By: Sean King, JD, CPA, MAcc
Principal & In-House Counsel, CIC Services, LLC
If a captive insurance company does not replace third party commercial coverage, is it evidence of a sham?
The short answer is an emphatic “no!” To suggest so would require complete ignorance of the origin of captive insurance companies (CICs). Yet the IRS and some captive insurance industry pundits have often listed not replacing third party commercial coverage as evidence of a sham transaction. This mischaracterization is usually cast with slightly different language, suggesting sham captives insure “esoteric risks” or “business risk.” Nevertheless, it is a mischaracterization and widely misses the mark in providing helpful and meaningful guidelines for separating sham arrangements from legitimate captive insurance structures.
Before addressing this specific question, let’s review common mischaracterizations that falsely identify legitimate captive insurance arrangements as a sham. Our list will continue to grow, but so far we have the following:
–Low claims rates
–Insurance premium costs do not drop due to low claims rates
Also, let’s also review real characteristics (or evidence) of a sham captive insurance arrangement. They are:
–Prearranged written or verbal understandings that no or very few claims (even legitimate ones) will be filed
–Prearranged understandings that insulate one or more insureds from bearing a meaningful portion of the losses associated with claims filed by other insureds
–Premium pricing is not actuarially determined.
–An actuary ignores sound modelling and knowingly (fraudulently) overprices policies.
Remember, the IRS and some industry pundits have offered a broad set of poorly-chosen characteristics for sham captives that are, frankly, wrong-headed and misidentify far more legitimate captives as shams than identifying true transgressors.
Now, let’s address the question at hand: If a captive insurance company does not replace third party commercial coverage, is it evidence of a sham?
Business Decision: Captives Are Subservient to the Needs of the Business NOT to Some Arbitrary Notion of What Constitutes Insurance
Fundamentally, risk management and insurance are business decisions that require owners, CFO and Risk Managers to make choices. Naturally, these choices should be guided by a cost-benefit analysis of commercial insurance, captive insurance or no insurance. Businesses, including those that own captives, should conduct a review of their risk management strategy annually. This review should evaluate the following questions:
–What are all the threats/risks facing the business?
–What steps can be taken to mitigate these threats/risks?
–Which threats will be insured commercially?
–Which threats will be insured by a captive insurance company?
–Which threats will not be formally insured?
–What are appropriate coverage levels for all insurance purchased?
–How much insured risk will be retained by the business or captive (deductibles)?
For many businesses, keeping all or some commercial insurance in place is the best business decision. This in no way diminishes the need, importance or legitimacy of risks insured by a captive.
Also, it is worth noting that captives give business owners flexibility. If third party commercial insurance costs increase, captives give business owners flexibility to shift more risk onto the captive and away from a third party. However, if commercial rates rise and a business does not have a captive, it is often too late. The business owner is stuck. A captive is most vulnerable in its first few years when it is building reserves and the ability to provide meaningful protection. It can be an extremely risky move to shift risk from commercial insurance to a newly formed (weak) captive.
Many captive insurance arrangements are on a glide path to assume some core risk (commonly insured by a third party). This transition usually occurs after a captive has achieved a strong position by building up reserves. The captive owners also have time to study and understand loss history. It would be ridiculous for a small or mid-size business owner to start a captive and shift all core risk from commercial insurance to the captive. A bad year with a few big claims could bankrupt the captive and the company, resulting in utter ruin. In risk management, it’s far better to lead with brains than with balls.
Nature and Unique Purpose of Small CICs
It is safe to say that larger corporations are more prone than smaller businesses to utilize captive insurance arrangements to replace some third party commercial insurance coverage. This is to be expected. It should be pointed out, however, that most large corporations with captives still rely on some form of third party coverage because their captives typically buy reinsurance. The risk management challenges faced by small businesses differ in some important ways from those of much larger companies. Fortune 1000 companies have more robust business models and operations than small companies. They tend to be geographically diversified, have more revenue streams, healthier balance sheets and better access to capital.
By contrast, smaller closely-held businesses are often geographically limited, have fewer revenue streams, have weaker and often highly leveraged balance sheets and limited access to capital and credit. Their business models are usually more fragile. Not surprisingly, an unexpected contingency (like a cyber attack that causes reputational damage) simply reduces the earnings per share (EPS) of a Fortune 1000 company by a few dollars but can easily be curtains for a smaller, closely-held businesses.
