Posts Tagged ‘captive’

House of Cards- 831(b) Small Insurance Companies

April 5, 2010

Don’t get me wrong….I’m a big fan of 831(b) Small Insurance Company structures.  Under this unique IRS rule the underwriting income for certain small insurance companies is tax-free to the insurance company.  Provided the ceded premium to the company is under $1.2M annually and there is real insurance risk transfer and risk distribution happening,  the company would only pay taxes on its investment income.

The difficulty isn’t in the structure, its how its being used.

The ancestor of 831(b) was the 501(c)(15) insurance company.  Provided there was real risk transfer and distribution and the ceded premium was less than $600K per year this company paid no taxes on its underwriting or investment income.  A nice structure for legitimate insurance transactions.  The structure was abused be zealous financial planners who “stuffed” millions of dollars of capital into the insurance company to support a small amount risk premium.  It wasn’t about insurance at all, but a mechanism to defer taxes on investments.  At the end of the day the IRS nailed down the abuses in 501(c)(15) companies and they have faded in popularity as a result.  This same crowd sees an opportunity in 831(b) to defer income on the underwriting of business risk.  It has become the financial wealth management tool de jour, only there are some problems associated it.

Typically these programs are put together upside down.  What I mean by that is that they are created primarily for the purpose of deferring taxation and not for any legitimate risk management purpose.  In order to make this financial planning tool work the consultants that use them must overcome two hurdles.  How do I create a risk coverage that I honestly hope will never have a loss and how do I create a risk sharing mechanism so that my client’s program satisfies the letter of the law regarding real insurance?   The first question is answered by creating coverages like terrorism coverage for medical practices or pandemic coverage for a manufacturer or stubbed my toe on the first Thursday of the month coverage (I made that one up!).  See, the question isn’t whether or not it could ever happen and if it did would it represent a significant risk to the policy holder, but rather that there is a policy that has been issued that I can put premium into my captive for.  Remember, this isn’t about risk management, it’s about tax and wealth management.

The second question is answered by allowing all the 831(b) companies that I have put together to share risk with each other on these sham policies.  Here is where the dangerous upper levels of the house of cards is built.  Should just a couple  of the coverages in one of the programs be challenged it could literally take down every one of the captives that share that questionable coverage’s risk.

I know, it doesn’t really sound like I’m really a big fan of 831(b) structures at all does it!  Well, I am, under certain conditions.  831(b) is an insurance company.  It’s business should be conducted like an insurance company; assuming real risk in exchange for a reasonable premium and for a legitimate purpose.  The process should start with risk and insurance and if there is some tax deferral advantages as an aside, then all the better.  It has to be built right side up and not purely as a scheme to beat the tax man.  We saw how well that went for the owners of 501(c)(15) companies, and if we think that the IRS won’t be looking at abuses in 831(b) as a means to enhance revenue we are only fooling ourselves.  If 831(b) is going to stand up to IRS scrutiny it has to be built on a foundation that is rock solid, with legitimate insurance coverages that can be shared without worry with other similarly structured captive insurance entities.

If you are contemplating this kind of structure at least seek out the services of an insurance professional who can point you in the right direction from a risk management perspective.  831(b) is a powerful tool when used properly, but if will only yield frustration and heartache if it is abused.

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Education is Key to Execution

January 8, 2010

Education is the key to being able to effectively implement and execute a sophisticated risk management regime like a captive insurance program.  This doesn’t only apply to the accounting and insurance professionals that are involved in the day-to-day operations of these types of programs.   It also applies to the risk managers who represent companies that own them and to insurance producers that help to set them up.

There are several venues to learn about captives and how they are used.  The International Center for Captive Insurance Education (ICCIE) provides an online platform of coursework that leads to the Associate in Captive Insurance (ACI) designation.  I am on the faculty for this program and it is an excellent course of study for accounting, insurance and business professionals to get a solid foundation of captive insurance concepts.  You can find more information at http://www.iccie.org/

Several associations provide annual conference opportunities that are full of great educational content.  The Vermont Captive Insurance Association, the Bermuda Captive Conference and the Cayman Captive Conference are all venue-oriented educational experiences and are excellent for delivering timely information on emerging industry issues.

For more general insurance and underwriting educational topics there are several continuing education websites that can provide the ongoing training needed to maintain licenses and credentials.  I sponsor one of these websites at http://cedarconsulting.360training.com

Finally, industry service providers organize conferences that have client education as their primary purpose.  USA Risk Group (www.usarisk.com), the largest independent captive services company, sponsors an annual educational conference for captive industry participants.  This type of conference is typically more focused on the practical nuts and bolts issues of captive insurance and the smaller group results in better access to speakers and service providers.   The conference is highly rated by participants.  This year’s conference will be held in Charlotte, NC at the Ballantyne Resort, May 26th-27th, 2010.  You can contact me by email at dennis.silvia@cedarconsulting.net for specifics on registration for this event.

