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.
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