Continued Pressure from the IRS on Bad Fact Patterns – How to Avoid Trouble

The Courts recently made a decision regarding the Reserve case for the IRS. This is the second case of late that has been decided against a captive owner in an effort to crack down on captives the IRS perceives to have a poor fact pattern, and therefore cannot meet insurance tax treatment standards. For example, captives that have been set up to undertake sham transactions or undertaking transactions that do not meet the bona fide insurance company characteristics would fall into this category.

According to the Avarhami v. Commissioner (“Avrahami”) judgement, the court provided four criteria that result in an arrangement constituting insurance.  These four criteria were also addressed in the Reserve Mechanical Corp (“Reserve”) v. Commissioner case, and are as follows:

  • The arrangement must involve insurable risk
  • The arrangement must shift the risk of loss to the insurer
  • The insurer must distribute the risk among its policy holdersIRS captives
  • The arrangement is insurance in the commonly accepted sense

Reserve outlined these four non-exclusive criteria to establish a framework for determining the existence of insurance for federal income tax purposes.  The court’s opinion focused on the idea of risk distribution, which led to investigating PoolRe Insurance Corp. (“PoolRe”), the stop loss insurer for Reserve. The judgement discusses the transaction in detail and stated there was a circularity of funds that invalidated the pooling arrangement.

To determine if a captive insurer has met the risk distribution criteria as a standalone captive without stop-loss or reinsurance protection, the courts looked at the total number of insureds and the total number of independent risk exposures. It has long been believed that the “law of large numbers” allows an insurer to minimize its total risk and reduce the likelihood of a single claim exceeding the premium received. In the Avrahami and Rent-A-Center court cases, risk distribution passing and failing thresholds have been observed as follows:

  • Rent-A-Center ultimately showed distribution of its risk by insuring the risk for 14,000 employees (workers’ compensation), 7,100 vehicles (auto coverage), and 2,600 stores (general liability coverage) in 50 states
  • Avrahami didn’t show distribution of risk by insuring 3 jewelry stores, 2 key employees, and 35 total employees. Further, one of the stores had 5 low frequency coverages and the other 2 stores had 2 low frequency coverages

Reserve, an Anguilla-domiciled captive, wrote 11 to 13 policies over the three tax years in question and had direct policies for 3 insureds.  Peak Mechanical & Components, Inc. (“Peak”), an S Corp for Federal income tax purposes, was owned in equal 50% shares by two individuals and was the primary insured under all policies. The policies were also issued to two other subsidiaries, although the operations were not significant. Peak operated two facilities and had a max of 17 employees. Reserve did not meet risk distribution based on this exposure profile alone; its exposures were similar in scale to the Avrahami’s.  Reserve contended that it still met the risk distribution safe harbor requirements, by having 30% of its gross premium for each of the tax years for unrelated parties via the reinsurance agreement with PoolRe.  A similar argument was made in the Avrahami case with their reinsurance pool.

Before it is determined whether Reserve distributed risk through the agreement with PoolRe, they evaluated whether PoolRe was a bona fide insurance company. In the eyes of the court, a captive should be able to answer “yes” to each of these questions and provide adequate support to:

  1. Is there no circularity to the flow of funds?
  2. Are the policies developed in an arm’s length approach?
  3. Did the captive charge actuarially-determined premiums?
  4. Does the captive face actual exposures and insurance versus business risk?
  5. Is the captive subject to regulatory control, and did it meet minimum statutory requirements?
  6. Was the captive created for non-tax business reason?
  7. Was a comparable coverage in the market place more expensive, or even available?
  8. Was it adequately capitalized?
  9. Were claims paid from a separately maintained account?

