G. Kristin Delano, Esq.
Introduction
PEO’s 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 PEO’s primary workers comp carrier as collateral.
Unlike a licensed insurance company, PEO’s are unable to take a tax deduction for their reserves. Assuming the PEO is an S corporation or a limited liability company, the PEO 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. This is a serious capital constraint on the PEO’s ability to grow its business.
Captive insurance can provide a cost effective way for a PEO to reduce the capital drain attributable to current tax exposure. The tax reduction is a result of the following factors:
The PEO can take a deduction for premium paid to the captive insurance company;
The captive can set aside the premium as tax deductible reserves. The PEO 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”.
Admittedly, the result may be no more than a deferral of the income tax. If the PEO’s collateral is used to pay claims, the deduction is available in the year of payment. On the other hand, while an immediate deduction may be available for premium paid to a properly structured captive, if at some future date, a portion of the captive’s reserves are released as being redundant, income will be recognized at that time.
However, the timing difference is important. First, the tax may be delayed to a future date when cash is available to pay it i.e. when reserves, which are highly liquid, are released. Second, reserves can easily be in seven figures, and the time value of money enjoyed by putting off tax impact can be significant.
PUTTING THE CAPTIVE SOLUTION TO WORK
Unlike traditional insurance, a captive usually is not a means for the PEO 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 PEO, (ii) capital that will be supplied to the captive by the individuals or entities that own the PEO and (iii) income earned by the captive on its reserves.
In this context “reserves” and “collateral” are close to being interchangeable terms. Sometimes PEO’s set aside and hold their own reserves against future workers comp losses. More often the reserves are delivered to the primary workers comp insurance carrier to be held as collateral. The release of the collateral on the part of the primary carrier is usually going to result in a corresponding release of reserves on the books of either the PEO or the captive insurance company, as applicable. If the reserves were deductible by the captive insurance company, then the release of those reserves will result in taxable income.
Usually, there will continue to be a requirement for the primary workers comp carrier to hold the reserves 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 deductible arrangement is strictly between the PEO and its high deductible carrier. If the PEO 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), the amount of their own assets that must be used to establish reserves is reduced.
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 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 reinsurance carriers; 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 PEO, 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 PEO to the captive;
There must be a distribution of risk within the captive i.e. the captive must insure several parties; 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 PEO and its high deducible carrier is to use the following example:
PEO 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 PEO, is going to be adequate to find risk has been shifted. Let’s also assume PEO 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 PEO’s premium) is $775,000. This difference must be supplied, in some form, by the parties that own the PEO and not by the PEO 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 PEO owner(s) as well as the premium may be used for this purpose.
CONCLUSION
Captives are not for all PEO’s. Most PEO’s with a guaranteed cost policy would not need a captive. Further, even if a PEO has a high deductible primary workers comp policy, unless the amount of collateral they are required to place with their primary carrier on an annual basis is expected to be $500,000 or more, a captive arrangement probably isn’t going to be a cost effective solution.
Finally, the captive arrangement does not change the basic economic arrangement between the PEO, its ownership group and the high deductible carrier. The PEO and its owners, together, will be responsible for the entire insurance exposure attributable to the deductible. However, the captive can be an effective tool to shift the timing of a tax impact from the time when reserves have to be posted (and funds may not be available for payment) to a time when reserves are released as unnecessarily large (and cash is available for payment).
Copyright © 2008 by Biber O’Toole Delano St. Petersburg , Florida
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