The Changing Face of Middle Market Captives

Captives have been around for many years, and they will continue to provide risk management benefits to their owners long into the future. However, there is one area where things look like they will be changing very soon and that is the so-called micro-captive.

With commercial insurance premiums increasing by 9.3% so far in 2023 and more hurt to come for consumers, the middle market continues to need captive options.

If micro-captives are no longer a viable option what can a middle market business do in order to take greater control of their own risk financing needs?

In this paper I will talk about standard captives and how they are still a wonderful option for the middle market wishing to reduce reliance on commercial insurance and the increases that are to come.

Micro-Captives - Proposed Changes by the IRS

After years of targeting micro-captives and those that promote them, the IRS issued IR 2023-74 in April that proposed changes to Micro-Captives under the 831(b) election that would identify transactions as Listed Transactions.

Where a transaction is a Listed Transaction the participants and material advisors in these transactions are required to disclose each reportable transaction on Form 8886 and are subject to penalties if there is a failure to disclose.

Not only can failing to disclose or register a listed transaction as required lead to adverse consequences but engaging in (or participating in) a listed transaction also significantly increases high-income taxpayers’ risk of facing an IRS audit of criminal tax fraud investigation.

There are certain exceptions to the proposed changes including one that stipulates that a captive with a loss ratio of 65% or more over the past 10 years is not subject to the change.

Many in the small captive space are seeing these proposed changes as a potential death knell for middle market pure captives.

Following IR2023-74 the IRS asked for comments and established a public meeting to discuss said changes. All comments were required by the IRS by June 12, 2023, and a public hearing in regard to these regulations took place on July 19, 2023. While Notice 2016-66 is obsolete, if the proposed regulations are finalized, taxpayers will have 90 days to file an updated Form 8886 disclosing the listed transaction to comply with the new regulations.

The final decision as to whether these proposed regulations are to be introduced by the IRS is awaited.

Standard Captives

The good news is that captive solutions are still going to be available for the middle market even if the IRS makes micro-captive transactions Listed Transactions.

Standard taxed captives can still provide all the core risk management benefits. However, for those who use their captive for wealth accretion rather than risk management the option will not be as attractive.

A standard taxed captive’s purpose must be a focus on risk. It should look at efficiencies that make the captive a far better option than commercial insurance. A business should only buy from their captive what you would otherwise buy from commercial insurer if it was available and cheaper.

A standard captive approach has previously been the purview of a limited few. However, by working with an informed insurance manager that provides a cost-effective service there is no reason why the middle market cannot continue to use a captive to meet risk management needs.

Standard Captive Benefits

The core benefits of a captive remain even with the reduced appeal of 831(b) elected captives. These include:

• Cost Reductions - By reducing the reliance on commercial insurers, and instead placing risk within a captive, less premium is paid to external commercial insurers and any profitability from underwriting activities remains within the same economic family.

• Availability of Cover - Certain types of coverage are unavailable or difficult to obtain because of such matters as historic loss experience or a change in the appetite of commercial insurers. By setting up a captive, an organization can insure these risks within their own insurance company that might include such things as wage & hour, cyber threat from a state sponsored entity, construction defect, supply chain and so much more.

• Risk Management and Underwriting Profitability - Conventional insurance is typically on a guaranteed cost basis and there can be little incentive to improve risk management as there is no participation in the profitability of the insurance program. However, with a captive insurance company the parent can benefit from good claims experience. A captive can therefore provide a great incentive to improve a risk management philosophy throughout an organization. In addition, the captive will maintain detailed records of losses that will highlight a needed focus for risk management purposes.

• Cash Flow Benefits – Without insurance a business will pay for losses from cashflow. When unexpected events occur that can put significant strains on cashflow. A captive provides a way to better manage the cashflow by the payment of premiums and the building up surplus to meet those unexpected events.

• Underwriting Stability - A captive insurance company is less vulnerable to the cyclical nature insurance pricing. This is certainly pertinent now given a hard insurance cycle coupled with a difficult economy.

• Reinsurance - Reinsurance is insurance that is only available to insurance and reinsurance companies, including captives.

In addition to these core benefits there are also certain tax benefits. Of note may be the accelerated tax benefit for claims occurring coverage that had a long tail to claims reporting and settlement such as Workers' Compensation, General Liability, Auto Liability and Construction Defect risks.

Accelerated tax benefit looks at timing differential between the premium payment and how claims are reserved within the captive. Where there is a longer tail exposure there is greater deferment of tax liability. The time cost of money during this deferment may provide significant economic benefit as compared to self-insurance.

Indeed, with accounting for loss, plus the accelerated tax benefit some captives would be better off by being taxed in a standard manner than as a micro-captive.