The court’s conclusion in Reserve’s case provided details of the concerns with evidence in support of the first six questions listed above, and concluded that the PoolRe quota share arrangement provided the appearance of risk distribution without actual risk distribution.  The court summary also highlighted the following:

  • Circularity of funds was exhibited with PoolRe receiving and distributing the same amount of money to Reserve
  • There was no evidence that the premium payments to PoolRe by Reserve and the other participants were determined by actuaries
  • Contracts were not determined in a like manner, nor using objective criteria

One of the major concerns the IRS addresses with the Avrahami and Reserve cases is that a one-size-fits-all rate for all participants in the pool/reinsurance agreement isn’t valid.  The court also addressed an alternative ground for the case, which would have been to evaluate “Insurance in the Commonly Accepted Sense”. To determine if an insurance arrangement exists, the following factors come into play:

  • Was the insurance company organized, operated and regulated as an insurance company?
  • Was it was adequately capitalized?
  • Were the policies valid and binding?Captive Checklist
  • Were the premiums reasonable and a result of an arm’s-length transaction?

The court summary pointed out several issues in Reserve’s support for answering the above questions, such as:

  • Reserve had no employees of its own performing services and the board members did not know how claims were made or handled.
  • There’s no evidence that activities were performed in its domicile.
  • Claims must have supporting documentation, yet there was no addendum for the program until after the policy date. An employee from the insured signed the checks as opposed to the insurer.
  • Binding and valid policies – policies must, at a minimum, identify the insured.
  • There were peak paid commercial market premiums of $95,828 in 2007 versus $412,089 to Reserve in 2008. This is a 330% increase in insurance premiums. In addition, Peaks premiums vary from year to year with no explanation.
    • Note, the Avrahamis similarly had significant increases in premium spend, with almost an 800% increase over a several year period.

These cases provide us and other captive professionals with guidance and clarity. As the industry grows, cases like these will form the cornerstones of how to properly operate and conduct business as a captive insurance company.

Key Takeaways

The IRS clearly has problems with some of the pooling structures used to qualify captives as meeting the risk distribution safe harbor tests. They are concerned that the premiums ceded to the pool and the transfer of risk into the insurance pool are not commensurate with one another, and that the pools are only being utilized to circle premiums to the captive participants, with each assuming no or minimal losses from the pool.

There should be clear documentation of premium determination by an actuary, illustrating why premiums are reasonable and that sufficient risk transfer exists.  Over time, if the total loss experience and premium ceded to the pool doesn’t produce a long-term average loss ratio consistent with the commercial marker, then the pool’s support in having arm’s-length contracts with each of the participants becomes weak and difficult to defend.  Long term average commercial market loss and loss adjustment expense (“LAE”) ratios for most lines of business generally fall in the range of 50% to 75%, hence the 70% loss and LAE ratio threshold in IRS Notice 2016-66 used to identify captive transactions of interest.

Finally, it is important to show sufficient support in a captive’s business plan, policies, and feasibility studies to address the questions above about an insurer/pool being a bona fide insurance company.

5 Ways VCIA is Future-Focused

The Vermont Captive Insurance Association (VCIA), founded in 1985, is the largest trade association for captive insurance in the world. As such, it’s no surprise that their annual conference yields both an impressive turnout and range of educational sessions. A long-time sponsor and member of VCIA, Spring anticipates the August event each year.

The VCIA 2018 Annual Conference, themed “Where the Captive World Comes to Meet”, was just as high-caliber as past years, but each event tends to build its own unique motif. This year, as about 1,100 insurance professionals gathered in Burlington, Vermont, and 40 presentations were made, the three-day conference seemed to emphasize “the future” most notably. The sessions below, along with general conversations I had with a range of people at the conference, are what led me to identify this theme.

  1. Future-Proofing Your Captive

    This presentation, including Spring’s Managing Partner, Karin Landry, urged audience members to consider emerging risks like climate, and highlighted ways in which one captive has and continues to prepare for the future. Then, Andrew Braille of AES Corporation outlined the organization’s plans for the future, including a 50% reduction in carbon intensity.

  2. Succession Planning: Bridging the Next Generation of LeadersEmerging Risks

    An experienced panel led this discussion on how to nurture and attract captive talent to ensure a bright future for the insurance industry, one that is aging and failing to appeal to millennials. Tips like developing mentoring relationships and utilizing updated technology were given.

