Captive Insurance - Practical Applications

QUESTIONS AND ANSWERS – STAFFING COMPANIES

G. Kristin Delano, Esq.

 

Question:        Do you recommend writing deductible buy-back coverage in a segregated cell?

 

Answer:           If the captive is going to write reinsurance of coverage written by the standard carrier (provider of the primary insurance covering the statutory requirement), then the policy can be written in a segregated cell.  Each of the leased employees is covered by the standard policy and can be counted as an insured by the for purposes of determining compliance with the tax requirement for distribution of risk.

 

If, however, the standard policy is a high deductible policy, then the standard carrier’s policy covers the leased employees for the first dollar of their coverage.  Injured employees will have not claim against the captive policy.  The staffing company is the only possible claimant.  If that direct policy is written in a segregated cell, there will be only one insured, and there won’t be any distribution of risk.  The arrangement won’t qualify as insurance for tax purposes.

 

Question:        If that is the case, why don’t we simply structure the captive arrangement as reinsurance of what would otherwise be the deductible layer so I can use a segregated cell to protect my assets?

 

Answer:           You can as long as the standard carrier will cooperate.  The problem with a reinsurance arrangement is that the standard carrier will be required to perform due diligence with respect to the captive and negotiate the terms of the reinsurance agreement.  Not all standard carriers are willing to be bothered.

 

Question:        If my assets aren’t in a segregated cell, how is my capital protected from the claims of other staffing companies?

 

Answer:           Your assets will be protected if the captive’s entire obligation with respect to each policy written is 100% reserved with a combination of premium paid by the insured plus capital supplied by the group that owns the insured.  Under such an arrangement, it’s not possible for the claims of any staffing company to exceed the capital supplied by the staffing company and its owners.

 

Question:        Is my standard carrier going to go along with this arrangement?

 

Answer:           If your standard policy is a high deductible policy, your standard carrier will want collateral.  However, there is no reason for them to care whether the collateral is supplied directly by the staffing company or is supplied by the captive placing its reserves into escrow.  As long as they have liquid assets to satisfy the staffing company’s obligations to pay claims, they should be satisfied.

 

Question:        Does the captive policy satisfy my statutory requirement to have workers comp coverage?

 

Answer:           No.  The standard policy written by your high deductible carrier satisfies the statutory requirement.  The captive policy is strictly for the benefit of the staffing company.

 

Question:        I have a guaranteed cost policy.  How would a captive program help me?

 

Answer:           Perhaps by switching to a high deductible policy, you can benefit from keeping a larger portion of your manual premium to add to the profitability of your staffing company.  If that is the case, the captive arrangement can help with your collateral requirements.  If you are not willing to switch to a high deductible policy, there is no reason to invest in a captive program.

 

Question:        What size should my staffing company be before I should consider a captive program?

 

Answer            There are three variables that have to be considered in determining whether a captive is economically feasible for your staffing company:

 

The staffing company’s manual premium;

 

The percentage of manual premium payable as premium to the standard carrier for the excess coverage; and

 

The percentage of manual premium represented by your loss pick/fund.

 

Generally speaking, if you have manual premium of $500,000, significant additional profits can be added to the bottom line of the company by using a captive structure.

 

CAPTIVE INSURANCE FOR STAFFING COMPANIES

G. Kristin Delano, Esq.

 

Introduction

 

Staffing companies with high deductible workers compensation insurance are, in a very real sense, insurance companies.  They are not licensed or regulated as insurance companies, but they bear significant risk traditionally born by insurance companies.  Substantial reserves must be established against these risks – reserves that are generally held by the staffing company’s primary workers comp carrier as collateral. 

 

Unlike a licensed insurance company, staffing companies are unable to take a tax deduction for their reserves.  Assuming the staffing company is an S corporation or a limited liability company, the staffing company must earn $1,538,500, and the owner(s) must pay $538,500 in federal income tax for every $1,000,000 in reserves/collateral it needs to establish.  If the staffing company is subject to a state income tax, the burden is even greater.  This is a serious capital constraint on the staffing company’s ability to grow its business.

 

Captive insurance can provide a cost effective way for a staffing company to reduce the capital drain attributable to current tax exposure.  The tax reduction is a result of the following factors:

 

The staffing company can take a deduction for premium paid to the captive insurance company;

 

The captive can set aside tax deductible reserves.  The staffing company could not take such a deduction, but the captive can, because the captive will be taxed as an insurance company; and

 

The captive’s reserves can be used to satisfy the primary carrier’s requirements for “collateral”.

