. However, where there is no need for the coverage these unneeded policies undermine the substance of the pool and can lead to low loss ratios.

• Non-insurance. I quite often see risks that are pooled that are pure business risks and not insurable risks. Obviously, if it is not insurance then that compromises the whole captive arrangement including the pool that the risk becomes a part.

• Wordings. A pool requires a legal agreement whether it is a shareholder, reinsurance or sharing agreement dependent upon the structure of the captive. They need to be specific as to the process. Most are very well written; however, I have also seen some that are vague and lacking in definition. An independent legal opinion on the agreement is a very good idea.

• Withheld premiums. Most pools these days require that the premium associated with the risks that are pooled be withheld by the pooling structure as collateral to pay losses. Some pools have low or no withheld premiums. In a commercial setting collateral would be required. The courts have similarly considered this a poor feature for a pool. If the pool you are participating in or that you are considering becoming a part does not require withheld premiums, then ask yourself how easy it will be for a loss that you suffer to be paid.

• Loss ratios. Many pools have very low loss ratios. I have heard managers explain that away as not atypical because covers offered by commercial insurers such as Title insurance have next to no losses. However, captive covers are not title insurance. Again, remember that risk distribution is there to help underwriting result trend to expected losses. If your actuary is pricing your policies with a 60% or 70% expected loss ratio how can the pool loss ratio keep being single figures? Something would seem to be amiss.

• Reporting. Commercial insurance arrangements involving reinsurance structures commonly involve the lead insurer providing what are known as cession statements to their reinsurers. These cession statements, usually issued monthly, provide the reinsurers with basic performance details of the risks that they have signed up for. Whilst rare, I have witnessed pooling arrangements where no information, particularly relating to losses that are reinsured, is sent to participants. It is as if the participants are not bothered if they have suffered a significant loss or not and can undermine the validity of the reinsurance arrangements. At a minimum captives should expect quarterly cession statements from the pool.

Risk pools are complex, and they require a great deal of thought and ongoing attention, but they can be a great way to diversify the risks faced by a captive and help with risk distribution when done correctly. This takes a risk-centric approach and a manager with insurance and reinsurance expertise.

If you want to know if the pool delivers what it purports to, do not take your insurance manager’s opinion as gospel; always seek independent advice.

Alternatives to Pooling

Many managers will offer a risk pool when other ways to meet risk distribution are available. Looking at alternatives needs a more risk-based approach to structuring the captive and of course it means the manager loses out on pooling fees. This is despite the three major recent legal cases centering on pooling and the IRS focusing on risk pools. Clients in the middle market deserve better and they should be asking their insurance manager for alternatives to risk pooling.

Multiple entities

Following on from several legal cases that involved multiple entities, particularly Kidde and Humana the IRS issues Revenue Ruling 2002-90. In that ruling 12 brother sister entities, in geographically diverse locations and with each entity operating in an unrelated manner, each insure their professional indemnity insurance with the captive. None of the operating subsidiaries have liability coverage for less than 5%, nor more than 15%, of the total risk insured. This ruling provided captives with an option to consider risk distribution in terms of the number of brother / sister entities as long as there was not a great diversity of insured risk within the group. If you have a large number of operating entities located in multiple states this may be something to think about when considering risk distribution.

Independent risk exposures

In many court cases involving captive arrangements the courts have often mentioned the concept of independent risk exposures. In Rent-A-Center the captive issued workers compensation insurance covering the 14,000 employees, auto liability covering 7,000 vehicles and general liability covering 2500 stores. In Rent-A-Center the court found that, whilst not focusing on the amount of risk faced by one insured, there was sufficient risk distribution arising from the number of independent risk exposures.

The courts have not defined what constitutes the threshold of acceptable independent risk exposures. Some actuaries are developing methodologies to consider ways to examine the level of diversity required for a set of individual risk units in order to reduce volatility of aggregate expected losses in adverse scenarios. This is a developing concept but hopefully a standard can be developed in order to have greater certainty that required risk distribution levels are met.

If a business has large number of individual risk exposures that may come from such things as employees, properties, customers, vehicles etc. then this may be something for the captive manager to consider when developing captive options

Non pooled third-party risk

Whilst the risk pool is a very common way to secure third party risk into the captive arrangements there remain many other ways for the captive to participate in third-party risk. For example, a property owner with enough tenants may work with a fronting carrier to provide their tenants with renters insurance and the front can reinsure back to the captive. Other commonly seen arrangements include property damage waiver programs, warranties, and subcontractor default insurance.

Selling insurance to customers and key partners can bring in welcome third-party income but it does have its own issues particularly relating to captive insurance regulations and procurement.

The captive client should discuss opportunities with their insurance manager to see if there are options to cover third party risks.

Conclusion

Risk distribution is fundamental to a successful insurance company. It is a complex concept with few defined expectations. Choosing a risk focused insurance manager that can provide guidance and opportunities for risk distribution is key to a successful captive.

Participation in a risk pool can be a good way to share risk with others but there are pitfalls when not done correctly. Be wary of an insurance manager who immediately suggests a risk pool. An in-depth evaluation of the risk pool should be conducted before anyone becomes a participant. Alternative ways for the captive to demonstrate risk distribution and diversify risk may be available; a good insurance manager will highlight options.

Finally, any business considering whether their captive has sufficient risk distribution should seek the advice of an independent legal professional.

If you have any concerns regarding your captive insurance arrangements or are interested in considering a captive as a way to finance the risks faced by your organization, please contact Albion Risk.

Greg Taylor

CEO

Albion Risk Consulting.