Most successful standard captives have as their core lines long tail risks because of the accelerated tax benefits that are afforded insurance companies, albeit that those tax benefits should never be the principal reason that the captive exists.

Insurance Broker Liaison

The need for efficiencies requires that evaluation of alternative options is conducted. This is why an independent insurance manager should look to work closely with a business’s insurance broker.

The broker will understand a client’s insurance needs and how the insurance market can or cannot respond to them. They will understand the pricing options for different commercial insurance programs.

The insurance manager, in consultation with the insurance broker, can evaluate options to fill gaps or demonstrate greater economic efficiencies by utilizing a captive.

By working together, the optimal blend of commercial, captive and self-insurance can be established to reduce a client’s total cost of risk.

Property Insurance

The brunt of premium increases in recent times has focused on property insurance. Despite the increases of the past few years there is undoubtedly more pain to come particularly in areas exposures to NatCat.

Captives have often struggled to use captives for property risks because of the capital needs as well as bank or lender interests. However, captives can help by taking a structured approach. A starting point may be taking on large deductibles and building up surplus in the captive to take on greater risk over time. If greater investment in the captive is an option, then greater property limits can be accepted. By working with an insurance broker your insurance manager can provide you with options.

Group Captive Alternatives

Brokers have long promoted group captives, particularly for casualty and healthcare programs. Whilst these may be valuable options for middle-market companies there may be greater benefit of looking at a single parent captive for some, particularly those with higher premiums. Each group program will have administration and capital costs and is limited to specific risks. By looking at a single parent captive a business may reduce the administration costs as well as being able to look at more lines of insurance. A single parent captive provides greater control that means a better risk management tool.

Working with an insurance broker and insurance manager that puts the client in control is increasingly important.

Risk Distribution

Risk distribution is a fundamental tenet of insurance and one that is applied to determine if a company acts as an insurer.

Insurance operates successfully when it is subject to the law of large numbers; As the number of exposure units increases, then the probability is higher that the actual loss will equal the actuarially determined expected loss. Simply put, where the law of large numbers applies the results from a portfolio of insurance is more predictable.

Many micro-captives have relied upon risk pools that share risk between many unrelated parties to establish a level of risk distribution. Many of these pools relied on insurance policies based upon remote risk scenarios to make the pool viable and the result was typically a low loss ratio. This suited the captive owners who sought wealth accretion as a reason to have their captive. Without the 831(b) election this may make less sense as a move to a true risk management need replaces the risk management want.

With the changes to 831(b) reporting the number of participants in these pooling structures is expected to reduce greatly thereby reducing the level of risk distribution. There is an expectation that the risk pools of the past may no longer be available to meet the diversification that captives need.

That will mean that captives, moving forward, will not be so universally available for middle market companies. Inherent risk distribution within the business’s operational set up will be far more important in order to have a successful captive, although some pooling may still be available.

Without a risk pool a captive manager who understands risk distribution is going to be a “must have” for captive owners.

Getting Started – The Feasibility Study

For many micro-captives the feasibility study in the past has been a fait accompli. The insurance manager would have just provided a basic actuarial report to show that the company was feasible with very little discussion needed. The tax benefit of the micro-captive appeared so obvious that all other aspects of the captive required less thought or scrutiny.

With a standard captive with a focus on risk and specific risk management needs, a far more detailed feasibility study is required. Any captive owner will expect their insurance manager to provide a detailed report that outlines:

• Business purpose,

• Captive structure,

• Insurance market outlook

• Regulatory, accounting and domicile analysis,

• Risk tolerance review

• Evaluation of commercial, captive and self-insured options

• Actuarial pricing and feasibility

• Findings and an action plan

The process to complete a feasibility will be consultative and will require input from many parties such as risk managers, accounting and insurance brokers needed by the captive manager.

The feasibility study should provide the prospective captive owner with an in-depth analysis to show the economic benefits and operational blueprint for success.

If a business works with an insurance manager just gives them an actuarial report, they should find a new insurance manager.

Overall

The apparent death knell for micro-captives does not mean that captive insurance for the middle market goes away.

The standard captive continues to provide all the core risk management benefits that a business needs as well as certain tax benefits that may be available.

With a far greater focus on risk and by working with a cost-effective captive manager who has an in-depth knowledge of captives and risk, the right company will benefit greatly from a standard captive.

With the hard market and significant turmoil, the time is ripe for middle market companies to seize the opportunity that a standard captive can bring now and into the future.

Take control of your risk environment and get in touch with Albion to see how we can help you.

Greg Taylor

Greg@albionrisk.com

August 2023.

Not legal advice: The content of this blog is provided for general information purposes only and does not constitute legal or other professional advice or an opinion of any kind. You are advised to seek specific legal counsel regarding any specific legal issues.