 

 

PUTTING THE CAPTIVE SOLUTION TO WORK

 

Unlike traditional insurance, a captive usually is not a means for the staffing company to shift risk to unrelated third parties.  The captive will establish its reserves, pay the claims and pay its share of captive administrative expenses with a combination of (i) the premium paid by the staffing company, (ii) capital that will be supplied to the captive by the individuals or entities that own the staffing company and (iii) income earned by the captive on its reserves. 

 

In this context “reserves” and “collateral” are close to being interchangeable terms.  The captives’ reserves are delivered to the primary workers comp insurance carrier to be held as collateral.  As the captive is unlikely to be licensed or admitted in the primary carrier’s state of domicile, the captive arrangement will not enable the primary carrier to receive credit against its reserving requirements unless it holds the captive’s reserves as collateral. 

 

The high deductible arrangement is strictly between the staffing company and its high deductible carrier.  If the staffing company fails to pay the amounts within its deductible, under the laws of most (if not all) states the primary insurance carrier is responsible for the entire amount of the claims from injured employees.  Therefore, the primary carrier must set aside reserves on their books to satisfy their responsibility.  If they hold a letter of credit, cash or securities (subject to state statutes), i) the amount of their own assets that must be used to establish reserves is reduced and ii) the primary carrier is assured that the funds will be there for the staffing company to make good within its deductible layer.

 

The captive will use its reserves to satisfy the primary carrier’s collateral requirements in a variety of ways depending upon the policies and procedures of the primary carrier.  The methods of posting reserves can include:

 

Putting cash (including savings accounts, certificates of deposits, repurchase agreements or similar near cash instruments) or securities into the possession of the primary carrier in return for a contractual obligation on the part of the primary carrier to use the reserves only for agreed upon purposes;

 

Placing the reserves into the kind of trust account used under various state statutes designed to permit domestic carriers to receive credit for reinsurance from non-admitted reinsurers; or

 

Delivering the reserves to a third party financial institution as collateral to support letters of credit in favor of the primary carrier. The benefit of this particular approach is that, subject to the liquidity requirements of the L.O.C. issuer, the captive and its ownership group may have more discretion with respect to the investment of the reserves.

 

 

FEDERAL TAX REQUIREMENTS

 

For the insurance premium to be deductible to the staffing company, the captive and its policy must satisfy the three basic federal income tax requirements:

 

The insured risk (workers comp exposure) must be shifted from the staffing company to the captive;

 

There must be a distribution of risk within the captive i.e. the captive issue policies to several insureds; and

 

The captive must be a real insurance company and not a sham.

 

 

PRACTICAL CONSIDERATIONS

 

An Example

 

The easiest way to explain how the captive would work together with the staffing company and its high deducible carrier is to use the following example:

 

Staffing company X is eligible for a manual premium (ignoring their mod factor) of $5,000,000 of which 30% ($1,500,000) is paid to their high deductible carrier.  That leaves 70% of manual ($3,500,000) that is available to pay premium to the captive. 

 

Whether risk has been shifted under a policy is a matter to be determined by an actuary in each case.  For purposes of this example, it is going to be assumed, if the premium paid is $3,500,000, a policy with an aggregate exposure of $4,200,000, based on the loss history of the staffing company, is going to be adequate to find risk has been shifted.  Let’s also assume staffing company X’s fair share of the captive’s administrative expenses is $75,000.  The difference between $4,275,000 (policy exposure plus administrative expenses) and $3,500,000 (the staffing companies premium) is $775,000.  This difference must be supplied, in some form, by the parties that own the staffing company and not by the staffing company itself. 

 

Assume the primary workers comp carrier may require collateral of up to $4,200,000, the captive will be in a position to supply it.  The capital supplied by the staffing company’s owner(s) as well as the premium may be used for this purpose.

 

 

CONCLUSION

 

Captives are not for all staffing companies.  Staffing companies with a guaranteed cost policy would not need a captive.  Also, the captive arrangement does not change the basic economic arrangement between the staffing company, its ownership group and the high deductible carrier.  The staffing company and its owners, together, will be responsible for the entire insurance exposure attributable to the deductible. 

 

However, if the staffing company has a high deductible policy and annual manual premium of $500,000 or more, it will  enhance its profitability substantially by putting a captive structure in place. 