  1. Blockchain & Distributed Ledger Technology

    VCIA attendees, myself included, learned a lot about blockchain during this Wednesday morning session. The presenters defined blockchain and explained how it will impact captives and the insurance industry at large in the years to come. Good news – experts expect blockchain to reduce costs, lower risks, increase trust, and save time for insurance professionals as it continues to evolve.

  1. Integrated Solutions: The Future of Risk Management

    Todd Cunningham and Carol Murphy highlighted the efficiencies to be gained by moving from a traditional insurance structure to an integrated model, where 1st excess coverage across lines all operates within the same system. They explained that this is the direction they see the industry will and should go.

  2. The Cognitive Captive: Artificial Intelligence for Smarter Insurance

    Tracy Hassett of edHEALTH, and two others informed attendees about how A.I. will affect insurance risks and the labor market, and explained the role that predictive analytics and “The Future of Mobility” will have.  A special focus was made on driverless cars and their impact on insurance.

To be clear, these are only a handful of informative and strong presentations (you can read about the others here), but the underlying theme is gear up for what’s to come.

I hope you enjoyed the summary, whether you were at VCIA or not. As you can see, I did manage to learn quite a bit despite the bike rides and cocktail receptions!

Don’t Risk Missing These 3 Hot Topics from RIMS

RIMS 2018Each year, the Risk Management Society (RIMS) hosts one of the largest industry events. The annual conference and tradeshow brings together thousands of insurance and risk experts, and for the 11th year in a row, the Spring team was among them. We were happy to take a break from Boston’s not-so-springy weather and head to San Antonio for RIMS 2018.

Over the course of the 3-4 days, I was able to a) meet and greet insurance colleagues, both new and familiar, b) party like a true Texan (in case you thought Risk Managers would make for a dull crowd – you may want to rethink this notion), and c) get a gauge on the most popular industry trends and concerns.

For this writeup, I’m focusing on point C, because between various networking and social events, there was a lot to learn at the RIMS annual conference, and I’d love to share some takeaways. Here are the most buzz-worthy topics, in my opinion.

  1. Cyber & Tech

As it has with conferences and news headlines over the past 5-10 years, technology took center stage at RIMS. However, I’m using “technology” as an umbrella term to represent a range of digitally-centric, Internet of Things (IoT) subjects, such as:

a) Cyber

During Berkshire Hathaway, Inc.’s annual shareholders meeting, Warren Buffett Chairman, President and CEO said, “Insurance is very early in the game in determining how to cover the risk of data breaches, ransomware anCyber RIsk Mitigationd other hacking perils”. He then went on to say that the risk itself is a “very material risk” that didn’t exist 15 years ago one that will get worse. The world of cyber threats and attacks continues to keep risk professionals up at night. From my actuarial perspective, the probability and severity of cyber loss events are becoming better understood, although there still is tremendous uncertainty due to the rapidly changing nature of the risk. The following Cyber sessions were presented at RIMS:

  • In “Are You Prepared for a Cyber Extortion Event?”, audiences were walked through different ransomware threats and a checklist for getting through such an attack.
  • Jason Trahan went into further detail in explaining the “Anatomy of a Cyber Event Claim”, which provided a preparation process for cyber claims as well as an extensive list of possible claims expenses.
  • A representative from Willis Towers Watson highlighted the importance of corporate culture when it comes to combating cyber risk.
  • A woman from The Washington Post Risk Management team led a discussion on the different insurance policies that intersect when it comes to cyber risk, and how to manage these overlaps.
  • Jeffrey Sharer of EY revealed some startling statistics such as: “89% say their cybersecurity function does not fully meet their organization’s needs”.
  • Joon Sung and Kevin Kalinich stressed the importance of recognizing and addressing your third party/vendor cyber exposures, nothing that cyber resilience is not just an internal matter.
  • During “Pay Up or Else: Ransomware Risks”, John Coletti and Anna Ziegler explained the latest trends and scams in the ransomware sphere and offered advice on how to be both proactive and reactive.
  • One session focused on communicating a cyber attack to your C-suite, board of directors, and/or other superiors. Ten best practices were shared, such as: “Have a customer notification plan and procedures in place.”

b) Autonomous Vehicles

In March, a self-driving Uber car killed a pedestrian in Arizona, and an autonomous Tesla vehicle caused another death in California. These two incidents are just a couple of many news headlines involving self-driving cars, which certainly pose a variety of risks. As such, they were discussed on several occasions at this year’s conference.

