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Captives: Time for a Second Look?

Captives: Time for a Second Look?

Captives: Time for a Second Look?
January 29
12:59 2018

ARTful Measures

Predicted rate increases mean the time is right to consider a captive for your clients

The year 2017 may well turn out to be one of the costliest in terms of loss events, in large part because of the damage caused worldwide by several major natural disasters. Property/casualty rates may begin to increase, causing business owners to consider alternatives.

A viable option is the captive insurer.

Many agents and brokers have considered the captive approach over the past several years but have not recommended it to clients because of the soft P-C pricing that has prevailed during that time. For that reason many insurance buyers have decided to remain in the conventional market. Some buyers, however, have begun to take a longer-term view of their risk management programs, and many are revisiting the possibility of using a captive.

Now is the time to decide: Do you want to continue to be an insurance salesperson or move to risk management consulting?

Predictions of significant rate increases during 2018 are being issued. Willis Towers Watson indicates that “commercial insurance buyers are likely to face rate increases for 2018 insurance programs as the industry continues to tally losses following one of the most active and financially disruptive hurricane seasons in history.” The Willis forecast projects growth in most lines of coverage.

Because significant amounts of cash are still available to the industry, Willis believes that pricing for most casualty lines will remain flat. Property, particularly for accounts with catastrophe  exposures, will see meaningful premium growth. Willis projects an increase of 10% to 20% for catastrophe exposures and 20% to 25% for catastrophe exposures that have experienced recent losses.

If you are an agent or broker who previously helped one or more of your clients review the captive option, you now might want to reconsider captive ownership. Beyond the obvious benefit of escaping the commercial market cycle, a number of factors are favorable for captive formation.

Recent tax court decisions have gone against the Internal Revenue Service. For example, in two cases (Rent-a-Center and Securitas Holdings) the court noted that captives can meet the risk distribution requirements by insuring a large number of risks as opposed to the IRS position that the criterion should be a large number of related policyholders. Industry observers believe these decisions were big wins for captive owners. They both represent a change to long-standing positions of the IRS concerning what constitutes risk distribution. Historically, this issue, along with risk transfer, has been the key to determining premium deductibility.

The majority of tax cases favorable to captives have involved larger programs. An exception to this trend deals with 831(b) captives or micro-captives. In August 2017, the tax court heard the case of a small captive that was owned and operated by Mr. and Mrs. Avrahami, who used their micro-captive o protect the majority of their company’s risks. The captive was formed in 2007 and insured the owners’ jewelry stores located in the Phoenix area. Additionally, the captive was used to insure their real estate holdings.

Although the enabling legislation for 831(b) captives was enacted years ago, the IRS has become concerned about these captives only over the last decade or so. This concern was so strong that IRS started including 831(b)s in its annual “Dirty Dozen” list. It also referred to these captives as “transactions of interest.”

The initial enabling legislation was of little concern, because the 831(b) election was aimed at small mutual captives. The major issue was a trend that the IRS noticed, namely establishing a micro-captive as part of a wealth transfer vehicle. The IRS did not think that wealth transfer captives met the requirements of the statutes. Based on this issue, the IRS went to tax court.

The decision in the Avrahami case (Avrahami v. Commissioner) was a rare IRS win. A key aspect of this case was that the court found that premiums paid to the captive were not deductible. Further, the court noted that there was an absence of “risk distribution.” In addition, all of these issues called attention to the company’s questionable business practices.

At that point, the decision would have to be considered a major win for the IRS. But this is not the end of the story. Although the IRS was troubled by their use, Congress was concerned about the ability of 831(b) captives to ensure that small mutual insurers would still be able to serve rural families. This was the group for which the original act was designed.

Not only did Congress continue to support the law; it also enhanced the program. Originally the amount of 831(b) premium income that was not subject to federal income taxes was set at $1.2 million. In December 2015, Congress increased the amount to $2.2 million. Implementation of this feature has greatly expanded the market for 831(b) captives. Growth over the last few years has been significant, with future use projected to be substantial.

In addition to the benefits noted above, business owners are beginning to see the real advantage of captive ownership. Although the traditional property/casualty market has been soft over the past 10 years, insurers now are being asked to cover emerging risks, like reputation, cyber, and contingent business interruption. Because some insurers have not responded to these needs, captives have been pressed into service.

Further, this list should include health and wellness exposures, where insureds are seeing the advantages of captive ownership. Interest in using a captive for health-related risks has been gaining ground slowly, because implementation has been a difficult task. Not only does it require the normal approval process from the captive’s domicile, but also it must be approved by the Department of Labor. In the past, this was a difficult and time-consuming task. However, the DOL has redesigned the approval process, and the expedited process has resulted in more movement to captives.

Insurance buyers also have moved to incorporate captives as part of their organizations’ overall risk management programs. And why not, considering that coverage from the conventional market for better-than-average businesses has been subsidizing insureds with poor loss experience? Underwriters have never found a way to successfully handle these better-than-average accounts, and in the longer term they have few ways to retain those accounts. Moving forward, it is clear that good accounts soon will look to captives to eliminate pricing inconsistences.

It was not all that long ago that captives were viewed as risk transfer vehicles only for Fortune 500 companies. Today, this is not the case. In fact, captives formed by mid-sized accounts have been the major driver of captive growth and they constitute the majority of projected expansion.

So, if you are an agent or broker with mid-sized or larger accounts, now is the time to consider a captive for your clients. Although rate increases undoubtedly will be a reality in the 2018 market, property reinsurance will still be available. The same will be true for casualty lines.

History likely will show that this will be one of the most advantageous times for captive formation. Not only will this be appropriate for your current insureds, but also it should be an excellent door opener for new business.

Now is the time to decide: Do you want to continue to be an insurance salesman or move to risk management consulting?

The author

Michael J. Moody, MBA, ARM, is the retired managing director of Strategic Risk Financing, Inc. (SuRF), a firm that was established to provide consulting services to captive and other alternative risk transfer mechanisms. As a regular columnist, he continues to actively promote the benefits of the ART market by providing current, objective information about the market, the structures being used, and the players involved.

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