 

 

 

 

WHY CAPTIVE INSURANCE FOR COMMERCIAL LANDLORDS - PROFITS

Commercial property owners serving third party tenants paying CAM charges can enjoy significant additional profits by using a captive insurance company to insure their windstorm deductible.  The following table shows how much additional profit can be enjoyed based upon the insured value of the properties they own. 

 

 The table is based upon the following assumptions:

 

The percentage of the captive’s premium that can be passed on to the tenants – 85%

 

The marginal income tax rate of the ownership group – 35%

 

The rate of growth of the insured values of the properties – 7.5%

 

The windstorm deductible – 5%

 

Results will vary from property to property.

  

Copyright © 2008 by Biber O'Toole Delano Fowler & Clarkson P.L., St. Petersburg, Florida. All rights reserved.

WHY A PEO WOULD WANT A CAPTIVE INSURANCE COMPANY - PROFITS

PEO’s required to post collateral with their high deductible workers comp carrier can enjoy significant additional profits by using a captive insurance company.  The following table shows how much additional profit can be enjoyed based upon the manual rate of the PEO.

    

The table is based upon the following additional assumptions:

 

The aggregate of the amount of collateral posted and claims payable within the deductible obligation – 45% of manual.

 

Marginal applicable tax rate to the PEO ownership group – 35%

 

PEO annual growth rate over the period – 15%

 

Results will vary from PEO to PEO.

 

 Copyright © 2008 by Biber O'Toole Delano Fowler & Clarkson P.L., St. Petersburg, Florida. All rights reserved.

QUESTIONS AND ANSWERS – PEO’S

G. Kristin Delano, Esq.

 

Question:        Do you recommend writing deductible buy-back coverage in a segregated cell?

 

Answer:          If the captive is going to write reinsurance of coverage written by the standard carrier (provider of the primary insurance covering the statutory requirement), then the policy can be written in a segregated cell.  Each of the leased employees is covered by the standard policy and can be counted as an insured by the for purposes of determining compliance with the tax requirement for distribution of risk.

 

If, however, the standard policy is a high deductible policy, then the standard carrier’s policy covers the leased employees for the first dollar of their coverage.  Injured employees will have not claim against the captive policy.  The PEO is the only possible claimant.  If that direct policy is written in a segregated cell, there will be only one insured, and there won’t be any distribution of risk.  The arrangement won’t qualify as insurance for tax purposes.

 

Question:        If that is the case, why don’t we simply structure the captive arrangement as reinsurance of what would otherwise be the deductible layer so I can use a segregated cell to protect my assets?

 

Answer:          You can as long as the standard carrier will cooperate.  The problem with a reinsurance arrangement is that the standard carrier will be required to perform due diligence with respect to the captive and negotiate the terms of the reinsurance agreement.  Not all standard carriers are willing to be bothered.

 

Question:        If my assets aren’t in a segregated cell, how is my capital protected from the claims of other PEO’s?

 

Answer:          Your assets will be protected if the captive’s entire obligation with respect to each policy written is 100% reserved with a combination of premium paid by the insured plus capital supplied by the group that owns the insured.  Under such an arrangement, there is no way that the claims of any PEO can exceed the capital supplied either by the PEO or its owners.

 

Question:        Is my standard carrier going to go along with this arrangement?

 

Answer:          If your standard policy is a high deductible policy, your standard carrier will want collateral.  However, there is no reason for them to care whether the collateral is supplied directly by the PEO or is supplied by the captive putting its reserves into escrow with that carrier.  As long as they have liquid assets to satisfy the PEO’s obligations to pay claims, they should be satisfied.

 

Question:       Does the captive policy satisfy my statutory requirement to have workers comp coverage?

 

Answer:          No.  The standard policy written by your high deductible carrier satisfies the statutory requirement.  The captive policy is strictly for the benefit of the PEO.

 

Question:        I have a guaranteed cost policy.  How would a captive program help me?

 

Answer:          Perhaps by switching to a high deductible policy, you can benefit from keeping a larger portion of your manual premium to add to the profitability of your PEO.  If that is the case, the captive arrangement can help with your collateral requirements.  If you are not willing to switch to a high deductible policy, there is no reason to invest in a captive program.

 

Question:       What size should my PEO be  before I should consider a captive program?

