The Malaise of the Middle Market

In recent years the IRS has been victorious in three notable captive cases: Avrahami, Syzygy and Reserve Mechanical. Based on the fact patterns in each case a seasoned captive professional would not have been surprised by the outcome. The continued failure in court is leading to a malaise for captives serving the middle market.

Too many non-insurance professionals, it seems, drive captive transactions that are influenced by things other than risk. They are usually CPAs or lawyers, who are aware of the tax benefits available to captive insurance companies and who rely on form at the expense of substance.

Captive owners can also be at fault and may be swayed by the potential tax benefits and may be complicit in the scheme by taking out insurance that is not needed or which is egregiously priced to maximize tax benefits.

Why have these problems only affected the middle market? That answer is simple; the middle market has an extremely beneficial tax option available to them. Take advantage of this at your peril unless you and your advisors are doing things for the right reasons.

Tax and The Insurance Manager

Taxation should not be a consideration for a captive manager or advisor. The captive manager has at its core some basic responsibilities that make up the basic expectations of an insurance company:

• Make sure that the transactions involve risk transfer,

• Consider the portfolio of risk accepted by the captive represents risk distribution, and

• Ensure that the captive acts like an insurance company and stays in regulatory compliance.

The insurance manager should concentrate on insurance and regulatory compliance. If an insurance manager is happy to talk tax strategies that is the simplest reason why a client should run away from them as fast as possible.

The insurance manager’s focus should be on insurance and if the captive owner wants tax advice, then they should speak to an independent tax advisor. If the client wants to take a particular tax strategy, then that has nothing to do with the insurance manager other than as a bookkeeping function after the fact.

Pooling

A risk pool is often at the heart of what many middle market insurance managers provide and was prominent in each of Avrahami, Syzygy and Reserve Mechanical.

If a pooling structure is provided by an insurance manager, it should focus on real risk, helping with risk distribution and limiting fluctuations in underwriting result. This can help greatly with capital requirements.

One of the ways that insurance managers convince business owners, particularly in the middle market, that a captive is a simple decision and tax compliant is by using a pooling structure. The pooling structure purports to offer a way for the captive to enjoy sufficient risk distribution. Risk distribution, otherwise known as the law of large numbers, is the basic premise for an insurance company and is one of the key requirements for a captive insurance company to be considered an insurance company by the IRS.

My experience with pools is that often form usually exceeds substance. I have witnessed many pool structures that are offered as “one size fits all” but I have never found one that does. Many have critical failings that negate risk transfer, others do not have equitable splits between reinsurance layer premiums, definitive actuarial support can be rare and very few have the level of transparency that allows the captive client to understand whose risk they are taking on. A great deal of trust is placed in the insurance manager for such structures and that is often made easier by the pool miraculously having a very low loss ratio. This should be a huge red flag for any captive client.

Why have these problems only affected the middle market? That answer is simple; the middle market has an extremely beneficial tax option available to them. Take advantage of this at your peril unless you and your advisors are doing things for the right reasons.

The risk pool must also meet the three pillars of an insurance company: risk transfer, risk distribution and act like an insurance company. Fails one test and the pool is compromised.

A good captive client will make sure that they understand:

• how the pool functions,

• criteria for being a member,

• the nature of the risks in which they are participating,

• how premiums are established,

• the losses that they must pay, and

• the actuarial back up to support the structure

If your insurance manager is not able to provide this information, then avoid the pool and avoid the manager. If the manager does provide this information, it is a good idea to share the information with your tax advisor.

What A Captive Client Should Look For.

Avoiding obvious pitfalls can be relatively easy but they can be time consuming; however, the captive client will be rewarded and will be able get the most out of their captive. Here are a few things that they should look for:

Focus on Risk. The captive client should work with the captive manager to identify and understand their own risk and what makes sense to put into a captive. Work with the manager and actuary to evaluate the most cost-effective way to manage your risk. The captive may not always be best. Work with a manager willing to work with your insurance broker to minimize your cost of risk and dovetail the approach to risk transfer.

Empowerment. A function of the insurance manager is to empower the client to make the best decisions possible by providing data and explaining their suggestions or recommendations. That includes data relating to

• Actuarial reports

• Pooling structures

• Claims settlements and reinsurance cession statements

• Risk distribution

• Regulatory filings

Documentation. An insurance company produces insurance policies, enters into reinsurance agreements and claim settlement agreements. Make sure that the documents correctly note names, addresses, amounts, limits etc... Make sure that your regulatory filings are correct. Make sure that your insurance manager provides documentation in good time and that they maintain a library of all your pertinent documents.

Teamwork. The insurance manager will include a larger team that will include claims adjuster, underwriters, actuaries, regulatory compliance and corporate specialists. Understand who your team is and what their abilities are. You are engaging the team so be prepared to know them all and their capabilities.

In short, captives when done correctly are a great way for middle market companies to finance risk. The captive client must make sure that there is real substance, that there is a legal form to the captive arrangements and that the captive manager will deliver a risk focused service. And never take tax advice from your insurance manager.

Greg Taylor

CEO

Albion Risk Consulting, S.A.