Much of the growth of the captive insurance industry is being driven by micro-captives, the type that serve small and mid-market businesses. And, some of that growth has resulted from increased use of “cell” captive structures—protected cell captives, incorporated cell captives, series cell captives and other varieties of cells.
What is a cell captive? Cell captives take different forms, but in essence they involve a group of related or unrelated people working together to share certain costs and benefits of owning captive insurance companies. They involve (essentially) purchasing your own segregated piece, or “cell”, of an existing captive insurance company. They are often positioned as a very low cost way for a small or mid-market business to benefit from captive ownership.
The alternative to participating in a cell captive is to instead form a free-standing captive under the exclusive control of the interested business owner, often called a “pure” captive.
We liken the decision between participating in a cell captive and forming one’s own free-standing pure captive to the decision between purchasing a condominium to live in or building a free-standing home. Condos definitely have important advantages, primarily spreading certain ongoing costs of home ownership (for instance, insurance, yard and grounds maintenance, trash collection, etc.) among multiple owners who come together for a common purpose. Additionally, one can usually purchase a condo for less than one could a free-standing home of identical square footage, primarily because certain construction and formation costs are eliminated or more broadly spread and because condominiums are more standardized and less customized. For instance, one might construct a dozen condos under a single roof, each with an identical or similar layout, and this is obviously less expensive than building out twelve separate roofs for twelve separate free-standing homes of equal size but varying designs.
But…and this is a big “but”…condos often have significant disadvantages versus owning a free-standing home. With a condo, your neighbors are much closer and more “in your face”. That’s great if you happen to have lovely neighbors, but…what if you don’t? And, those neighbors can change over time, and this is completely beyond your control.
And, what if your neighbor, unknown to you, operates a meth lab next door? You could be exposed to toxic fumes, or your condo could be damaged in a fire/explosion that was too big to contain. Fire walls between condos are designed to help contain fires within a given development, but they are far from perfect and fires often spread between condo units much more readily than between free-standing homes.
Additionally, condo association dues, designed to cover “common” costs, can be raised without the consent of any given owner. And, once raised, it’s not exactly easy for a protesting condo owner to just abandon his/her condo and move to another. “Unwinding” a condo relationship can be cumbersome.
By contrast, free-standing homes, while more expensive, are much more flexible, and are usually therefore preferred by those who can afford them. When you own your own home, you can design it as you see fit, build onto it whenever you want, or tear part of it down on a whim. You get to pick your own plot of land. You can negotiate with service providers (for instance, your trash or lawn service) to achieve terms satisfactory to you. A fire in your neighbor’s house two doors down is little threat to your home. And, if you don’t like your neighbors, at least they are much further away from you.
A cell captive is more like a condo because, with a cell captive, your “cell” is legally and contractually “linked” to various others, like a condo unit is linked to its neighbor units. You usually won’t have any say in who your fellow cell mates are, and some of them might behave in dangerous ways unknown to you. For instance, some related cells might insure risks that you’d never even consider assuming, or they might engage in very aggressive tax practices that are likely to earn the ire of the Internal Revenue Service.
True, there are legal “firewalls” (“protected cells” and “incorporated cells”) designed to insulate your cell from exposure to the risks of others, but like with a condo, firewalls are not failsafe. There are at least two ways in which such firewalls have been known to fail.
The most pressing is the risk of IRS audit and defense cost contagion. If one of your cell mates has their cell captive audited, the IRS is almost certainly going to learn that such a cell is only one of a great many cells (condos) in the overall structure (building). It will also learn that a great many (if not all) of those cells (condos) are managed by the same captive manager (condo association). Thus, if one cell is “bad” or overly aggressive, might they not all be?
The IRS will certainly want to know the answer to that question, meaning that, essentially, the chances of your captive being audited increases in direct proportion to the number of cells in your overall cell captive structure.
Champions of cell captives often emphasize how many cells are in their structure, on the theory that more captives makes the structure more credible. However, it also makes it exponentially more susceptible to audit contagion, something that prospective owners rarely consider.
Even if you have operated your cell captive in perfect compliance with all tax laws, there’s still reason to dread an audit. Audits are stressful, a tremendous hassle, and are costly to defend. And they can be significantly more expensive to defend when your captive is part of a cell structure. Here’s why:
Assume a cell structure with 30 “independent” cells. After auditing a few cells and finding at least one “bad actor”, the IRS decides to audit them all. That’s 30 captives now being audited, each with their own CPA and potentially their own legal representation. When the Service demands information from each cell captive, the relevant CPAs and/or attorneys who serve each cell are going to want to coordinate their efforts to ensure consistent and accurate responses (since inconsistent or inaccurate responses by one of the cells could cause the IRS to second-guess or ask more questions of other cells). How do they ensure consistent and accurate responses? They have a lot of conference calls, emails, and other communications. Imagine the cost of 30 plus different CPAs/attorneys, each billing by the hour and each representing a different “cell”, trying to coordinate their responses to a 40 question (each with multiple parts) Information Document Request (IDR) from the IRS.
As you can see, defense costs in a cell structure multiply exponentially, often to the point that defending the captive is no longer an option, and the only “rational” course of action is to acquiesce to the Service’s sometimes unreasonable demands, even if one’s captive is, in fact, perfectly legitimate.
Advocates of cell captives often argue that this problem (cost contagion) is easily resolved by having all cells agree to common representation, so that one CPA or attorney represents all cells before the IRS. But, in actuality, this does little to solve the problem. First, getting such agreement from 30 unrelated business owners isn’t often easy and is sometimes impossible. Second, whichever CPA or attorney is chosen for the representation will likely have little or no knowledge of most of the cells and their related insureds. Consequently, the “common” or “shared” advocate will have to spend a significant amount of time getting to know and understand the unique characteristics of each captive insurance arrangement. This can take as much time, if not more time, than simply having each cell use their own attorney and CPA, laboring to coordinate responses as needed.
Another way firewalls between cells have been known to fail is that the contractual obligations of one cell can, under some circumstances and in some jurisdictions, become obligations of another cell (perhaps yours). While this is not supposed to happen (state law usually provides that the liabilities of each cell are independent of each other), courts haven’t always interpreted things that way. See, for instance, this case from Montana:
Even the most ardent proponents of cell captives admit that there is very little court precedent supporting the idea that the obligations of one cell are legally fire-walled from those of another in every instance. They should be in theory given the statutes in question, but as Yogi Berra once said: “In theory there’s no difference between theory and practice, but in practice there often is.”
In conclusion, cell captives, just like condos, have their place in the world. For example, where all cells in a given structure insure primarily a single insured or a group of related insureds, their pros are compelling and their cons are few. And, even when that’s not the case, cell captives are a good solution for small businesses that simply can’t afford their own free-standing captive, just as condos are a good option for homeowners who can’t afford to build their own free-standing home.
But, in our view, businesses that can afford their own free-standing captive should far more often than not choose that option over a cell captive structure. At a minimum, they need to be aware of the risks and dangers of a cell captive structure along with the benefits before making an educated decision.