 

Answer           There are three variables that have to be considered in determining whether a captive is economically feasible for your PEO:

 

The PEO’s manual premium;

 

The percentage of manual premium payable as premium to the standard carrier for the excess coverage; and

 

The percentage of manual premium represented by your loss pick/fund.

 

Generally speaking, if you have manual premium of $500,000, you may want to look further to see if a captive program makes sense .

 

Question:        Do you have any financial illustrations that will assist me in evaluating a captive program as applied by my PEO.

 

Answer:           Financial illustrations are available upon request.

 

Copyright © 2008 by Biber O’Toole Delano Fowler and Clarkson P.L., St. Petersburg, Florida.  All rights reserved.

CAPTIVES – A WAY TO GO BARE ON WIND COVERAGE

G. Kristin Delano, Esq.

 

Lenders customarily require mortgagors to maintain windstorm coverage on their properties.  There are a number commercial property owners, however, who would prefer not to purchase the insurance, but instead would like to take their chances.  The captive insurance solution is a way for both parties to have their way. 

 

The captive structure otherwise described on this site, while it qualifies as insurance, is for all practical purposes, self insurance.  The ownership of the property is typically in a special purpose entity (SPE) - frequently a limited liability company.  The premium paid by the SPE is reasonable in relation to the risk and transfers a risk where it is distributed inside the insurance company.  It will qualify as insurance. 

 

The people who own the special purpose entity, however, provide the rest of the financial backing for the policy – cash and letters of credit.  From their point of view, it is self insurance.

 

The coverage doesn’t need to be limited to a self insured retention.  Instead it can cover 100% of the wind risk. 

 

The policy and the reserves held with respect to the policy can be assigned to the mortgage holder.  The mortgage holder doesn’t need to be concerned with the identity of the captive, because it will hold letters of credit and cash reserves equal to the policy limits.  The mortgage holder will be delighted.  It not only has full coverage for the wind exposure, but it now has a source of significant additional deposits.

 

Both parties win.

 

Copyright © 2008 by Biber O’Toole Delano Fowler and Clarkson P.L., St. Petersburg, Florida.  All rights reserved.

QUESTIONS AND ANSWERS – REAL PROPERTY

G. Kristin Delano, Esq.

 

 

Question:       Do you recommend using segregated cells for the insurance written for my real estate?

Answer:          Not unless there are 12 or more insured entities in the segregated cell.  If an ownership group has a number of insured entities, they could put all of their insureds in a segregated cell.  Otherwise, a segregated cell can not be used as there would be no distribution of risk. Each cell is treated pretty much as a separate insurance company.  Please see Rev Rule 2002-89, Rev Rule 2008-08 and Notice 2008-19 on the sidebar to this website.  Also beware of the trap as to single member LLC’s.  Please see Rev Rule 2005-40 on the side bar of this website.

Question:       If my assets aren’t in a segregated cell, how is my capital protected from the claims of other PEO’s?

Question:       Do you recommend using segregated cells for the insurance written for my real estate?

Answer:          Not unless there are 12 or more insured entities in the segregated cell.  If an ownership group has a number of insured entities, they could put all of their insureds in a segregated cell.  Otherwise, a segregated cell can not be used as there would be no distribution of risk. Each cell is treated pretty much as a separate insurance company.  Please see Rev Rule 2002-89, Rev Rule 2008-08 and Notice 2008-19 on the sidebar to this website.  Also beware of the trap as to single member LLC’s.  Please see Rev Rule 2005-40 on the side bar of this website.

Question:       If my assets aren’t in a segregated cell, how is my capital protected from the claims of other PEO’s?

Answer:          If the captive’s entire obligation with respect to each policy written is 100% reserved with a combination of premium paid by the insured plus capital supplied by the group that owns the insured, there is no way that the claims of one insured can exceed the capital supplied either by the insured or its owners.

Question:       What value of real estate must be insured for the captive program to be economical?

Answer           The principal variables to be considered are:

The insured value of the real estate (can be the aggregate of separate buildings at separate locations);

The percentage of the insurance premium that can be passed through to third party tenants; and

The amount of commercially reasonable premium that can be charged for the coverage given the buildings’ location.

Generally speaking, you are going to need to have a total insured value approaching $20,000,000 or more for such a program to be profitable for you.

Question:       Can I use a captive to insure something other than the windstorm deductible?

Answer:          Yes.  In Florida we have a problem with windstorm deductibles, but the structure will work for any number of coverages.  For example it could be used to cover earthquake, hail, structural damage from active soils (in such places as Texas), excess flood insurance, sign damage etc. 