Education in and of itself is worthless.  It’s not in the knowing, but rather in the application of the knowledge that yields results.  These educational opportunities will give you what you need not only to understand the concepts of captive insurance but to apply them to your circumstances.

Execution is always the factor that divides the successful and the wannabe.  Gain the knowledge you need but don’t forget to deploy that knowledge in a meaningful way to solve risk related problems for your organization.

Blowing the Dust Off Your Captive’s Business Plan

September 30, 2009

In the new captive formation process the creation of the business plan uses the largest amount of time and intellectual resources.  That’s understandable because the document forms the foundation of the startup.  Front companies, reinsurance and claims administrators all use the statistical data and the narratives of the business plan to set their pricing and terms and conditions.  Domiciles use the information to judge the insurer’s acceptability and its potential to be successful within the location’s regulatory framework.   Once licensed, the business plan is used by auditors and regulators to make sure that the captive is operating according to its original approved plan.  Even years after a captive is licensed, regulatory bodies like the IRS take an interest in the business plan and how a captive is operating currently compared to its original business plan.

A business plan is required of virtually every captive.  The real question regarding a captive’s business plan is whether or not it is a static document or a dynamic document.  Once created and used as a part of the formation process can you just stuff it in a drawer and forget about?

The simple answer is no!  The captive business plan should be a dynamic document that is reviewed regularly.  Let me give you a couple of reasons why…

Stakeholders like the domicile’s insurance department, your audit firm, claimants, reinsurers, the  Internal Revenue Service and the shareholders of the captive’s parent in a publicly traded environment all rely on the accuracy of the business plan to portray the business of the captive.  Unless this document is regularly reviewed and updated it is doomed to be inaccurate and will likely contribute to a problem for the captive and its ownership.  At a recent captive insurance conference session dealing with IRS regulation of captives, the two attorneys conducting the session both emphatically agreed that an updated and accurate business plan was a powerful deterrent to IRS “fishing expeditions” into the taxation status of a captive.

Another reason for periodically dusting off the business plan is to make sure  that the captive is still supporting the parent’s strategic goals.  In my consulting practice I am regularly contacted by firms that own a captive and that have had personnel changes over the course of several years and they find themselves in the unusual position of not knowing why they even have a captive in the first place.  Either the new management is not schooled in the use of captive insurance as a part of a creative risk management regime or the company’s strategic goals have moved so far that the captive is no longer relevant.  A regular review of the captive’s business plan allows the captive to be re-aligned with the corporate goals and to make a powerful addition to accomplishing those goals.  Not only is this recalibration critical in keeping management informed of the captive’s capabilities, it can often contribute to new uses for the captive that keep it relevant and a contributor to overall success.

This review should be conducted every couple of years and should be the product of not only fact checking the captive’s operations against the existing business plan, but understanding the parent’s overall business goals and how  the captive might contribute to achieving them.  If you are interested in discussing how this process works send me an email at dennis.silvia@cedarconsulting.net and I would be happy to contact you to discuss it.

All Your Eggs in One Basket

September 4, 2009

Don’t Put All Your Eggs in One Basket

Its easy to see how it happens.  Your insurance broker comes to you with a great idea about how to more efficiently finance and manage your insurance risk.  They bring in the brokerage’s experts to conduct feasibility studies and work with you to license a captive insurance company.  The have their reinsurance brokers place the reinsurance and have their captive manager take care of the regulatory and management operations.   Because of their fully integrated capabilities your broker has delivered a captive insurance solution entirely from within the broker’s organization.  That’s good, right?

One of the biggest decisions that face the owners of captive insurance companies is whether or not to consolidate all the insurance and captive management services in one basket.  There are some obvious advantages to doing this.  It is simpler, and may be less expensive initially to let your broker put your entire program together.  They may even be willing to do the feasibility work within the existing fee structures, only charging for the ongoing management and collecting the commissions on the reinsurance placements.  But what are the disadvantages?

  • When a captive insurance program is created entirely from within a single organization with no outside input then you get that organization’s cookie-cutter program.  They only do things a certain way and that is what you will get, whether its the best structure for you or not.
  • With no outside involvement there is no “gate keeper” making sure that the broker’s organization is doing everything it can to advantage the captive owner even if it means that it might disadvantage the broker’s organization.
  • Most broker organizations are limited in the number of domiciles that they can effectively do business in which means that they cannot be completely domicile neutral.  You may end up being steered to a domicile that suits their operational characteristics but may not be the best choice for your company.
  • Even in the best of brokerage organizations things slip through the cracks.  The broker is less likely to spend the same amount of time reviewing work done by an internal department then they might work from outside.  The checks and balances of having a diverse makeup in the captive’s support mechanisms are eliminated.
  • Pricing for captive services can often be overstated when billed all together as opposed to being presented on a line by line basis.
  • Brokerage organizations are typically polarizing in the industry.  Some companies get along well with other companies and frankly some don’t get along at all.  An independent manager can often involve service partners that a brokerage could not because of conflicts in corporate cultures.

