By Sean G. King, JD, CPA, MAcc
Principal & In-House Counsel, CIC Services, LLC.
At its extremes, the captive insurance industry is currently divided into two camps. In recent years these two camps have made war on one another to their respective detriments. The purpose of this essay is to describe the two camps, elaborate on the origins of the war, forecast its inevitable outcome and call for a truce.
Right versus Left
The captive insurance industry was originally built by people who focused, of necessity, almost exclusively on the right side (the liability and equity side) of the captive insurance company’s balance sheet. These captive industry originators and their descendants were, and are primarily are today, risk management specialists, international property and casualty brokers, actuaries, and specialist lawyers, all of whom consider the “main” (and arguably the “only”) purpose of a captive insurance company to be the underwriting and issuance of policies, the payment of claims, and calculating actuarial reserves. To the extent that any of them make note of the left side (asset side) of a captive insurance company’s (“CIC’s”) balance sheet, it is mostly just to verify that the company is liquid and solvent.
For convenience, I will refer to this group of originators and their descendants–those who focus on the liability side of a captive’s balance sheet–as the “Old Guard”, partially out of deference to the fact that they “invented” the captive industry in the United States.
However, over the last decade, and particularly over the last five years, another group has entered the captive space, garnering a significant percentage of its growth. This group, like the Old Guard, has a strong (but different) background in risk management, consisting primarily of asset protection specialists, fiduciaries, wealth managers, financial planners, and life insurance producers. This “New Wave”, as I shall call them, is distinguished from the Old Guard primarily by the fact that the New Wave’s particular (though not exclusive) expertise is managing the left side (the asset side) of the company’s balance sheet and that they serve a different clientele (primarily small businesses).
Follow the Money
The sources of conflict between the two sides are multifaceted. The first and most obvious is simply the amount of success the New Wave has enjoyed in recent years, garnering most of the industry’s growth. The Old Guard is clearly frustrated by the arrival of a new competitor. In response, the New Wave points out that most of its traction has been with smaller businesses traditionally overlooked by the Old Guard. Consequently, the New Wave’s growth has not come at the Old Guard’s expense.
The second source of conflict is how each is paid. The Old Guard is compensated primarily (usually exclusively) on a fee-for-service basis for attending to the liability side of the captive’s balance sheet. By contrast, the New Wave charges similar but often lower fees for the same services. However, the New Wave is often also partially compensated, on either a fee-for-service or a commission basis, for attending to the asset side of the captive’s balance sheet. This disparity in methods and amounts of compensation leads to conflicting incentives, and provides each with an opportunity to disparage the other.
For example, the Old Guard, occasionally rightly, insists that, being motivated primarily by asset-based compensation, the New Wave neglects the liability side of the balance sheet, resulting in poorly-formed and operated captives that may not achieve the owner’s or business’s objectives and that may not withstand scrutiny by regulators or the IRS. Citing a few extreme examples of New Wave negligence, prominent Old Guard members have actively and publicly sought to sick regulators, especially the IRS, on the New Wave.
For instance, the Old Guard has argued to the public, IRS and regulators that the New Wave is primarily a bunch of “salespeople” and “promoters” who are helping clients set up sham captive insurance companies as a means of creating a tax-deductible investment portfolio. As evidence of this, the Old Guard points to the particular type of captive employed (831(b)’s typically), the types of risks these captives insure (often high impact but low frequency risks), and how the New Wave is paid.
The New Wave responds, mostly rightly, that any “real” insurance company must do an effective job at managing both sides of its balance sheet, and any “captive manager” worthy of the name should be capable of both. They note that large commercial insurance companies devote as many resources, and often more, to managing assets as to managing liabilities. The New Wave insists that, with a few notable exceptions often hyped by the Old Guard, it does not neglect the liability side of the balance sheet but rather, unlike the Old Guard, simply gives due regard to the asset side as well. It continues by noting that a great many captives managed by the New Wave have, in fact, survived IRS and regulator scrutiny. The New Wave insists that it is compensated appropriately (in accordance with industry customs), that the smaller companies it serves are not large enough to do the necessary asset management work in house like a commercial insurer would, that 831(b)’s are the only economically feasible way for smaller businesses to benefit from captives, and that the risks these captives insure are in fact very real and very relevant as evidenced by the government’s own website, ready.gov.
Endless debates over the above issues have ensued, many in the various LinkedIn Forums devoted to CICs.
History Repeats Itself
For those, like me, who have spent long enough working in the qualified retirement plan space, the captive industry turf war is “déjà vu all over again”.
Prior to the mid to late 1980’s, the qualified plan industry looked much like the captive industry does today: It was highly fragmented and was then dominated by technical experts who focused almost exclusively on the liability side of the retirement plan’s balance sheet—specialist attorneys, actuaries, and TPAs.
Anyone wanting to establish a plan needed then to consult expensive ERISA attorneys to obtain a custom-drafted plan document. The primary purpose of that document was to spell out in writing exactly who would be entitled to receive payments under the plan, how much, and when. Said another way, the language of the document determined the plan’s liabilities. It’s easy to see that these ERISA attorneys are analogous to today’s specialist captive attorneys, who draft the underlying policies that likewise determine the liabilities of the captive insurance company.
Then, once a qualified plan was finally established, the actuaries and TPAs took over. Like the captive actuary today, the purpose of the retirement plan actuary was to estimate, using actuarially-sound principles, the liabilities of the entity (the plan) at a given moment. And, like today’s captive manager, the role of the third-party administrator or record-keeper was to account for everything properly and to ensure that the plan is operated in compliance with the underlying documents and government regulations. These actuaries and TPAs were able to charge sizeable fees for their services, however the size of those fees meant that qualified plans were largely unused by many small and medium sized businesses.
