Don’t Let Old Guard Thinking Choke Off Profits In Your Captive Strategy
By Sean G. King, JD, CPA, MAcc
Principal, In-House Counsel, CIC Services, LLC
Over our 10+ year history in the Captive Insurance world, it’s become apparent that there are essentially two factions of “professionals” providing services to the industry. We’ve affectionately dubbed these two divisions the “Old Guard” and the “New Wave.” This article takes a closer look at the two sides in an effort to give “outsiders” some background and perspective on the industry.
Political History of Captives Part 1—The Old Guard
For decades the captive insurance company industry was tiny, exclusive, relatively unknown, and controlled by a handful of specialist attorneys, actuaries and captive managers (the “Old Guard”). This Old Guard was seemingly diverse on the surface but generally had a few important things in common:
First, they were fortunate enough to work in an industry that required highly specialized knowledge and, therefore, had inherent barriers to entry. Captive attorney Jay Adkisson, who is not a tax attorney, famously noted in his 2006 book titled Adkisson’s Captive Insurance Companies that, at the time it was published, there were probably only a half dozen competent captive attorneys in the country. Jay was probably wrong on that count (Jay is renowned for self-serving statements of hyperbole, and there were probably a couple dozen or more competent captive attorneys in the country even then), but his broader point, that the Old Guard was quite small in number, was spot on.
Second, due to these barriers to entry, the cost of forming and managing captives back then was quite high (at least by today’s standards). Consequently, the client businesses of the Old Guard were primarily large, sophisticated, “corporate”, and wealthy. Essentially, captives were niche market product that appealed to a limited clientele, and the Old Guard rather liked it that way.
Third, the combination of high barriers to entry for competing professionals and a sophisticated clientele meant that the Old Guard had to do very little by way of marketing. Essentially, prior to the early to mid 2000’s, anyone wanting to form a captive had to go to, and through, them. They were the “gatekeepers” to the captive industry.
The common business factors noted above caused the Old Guard, even though they competed among themselves, to develop similar ways of doing business (no collusion required) and a certain shared view of the industry.
For instance, because they had little need to actively market their services to the public on a wide scale, they never became great communicators or evangelists for captives. In fact, rather than trying to help the public and other professionals really understand how captives work, and how simple they are to own and operate (no more difficult than, say, a defined benefit pension plan in many cases), they were motivated to do just the opposite–that is, to make doing a captive sound as complex and technical as possible, sometimes even scary, thereby reaffirming the importance of their role as gatekeepers and making the barriers to entry for any prospective competition seem impenetrable.
Partly for this reason, the Old Guard came to look with disdain upon anyone actively marketing captives to the general public, especially anyone who effectively communicated just how approachable captives really are, or at least can be.
Additionally, because of their common backgrounds (law, actuarial studies, and P&C insurance primarily), they tended to focus upon the “liability” side of the captive equation rather than the “asset” side. That is, their work focused almost exclusively upon risk management aspects of a captive—that is, pricing the policies issued by the captive, calculating the captive’s reserves and potential liabilities, paying claims, etc., and they almost completely ignored the other side of the balance sheet—that is, how given captive might manage its assets so as to best support it’s long-term claims-paying ability and support its profitability. This is some what strange since “real” independent insurance companies give asset management at least as much attention as liability management and underwriting.
Political History of Captives Part 2—The New Wave
Then, starting in the early to mid-2000’s, the captive industry began to experience rapid changes that, over time, tended to undermine the gatekeeper role of the Old Guard. First, inspired by the success of Vermont in attracting captive business to the state in the 1990’s, other states and some foreign jurisdictions started to compete heavily for captive business. Whereas only a dozen or so states and a limited number of foreign jurisdictions actively licensed captive insurance companies prior to the mid-2000’s, and even fewer were truly “captive friendly”, today at least twenty-six states, the District of Columbia, and a great many foreign jurisdictions compete to be the most accommodating for licensing and regulating captives. As a result, lawyers, CPA’s and other professionals in each of these jurisdictions have become increasingly familiar and competent at forming and managing captives, expanding greatly the public’s access to them, and thereby diminishing the influence of the Old Guard.
Second, due to this new competition among licensing jurisdictions and their respective professionals, the cost of setting up and operating captives dropped precipitously beginning in the early to mid 2000’s. Whereas as recently as the mid to late 1990’s setting up a captive required a prospective client to make an initial capital contribution of as much as $1 million cash just to get licensed, and also to incur set-up costs of as much as a $225 thousand dollars or more, and ongoing operating costs in excess of $100 thousand per year, today’s captive can be established and licensed with capital and costs of only a fraction of these amounts. This too greatly expanded the public’s access to captives, and made captives economical and appealing to smaller and smaller businesses. Much to the chagrin of some in the Old Guard, doing a captive was on the cusp of becoming “turnkey”, just like doing a qualified plan had been for decades.