  • In a session entitled, “Driving Insurance Forward”, Katherine J. Henry provided an overview of how autonomous vehicles are covered, the consequences they can bring and ways to confront this emerging risk.
  • Representatives from Liberty Mutual and Ford Motor Company teamed up to explain the different industries that will be affected by the rise in self-driving cars, from oil to advertising companies. Their presentation spoke to the broader trend of disruption in the automotive industry, pointing out 4 facets to consider: autonomous driving, electrification, connectivity, shared mobility/economy.

c) Social Media & Mobile Apps

Considering the recent Facebook privacy scandal, it was important to look at social media and mobile issues from the perspective of risk management and mitigation.

social media risk

  • Gregory Bangs of XL Catlin spoke to the topic of “Social Engineering”, which can incorporate a range of scams such as vendor impersonation and malware. He explained what these fraudulent activities can look like and their implications for insurance coverage and employee preparedness.
  • In “Swipe Right on Insurance”, Cort T. Malone and Stephanie Hyde discussed the risks and insurance options related to social media platforms and mobile apps, as used by employees. They covered things like harassment, privacy, reputation, business torts, intellectual property and the regulatory environment.

d) Wearables

  • Thomas Ryan highlighted the opportunity a “wearable” device poses from a workers’ compensation coverage standpoint and guided the audience on selecting a wearable vendor for corporate use.
  • Two experts from Modjoul Inc. and Cotton Holdings Inc. explained wearables in detail – why use them, how to use them, how they work with insurance carriers, etc. Through a case study, they also endorsed wearables as an option to keep employees safe and productive.

e) Drones & Other Tech Matters

  • Chris Proudlove of Global Aerospace and Vincent Monastersky of Fox Entertainment Group presented the challenges and opportunities associated with the widespread growth of drone use, both commercially and personally. It turns out, over 75% of drone-related claims were caused by operator error. Further, they outlined coverage types and options.
  • A session on emerging technologies, including smart sensors, wearables, drones and artificial intelligence gave audiences a broad but detailed landscape of how all of this connectivity affects the “risk ecosystem”, and tips on drones business riskhow to prepare for the future.
  • Another discussion, led by Tim Yeates, covered the “Fourth Industrial Revolution” and the benefits and risks of the level of information being shared today. Thought-provoking questions like, “Who do we trust – human intelligence or artificial intelligence?” were posed.
  1. Natural Disasters

In 2017, the U.S. was hit hard with Hurricanes Maria, Harvey and Irma as well as wildfires in California. Outside the U.S., the Caribbean was crushed with those same hurricanes, a devastating earthquake hit Mexico, extreme flooding impacted areas like Bangladesh and Sierra Leone, and areas of China suffered from landslides and typhoons. Unfortunately, this is not an exhaustive list.

As risk professionals we need to look at these occurrences from a different lens, so it was no surprise that the word “catastrophe” was rampant at the RIMS 2018 conference.Catastrophic Loss