With double-digit interest rates and a stock market that had gone nowhere fast for years, it’s not surprising, perhaps, that these technical qualified plan experts neglected the asset side of the retirement plan equation. Just how much it was neglected is evidenced by the fact that the dominant industry group was named the American Society of Pension Professionals and Actuaries (ASPPA). At that time, asset managers had little to no role in the organization.
Then, starting in the late 1980’s and early 1990’s, everything began to change in the qualified plan world. Bolstered by falling interest rates and a rising stock market, and seeing a large pool of neglected assets ripe for management, mutual fund companies and insurance companies—in other words, asset managers—entered the qualified plan space en masse. They created prototype plan documents that, for the first time, allowed even the smallest of businesses to easily and quickly establish a qualified plan without having to consult an expensive ERISA attorney first. The insurance companies employed a great many actuaries and, subsidized by asset management revenue, they began offering actuarial services to the public at greatly-discounted rates. Using new computer technology and software, both insurance companies and mutual fund companies developed scalable recordkeeping and administration platforms, and likewise offered these services to the public at rates the TPAs couldn’t easily match.
The result was decade or so of war and transition in the qualified plan industry, but even early on in the battle the eventual outcome was clear. With a broader and more diverse revenue streams, including asset management revenue, the insurance and mutual fund companies were able to provide the public with better and more turnkey qualified plan services at a lower cost. Increasingly, ERISA attorneys and actuaries and TPAs became employees of mutual fund companies, insurance companies and wealth management firms. But importantly, their careers were not destroyed. Far from it. As a result of huge growth in the industry fueled by the superior financial and marketing resources of the asset management firms, these actuaries, attorneys and record keepers were in greater demand than ever. Leveraging economies of scale and their more diverse revenue streams, their new employers actually paid better than their old ones.
Many in ASPPA initially resisted this transition. For years, ASPPA refused admittance to anyone who didn’t come from a “traditional” qualified plan technical background, or relegated them to subordinate levels of membership. Like today’s captive Old Guard, many in ASPPA called for regulation that would bar their new competitors, or at least put them at a severe disadvantage. However, as many of their old industry friends began to take new positions with the insurance and mutual fund companies, often with higher pay and more benefits, the hostility eventually waned. Today ASPPA actively recruits new members from among the asset management community, and its current President (and my long-time business partner), Kyla Keck, is employed by an asset management firm.
It is apparent that the captive industry is going through almost the exact same transition experienced by the qualified plan industry in the late 1980’s and 1990’s. And, it’s also apparent that the outcome will be the same.
The Speck in Your Brother’s Eye
Many large companies, including a majority of Fortune 1,000’s, already own one or more captives. Combine this with the fact that Small businesses constitute 99.7 percent of all businesses in the United States and that they employ over half of all private sector employees, and its easy to see why the 831(b) variety of captive is increasingly popular and necessary.
However, rather than learning the positive lessons of the qualified plan industry, the captive Old Guard is increasingly alarmed by the ascendance of 831(b)s, and more importantly by the increasingly prominent role of the asset management types who service them. And, like their forerunners in the qualified plan industry, the Old Guard is acting defensively rather than proactively. Rather than embracing the growth of the industry, celebrating its positive impact on small businesses, and self-regulating to ensure that these smaller varieties of captives are “done right”, many in the Old Guard instead are actively calling for regulatory scrutiny. This approach likely won’t work any better for the captive Old Guard than it did the qualified plan Old Guard.
On the off chance that it does, the regulatory scrutiny will certainly adversely impact the entire industry and not just the Old Guard’s intended targets. Regulators, especially those like the IRS (which is the favored “hammer” of the Old Guard) who are incentivized to raise money, tend to work with cleavers rather than scalpels. Small CIC’s making an 831(b) election are deferring taxation of $100,000 to $500,000 per year. By contrast, many large CICs traditionally served by the Old Guard are effectively deferring tax payments on tens of millions of dollars via the actuarial reserving process that permits them to deduct future expected claims today. Which is the larger potential source of revenue for the IRS? Benjamin Franklin’s words upon signing the Declaration of Independence come to mind–-“We must hang together or we will surely all hang separately.”
A Better Way
Barring regulatory uncertainties, the outcome of this evolutionary process is a foregone conclusion. The qualified plan industry has already shown us our future. In the future, the captive industry, like the qualified plan industry, will be dominated by small businesses forming the smaller and more “turnkey” or “prototype” forms of captives—the 831(b) variety—and served largely by the risk management advisors who traditionally serve small business–asset protection specialists, fiduciaries, wealth managers, financial planners, and life insurance producers, for example. The Old Guard will continue to serve its larger clientele, and many may even start working with 831(b)s as well, and to everyone’s benefit.
The sooner we start this reconciliation process the sooner we can realize our future and avoid the years of unnecessary war experience by our qualified plan brethren. To sufficiently reconcile, we need to agree that any responsible insurance company is going to pay at least as much attention to managing its assets as managing its liabilities. We must also agree that there is therefore nothing untoward or improper about New Wave risk management specialist–asset protection specialists, fiduciaries, wealth managers, financial planners, and life insurance producers, for example—being involved in the captive industry. Quite the contrary.
Working together, we can self-regulate, banishing the incompetent and the ill-intended from our midst. Working together we can grow this industry faster than ever before, and to our mutual benefit. And, working together, we can ensure that regulators don’t become overly dogmatic, doing grave harm to us and our clients.