As the assets inside of captives began to grow exponentially during the 2000’s, captive insurance companies finally started gaining the attention of financial professionals–people who manage assets. For the first time, the asset side of the captive equation—that is, how the captive manages its assets—began to get specialized attention. These financial professionals, the “New Wave” as I call them, had a few things in common:
First, they realized that how the captive deploys its assets is at least as important to its long-term profitability as how it manages its liabilities, and maybe more so. Prior to the New Wave’s involvement, captive assets were often just kept in simple interest-bearing bank accounts (back when one could actually earn some interest on such accounts), loaned back to the insured operating business (where they could theoretically be deployed at a higher expected ROI), otherwise used to purchase assets (often illiquid ones) that benefited (or could be leased back to) the insured operating business, or plopped into some managed account with little regard to matching assets and liabilities. These arrangements often resulted in the captive sitting on “lazy money” or investing in illiquid assets without sufficient regard to the claims-paying ability of the captive or to the tax implications of the investment activity.
Second, the New Wave, unlike the Old Guard, was accustomed to working with the retail public, primarily small businesses and their owners who made up a significant portion of their pre-existing client base. As such, they were generally excellent communicators—experts at describing complex arrangements (like qualified retirement plans, for example) in ways that their clients could understand and easily act upon. And, they were often expert marketers and salespersons, having come from an industry (financial services) where sales and marketing skills are paramount. These communication and marketing talents, combined with an existing base of prospective captive clients, proved particularly beneficial to the New Wave. Where the Old Guard had often previously engaged in intentional obfuscation and delighted in complexity, the New Wave promoted illumination and demonstrated simplicity, therefore accounting for an increasing percentage of captive “sales”.
Third, some in the New Wave, or at least many of the more successful ones, had significant experience managing assets for highly regulated entities such as pension plans, banks, non-qualified deferred compensation plans, and the like. Captives, likewise being regulated, were therefore a natural fit for their expertise, and an untapped market, for their services.
Thus, the most successful of the New Wave often had significant advanced financial planning experience. Successful financial professionals, in general, have excellent marketing and networking skills, are highly effective communicators, understand the asset side of the captive equation, appreciate the risk management benefits of a captive, have experience with similar industries, and are highly compensated for the work they do.
In short, top financial professionals represent one of the most well trained and highest paid sales forces in the country, and they and their allies quickly began to take captive market share from the Old Guard starting in the mid-2000’s for the reasons noted above.
Political History of Captives Part 3—The Old Guard Reacts
The reaction of the Old Guard has been predictable.
Any business model losing market share to competitors generally typically resorts to four defenses: First, it tries to differentiate itself from the up-and-comers, usually based upon its “superior” knowledge and experience. Ideally, this is a positive differentiation; with the defensive business model touting it’s superior market share and years of service. From a marketing strategy perspective, the idea is to differentiate itself from its up-and-comer competitors without actually acknowledging their existence. “Let’s not give them anymore attention than they deserve”, is the general theme of the defensive strategy. One is reminded of Microsoft’s refusal to mind Apple for years.
But, when the business model under attack has inferior communication and marketing skills, as the Old Guard does, positive differentiation often fails. When it does, the failing business model usually resorts to “negative differentiation”, also known as ridicule. Rather than highlighting its superior experience and market share in a positive way, the failing model begins to attack the relative “inexperience” of the “small-time” up-and-comers. Just Google “Steve Balmer Apple quotes” to see what this looks like first hand.
And, when negative differentiation fails to stem the tide, the failing model resorts to intimidation and scare tactics. Specifically, it tries to scare the public away from working with the up-and-comers by implying, or in some cases outright stating, that the “newbies” don’t know what they are doing and, at best, will sell you an inferior product or, at worst, will subject to you fines, penalties, and maybe even prison! Witness, for example, this article by Jay Adkisson.
And finally, if scare tactics fail to break the approaching tidal wave, the worst of them appeal for regulation. Specifically, they attempt to position themselves with regulators as the “good guys” and their competitors as “rouges” or “promoters” whose “schemes” endanger the public, or even the republic, and who must therefore be brought to heel via increased oversight, scrutiny and regulation. In short, in a last desperate attempt to defend their falling barriers to entry, they invite regulation of their industry believing, often incorrectly, that such regulation will protect them from their new competitors (think Atlas Shrugged).
Political History of Captives—Takeaways
Regardless of where you fall in the debate between the Old Guard and New Wave, there’s no arguing that when formed for the proper reasons, captives are incredible risk management vehicles. But risk management is only part of the story. The key is finding a captive manager who understands the importance of both sides of the captive’s balance sheet, and pays each side their due justice. Managers who are hyper-focused on the liability side could cause the captive owner to leave thousands, if not millions of dollars on the table. Likewise, managers who concentrate all their efforts on the asset side may expose the captive owner to additional risks and scrutiny.