  • Stephen Moss explained the anatomy of a catastrophe risk model and pointed out the large protection gap, noting that about 50% of the losses incurred from 2017’s most impactful natural disasters were uninsured.
  • An attorney from McCarter & English, LLP focused on business interruption losses resulting from catastrophic loss, discussing pitfalls that could cause your claims to be undermined as well as best practices for getting coverage.
  • Robert Nusslein of Swiss Re explained parametric natural catastrophe insurance for hurricanes and earthquakes, how it differs from traditional insurance and how it can help fill in gaps.
  • In “The Future of Climate Risk Management”, audiences learned about their company’s climate risks – the size, scale, complexity and reach. Then, the speaker introduced solutions and tools for such risks.
  • James Pierce spoke on “Mother Nature’s Onslaught” and speculated on whether a new norm is needed in combatting natural disasters.
  • One session, “The Sky Fell”, went into further detail on catastrophic claims: common claim mistakes, communication issues between layers of insurance, crisis management tactics, TPA management and more.
  • The CEO and Founder of Orbital Insight, a geospatial analytics company, outlined how technologies like satellite and drone imagery as well as AI and cloud computing can provide insight into catastrophic risk assessments. He even showed audiences imagery showing flood detection for Hurricane Harvey, as one of several illustrations.
  1. Compliance

Compliance is always a key concern in this industry. What changes year to year are the specific areas of compliance focus, some of which are below.

  • Lisa Kerr and Bruce Wineman led a session on multinational program compliance – highlighting regulations, tax law, offshoring and variability as things to look out for.
  • A different presentation focused on Medicare and Medicaid compliance, going over the boatload of associated acronyms, lien compliance, reporting and what to look for in a partner.
  • In “Risk Management, Compliance and Preparedness”, attendees received an overview of SRM and ERM, examples of strategic risk, automation advice and more.

 

If you were able to make it to the RIMS conference this year, I hope this helps you retain they event’s key takeaways. If you couldn’t make it to San Antonio, well, now it’s almost as if you were there!

Please feel free to reach out with any questions, actuarial or otherwise. In the meantime, put RIMS 2019 on your calendar – April 28th – May 1st – in Boston (our backyard). We’re already excited for it!

When Was Your Captive’s Last Check-Up?

You’ve had your P&C captive for years and it has continued to perform well throughout. So, what next? How do you capitalize on this success and build on your captive or rebuild an underperforming aspect of it? One word: Refeasibility. Okay, so ‘refeasibility’ isn’t really a word (according to Oxford Dictionary). At least it hasn’t been traditionally, but it is one that needs to be on the tip of the tongue of every captive owner. It is a word that has become somewhat synonymous with captive optimization and very accurately describes what captive owners need to do with an older captive: conduct a new (re)feasibility study.

The Importance of Refeasibility

As with all other business matters, your company’s captive needs and goals are likely to change over time, especially with new and emerging risks sprouting up frequently. Much like your family car, a captive should have a check up on a periodic basis. As a captive matures and companies evolve, captives need to be re-examined to determine if changes should be made to align with current organisational needs. Key reasons for this re-examination include the following:

  • Positive or negative experience
    • Example: unexpected adverse loss experience, such as supply chain interruption, resulting in business income loss not covered by insurance
  • Surplus release or addition
    • Example: surplus growth for the captive has been good and, as a result, there is now opportunity to add/expand coverages insured in the captive
  • Opportunities to add new lines of coverage (that perhaps didn’t exist or weren’t relevant before)
    • Example: Employee benefits or cyber risk
  • Change in the risk profile of various risks
    • Example: Litigiousness is on the rise in the insured’s industry and additional protection is needed
  • Changes in the regulatory environment
    • Generally speaking, regulatory changes have impacted business directly or indirectly, resulting in loss of revenue. This is a leading concern for small business owners.
  • Changes in law (such as those resulting from case law outcomes like the recent Commissioner vs. Avrahami case)

To address all these potential changes, our Spring CARE (Captive Analytical Risk Evaluation) team recommends a captive evaluate its risk appetite and risk exposure at least every ? ve years. Are you still writing the right lines in your captive? Are you still in the right domicile? Would a different structure be more profitable? Would other service providers make a difference? Have your claims changed signi?cantly? Have regulations changed over the years? All this and more can be answered with a good review of your captive by a professional consultant.