Question:       Does this program work for condo associations or apartments?

Answer:          This is a program for lessors who pass through their operation costs to third party tenants as a common area maintenance expense – such as commercial office buildings or shopping centers.  Generally neither condo associations nor apartments pass through common area maintenance expenses.  Similarly, if the commercial property is owner occupied, there is no reason to use this captive program. 

Copyright © 2008 by Biber O’Toole Delano Fowler and Clarkson P.L., St. Petersburg, Florida.  All rights reserved.

 

 

WINDSTORM DEDUCTIBLE - A CAPTIVE INSURANCE SOLUTION

G. Kristin Delano, Esq.

 

Introduction

 

In recent years commercial real estate owners have faced higher windstorm deductibles than in the past.  While the standard deductible is 5% of the insured value, higher deductibles have been quotes, and some property owners have been unable to get windstorm coverage at all.  On $20 Million in insured value, the windstorm deductible at 5% would be $1 Million.  If the landlord self insures that deductible, he has no common area maintenance (“CAM”) expense to pass on to tenants.  However, bearing the windstorm risk is a real cost of owning and operating a building; it is a legitimate CAM expense.  In the event of windstorm damage, the landlord will bear the entire amount of the deductible, and may or may not be able to impose a portion of that expense upon tenants as an after the fact CAM charge.

 

 

Putting The Captive Solution To Work

 

A captive insurance company can be used to routinely raise funds from tenants to cover at least a portion of the windstorm deductible.  As long as the premiums paid are within the range of commercial reasonableness and satisfy all of the tax requirements for deductibility, they can be a means of raising funds from tenants to create reserves against future storm damage.

 

 

An Example

 

Assume real estate worth $20 Million and a windstorm deductible of 5% or $1 Million.  Also, assume that a fair premium for the first layer of property risk is $1 for every $5 of insurance coverage. The amount that constitutes a fair premium for coverage will vary depending upon the location of the property and whether the general status of the market for wind coverage.

 

The premium for a $1 Million policy would be $200 Thousand.  The captive will need capital to cover the entire $1 Million in liability on its policy plus its administrative expenses.  The additional $800 Thousand can’t come from the insured as no risk would be shifted; the structure wouldn’t’ qualify as insurance for federal income tax purposes.  Instead the owners of the insured will need to make a contribution to the capital of the captive.  This can be done through a combination of cash and other secure non-cash instruments. 

 

If there is a serious windstorm in the first policy year, the landlord will have $200 Thousand of tenant money (less applicable expenses) to effect repairs and will only have to supply $800 Thousand of its own funds - rather than the entire $1 Million.

 

However, to the extent that there is no significant wind damage, the premium becomes earned premium.  The lessor will be entitled to retain the profit from the policy – to create reserves for future losses, or otherwise.

 

Again, if there is significant storm damage, the tenants will contribute to the repair of the property, if not, the ownership group will profit from the tenant contributions.

 

Copyright © 2007 by Biber O’Toole Delano Fowler and Clarkson P.L., St. Petersburg, Florida.  All rights reserved.

 

CAPTIVES ARE NOT JUST FOR WINDSTORM - OTHER PROPERTY APPLICATIONS

G. Kristin Delano, Esq.

 

In an article published on this site on February 14, 2008, I wrote about how captive insurance could be used to cover windstorm deducibles.  Generally, commercial property owners can pass the premium on to tenants as a common area maintenance (“CAM”) expense.  The captive can easily become the owners’ profit center.

 

It is possible to apply the same captive arrangement to cover any number of property perils.  For example, the property owner may wish to cover flood exposure in excess of the coverages available from the federal flood insurance program.  Earthquake coverage may be unavailable or very expenseive.  Also, standard policies don’t generally cover landscaping or building signs. 

 

Just as is the case with the windstorm deductible, if the property owner simply self insures these risks, there is no CAM charge to pass through to the tenants.  To the extent that the owner is able to pay a commercially reasonable premium to a captive for these coverages, a CAM charge is created, and the tenants will carry their fair share of these legitimate items of building operating expense. In years when there are no claims or minimal claims, the owner will benefit from a profitable captive insurance program.

 

Copyright © 2008 by Biber O’Toole Delano Fowler and Clarkson P.L., St. Petersburg, Florida.  All rights reserved.