Underwriting Best Practice for Middle Market Captives

The US middle market captive market faces intense examination from the Internal Revenue Service following the introduction of IRS Notice 2016-66. Transactions within 831(b) structures are now noted as “transactions of interest” and subject to additional documentation and disclose requirements. Every insurance contract entered into is now under scrutiny. The IRS will be looking closely at all transactions and will quickly focus on those that do not conform to their expectations.

Within 2016-16 the IRS has listed aspects of transaction involving 831(b) captive insurance companies that they believe are characteristics of tax avoidance. These include: -

1. the coverage involves an implausible risk;

2. the coverage does not match a business need or risk of Insured;

3. the description of the scope of the coverage in the Contract is vague, ambiguous, or illusory; or

4. the coverage duplicates coverage provided to Insured by an unrelated, commercial insurance company, and the policy with the commercial insurer often has a far smaller premium

5. the amounts of Insured’s payments under the Contract are designed to provide Insured with a deduction under § 162 of a particular amount;

6. the payments are determined without an underwriting or actuarial analysis that conforms to insurance industry standards;

7. the payments are not made consistently with the schedule in the Contract;

8. the payments are agreed to by Insured and Captive without comparing the amounts of the payments to payments that would be made under alternative insurance arrangements providing the same or similar coverage;

9. the payments significantly exceed the premium prevailing for coverage offered by unrelated, commercial insurance companies for risks with similar loss profiles; or

10. if Insured includes multiple entities, the allocation of amounts paid to Captive among the insured entities does not reflect the actuarial or economic measure of the risk of each entity.

By noting the characteristics about which they are concerned the IRS has provided a roadmap for captive insurance companies, insurance managers and prospective captive sponsors.

An independent underwriter can significantly help the captive and the insurance manager to clearly navigate the road ahead.

An actuary has a key role to play in the underwriting process especially where there is deviation from any commercial market comparative. However, an underwriter can also provide an important conduit to maximize the benefit of an actuary.

The role of the underwriter within the captive transaction is to collect key data, identify risk exposures, analyze key risk areas and design the insurance program. Based upon a thorough documented risk assessment and insurance program the actuary can then determine pricing.

It is the underwriter’s role to document within their analysis the specific risks faced by the insured party and assist the actuary to quantify premium to the coverage they are proposing. Any premium allocations should also be conducted by the underwriter in conjunction with the actuary.

The underwriter must be fully cognizant with the scope of the coverage he is underwriting to and that the insurance policy is clear and lacking in the ambiguity or doubling up of coverage that the IRS will be looking for. The underwriter is responsible for the policy wording and any endorsements that may be necessary. It is suggested that the captive, or pool if being used as a front, require the underwriter to formally acknowledge that the issues policy aligns with his underwriting.

All captive underwriting should be determined at arm’s length and ideally should be independent of the captive insurance manager especially where a pooling structure controlled by the insurance manager is being utilized. Wherever possible, conflicts of interest between Insured, Captive and Insurance Manager should be minimized.

In line with 9) above the underwriter, as part of his arm’s length risk assessment, should include commercial benchmarks used and should fully justify any changes established in the captive program. Typically, this would involve amendment to premium charged in view of such things as a broader policy coverage, an increased limit or a reduced deductible.

Where commercial insurance benchmarks are not available the underwriter should establish a risk profile sufficient to explain pricing parameters such as alternative benchmarks, empirical data or severity and frequency analysis. This will assist the actuary in determining a reasonable premium. The underwriter should be aware that comparisons to other captive programs can be valuable, however, they can also compound errors.

Albion Risk Consulting S.A. provides its clients with arm´s length a specialist captive underwriting service. We work closely with captive insurance companies, insurance managers and actuaries to develop innovative compliant captive insurance programs and risk distribution models.

Contact Albion to see how we can help you navigate the IRS roadmap to underwriting best practice.

Greg Taylor

Albion Risk Consulting, S.A.

10th July 2017.