Captive optimisation starts with a captive refeasibility study. Every refeasibility study is different to varying degrees; the scope and resources required to conduct the study are dependent on the captive’s current structure, the events (if any) that triggered the study and the goals of the company. That said, through our Spring CARE system, we follow a carefully-constructed evaluation structure when our team works through the process of evaluating captive client’s existing captive. Generally speaking, we follow and recommend the following ? ow process in conducting a refeasabiity study, starting with goals and ending with measurement.

Goals StageRisk Transfer Vehicles

In this initial stage, it is important to focus on con? rming the goals and objectives of your captive, both new and old. Have the older goals been achieved? How have the goals changed over the years? This is a critical step in laying the groundwork and direction of your refeasibility project. Also critical at this early point is the collection of data. We consider the data to be collected here as not only the stats and facts of the captive, but also the more subjective (non-paper) data that can be gleaned through management interviews and informal stakeholder surveys. Finally, in any good refeasibility study, it is very important to identify changes in your risk pro?le. The risk matrix to the right shows the four classic actions a company can use to handle each of their risks (DeLoach 2000).

Typically,  high probability or high impact risks should be considered for insuring in your captive. Some of the most common risks to insure in captives are listed below . Emerging risks should also be considering in this assessment. For example, A new technology like driverless cars will create both risk and/or opportunities across various industries.

Coverages commonly written into captives:

Employee Benefits Risks Property & Casualty Risks
AD&D Auto Liability
Life/Loss of Key Employee Business Interruption
Long-Term Disability Directors & Officers Liability
Medical Stop-Loss General Liability
Voluntary Benefits Professional Liability
Retiree Benefits Property (deductible or excess layer)
Pension Buy-Outs/Buy-Ins Trade Credit
Workers’ Compensation
Commercial Policy Excluded Risk

 

Impact Stage

You want to be sure you have a clear idea of what you’re looking to accomplish, and to what extent. The Impact Stage of a refeasibility study involves looking at all the different pieces of tCaptive Optimizationhe captive puzzle to determine how they would be affected by the changes you’re considering. A few activities that a professional captive optimizer would look to accomplish in this phase would be:

  • Conducting an analysis of your risk financing optimization
  • Reviewing your current reinsurance levels and optimizing your reinsurance use
  • Stress testing of the captive with reasonable adverse case outcomes

Strategies Stage

It’s important to outline the methods you plan on utilizing in your captive refresh; in this Strategies Phase, a professional captive optimizer would ?rst analyse any additional lines of coverage that could be insured by your captive.

Secondly, a surplus management strategy would be developed. There are various considerations in appropriately managing the capital and surplus levels over the life of a captive, including average cost of capital, retention levels, reinsurance use, taxes and a number of others that a team of actuaries and consultants would review and develop strategy to address.

Structure Stage

Now that you know what you want to do and how, it’s time to take a closer look at how it will all work together in a logical structure. Market changes should give you some food for thought. For example, pure captives are increasingly changing to sponsored entities. In this Structure Stage, it is important to identify investment management best practices as well as the optimal collateral structure.

Measurement

Finally, all sound captive projects end with measurement. This is the time to collect new data and determine to what extent goals were met, and impacts made. A great deal of this stage relieCaptive Refeasibility s on the creation of solid industry benchmarks to measure current and future captive performance against. It is also important in the Measurement Stage for the optimization team to develop implementation plans based on their findings and make actionable recommendations for helping you achieve the goals that were established in the first phase of this project. At the conclusion of the measurement phase, a professional captive optimization team, such as our Spring CARE team, would produce a refeasibility report for your captive. In this report, all of the ?ndings of the refeasibility study are outlined and reviews along with the recommendations developed in this phase. These ?ndings can serve as a base line for measurement.

Conclusion

Regardless of how old or new your captive is, there are a number of internal and external factors that have changed since it was created. With all the changes taking place in the industry, it is a great time to have a professional come in and not only take a snapshot of how your captive is currently performing, but also help you project and strategize where your captive should be in the future. Now is a great time for a captive refeasibility study.