For these reasons and others, the vast majority of small businesses fail, particularly in the event of a disaster or crisis. Nearly two-thirds don’t survive their founders. And, per the SBA statistics cited on ready.gov, 40 percent of small businesses affected by a natural or human-caused disaster never reopen their doors.
As a result, small CICs that serve small and mid-size businesses are often characterized by their focus on insuring first-party exposures (including deductible reimbursements), business interruption or loss of income events and other low-frequency but high-severity events that larger companies may simply write-off as a “one time” operating or restructuring loss.
For the most part, larger captive insurance companies are a means to more economically replace traditional commercial insurance arrangements—like workers compensation, automobile liability, general liability etc. However, smaller companies often view captives as a means of insuring existential threats to the business that are not readily insurable at all, or at least not cost-effectively, in third-party commercial insurance markets. It is arrogant and wrong-headed to assume that since large Fortune 1,000 captives often replace third party commercial coverage, small captives must have the same approach to be legitimate insurance entities.
Historical Perspective: The Father of the Captive Insurance Industry
While this may seem unusual, the tendency of small captives to insure non-traditional low-frequency but high-severity risks actually honors the original purpose of captives: Youngstown Sheet & Tube famously formed the first captive insurance companies offshore to insure exactly such types of risks. The approach was developed by insurance broker, Frederic Reiss, and he is affectionately known as the “Father of Captive Insurance” to this day. The Captive Insurance Companies Association (CICA) has developed an outstanding tribute video to Mr. Reiss. You can CLICK HERE to watch it.
Modern Perspective: Even Captives for Fortune 1,000 Companies Often Moved Cautiously To Take On Core Risk Insured with Commercial Carriers
Even large companies, including Fortune 1,000, have typically taken a cautious approach to replacing third party insurance with captive insurance. Many large captive programs were started specifically for one or two unique risks. Then over time, their captive program carefully expands to include more risks and shift increased responsibility onto their captive programs. Having attended numerous captive conferences, I have heard such stories first hand during presentations from large company risk managers at Walgreen’s, Verizon, Caterpillar and Snap-On to name a few.
CLICK HERE to read about Walgreen’s captive program.
CLICK HERE to read about Verizon’s captive program.
CLICK HERE to read about Caterpillar’s captive program.
CLICK HERE to read about Snap-On’s captive program.
Additional Perspective: U.S. Tax Court Statements Regarding Captives
Tangentially related, it’s worth noting that the U.S. Tax Court does not expect captive insurance companies to operate like commercial insurance companies.
The court has routinely recognized what the IRS and some industry pundits struggle to grasp… that captive insurance arrangements should not be expected to mirror typical commercial insurance to be legitimate. CLICK HERE to read about the Rent-A-Center case.
As can be seen, captive insurance arrangements do not have to replace third party commercial insurance to be legitimate. For small and mid-size businesses, it can take years for its captive to build up the reserves necessary to consider replacing commercial coverage for some core risks. It’s important to remember that small and mid-size businesses are different from large corporations. Large corporate risk management strategies are usually purely financial – all about the money. Risk management for small and mid-size businesses is less about the money and more about the very survival of the enterprise.
Consider two simple examples. Did Target’s massive data breach close the company? Sure, the crisis cost Target a lot of money and some unfortunate executives and employees lost their job. But Target is still in business. A similar crisis could easily shutter many small and mid-size businesses. CLICK HERE to read about Target’s data breach and the insurance costs associated with it. As a second example, consider Hurricane Katrina. How many Fortune 1,000 companies closed as a result of the calamity? The answer is: NONE. Yet, Katrina permanently destroyed many small and mid-size businesses.
The risk management challenges facing small businesses and large corporations are completely different! For this reason and the prior reasons listed in this article, it is thoroughly absurd to suggest that: “Not replacing commercial insurance is evidence of a sham.” With that in mind, the following are characteristics of sham captive arrangements:
–A captive insurance company is formed for tax savings only with no attention paid to risk management
–A captive owner treats the reserves in the captive like a personal checking account with disregard for future claims the captive may be required to pay
–Related to the above, a captive owner simply uses a captive as a “pass-through” vehicle, withdrawing money from the captive without reporting dividends