In my consulting practice I have reviewed programs that have had the captive services completely integrated within one brokerage organization.   My reviews always turn up issues.  In one case a mismatch between the terms and conditions of the policies being written by the captive and the reinsurance treaty could have caused an enormous financial problem for the captive.  In an another case the overall charges for the program were much higher than average because they were being billed in a lump rather than being detailed line by line.

If you are considering a new captive program be sure to weigh the advantages and disadvantages of an integrated approach.  Try to involve at least one outside advisory component to the program in order to mitigate the potential problems.  If you already have an integrated program, hire a consultant to do a review of your captive and make suggestions on structure and operations as well as benchmark your costs.  Its never a good idea to have all your eggs in one basket.

The Battle of Frog Pond

March 25, 2008

 

 

When I was in grade school my father was transferred to eastern Connecticut from Texas.  Besides all the normal “new kid” on the block stuff, I also had to deal with my Texas y’all standing out against the background of “pawkin the caw”.  I had heard some pretty tall tales while living in Texas, but I was quickly indoctrinated to Yankee humor when I was told the story of the Battle of Frog Pond.  Bear with me, this actually has an insurance lesson in the story…….

The summer leading up to the fateful night in June of 1754 had been filled with terrifying stories of the French and Indian War.  Stories of atrocities committed by both sides in the battle and then reprisals by the other spread like a disease carried by the travelers on the Boston Post Road that passed through Windham Center.  The settlements in eastern Connecticut were pretty spread out and essentially stood alone from a defense perspective.   A local attorney, Col. Eliphalet Dyer, had just raised a militia to join General Putnam in fighting the French and Indians at Crown Point, leaving Windham Center defended mostly by old farmers and shopkeepers.

In the early hours on that fateful day in June the townsfolk were awakened by a unholy noise coming from just over the eastern ridge of the town.  Some literally ran into the streets naked and fell to the faces in the town square praying for forgiveness because they thought it was surely the end of the world.  Others gathered muskets and powder and made their way in the moonless night to the ridge east of the square, ready to defend the town against the onslaught of whatever the dawn would reveal.  Lining the ridge the makeshift militia prepared for battle in the pitch blackness of the early morning.  In town lanterns burned while women tore strips of cloth for bandages and boiled water for wound dressing, all along praying that if the end came for them and their children at the hands of savages that it would come quickly.

As the morning sun began to rise over the Connecticut foothills to the east all attention was focused to the sloping ground that led to Col Dyers farm, but instead of seeing hordes of savages ready to attack, the defenders of Windham Center witnessed instead the carnage of thousands of bullfrogs.  Their carcasses lied belly up in the mud that surrounded the place where the pond and stream had been at the bottom of the hill.  As it turns out, a draught had been effecting the area for some weeks, but with the flurry of activity surrounding the militia muster and the absence of Dye from his farm, no one noticed that the pond was slowly drying up.  On that night something snapped in the frog community as they battled for the last bit of water and that was the sound that the townsfolk heard.  Not ones to be cheated from a good victory, the locals decided to call it the Battle of Frog Pond and to this day a monument stands at the side of Rt 14 as it passes by Frog Pond commemorating the battle.  In fact the Windham County symbol is the frog and the sheriff’s patrol cars are adorned with a giant bullfrog symbol.  The picture above shows one of the frog statues that guard the entrance to the bridge over the river that passes through the county’s seat of Willimantic.

Now, where is the insurance lesson in all this?  You can take pride in your preparation to fight the battle even though you may not be called on to fire your musket.  Understanding about captive insurance initiatives and their proper application to particular insurance needs may be more than half the battle won when trying to protect your book of business from being poached by the big global agencies.   The water is drying up in the insurance pond and agencies, like the frogs in our story, are fighting over the remaining client base.  Agency education is key to anticipating the need for a sophisticated captive insurance program and offering that option to your clients long before someone rides in and offers that service to your client first.

Cedar can help you evaluate your clients potential for alternative risk financing.  When we work with agents we never try to replace the agent in his relationship with the client.  We consider ourselves to be adjuncts and work to serve the client on your behalf.  Let me suggest that you check out our website for more information or send us an email if you would like to discuss a particular client’s situation.

You can reach me at dennis.silvia@cedarconsulting.net