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The COVID-19 Pandemic: Opportunities and Implications for Captive Insurance

The COVID-19 Pandemic: Opportunities and Implications for Captive Insurance

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The COVID-19 Pandemic: Opportunities and Implications for Captive Insurance explores the challenges presented by today's business and economic upheaval, as well as the hardening insurance market, and what it means for the captive insurance industry.

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Stewart Feldman: Captive Insurance Person of Interest

Stewart Feldman 600x300
June 04, 2018
We don't normally find many individuals holding both certified public accountant (CPA) and juris doctor credentials in the captive industry. How did you decide to pursue both professional designations?

In my mind it was a natural move. Over the years, I was frequently involved in insurance matters—both P&C and life—for significant closely held businesses. This led me to engage in alternative risk planning in the 1990s, leading to captive planning beginning more than 20 years ago. The nature of captive planning in the for-profit sector (that is for other than, for example, a not-for-profit hospital), calls for heavy involvement by tax and corporate lawyers. Unless the approach being taken is a "one size fits all" or a cookie-cutter approach as seen in cell arrangements, we don't think it is possible to properly engage in this captive work without significant senior attorney and CPA involvement on the operational side as well as in the planning's design side. For this reason, I feel right at home in this area. Despite it frequently being brushed under the carpet, the fact remains that many significant planning and operational issues are legal, tax, and professional accounting in nature.

What drew you into the alternative risk transfer market and captives specifically?

In the 1990s, we began seeing clients with significant risk mitigation demands. We frequently saw, for the last several decades, the limitations of commercial insurance, with the many exclusions, and the difficulty of collecting on commercial losses. These difficulties were seen by us with large companies (e.g., Exxon on its Valdez pollution claims arising out of Valdez) and with smaller companies (e.g., injection well operators whose liability carriers arbitrarily delayed and denied coverage). We thought that there must be a better way. Because many of us are corporate and tax lawyers by background, we identified captives as a well-tested solution.

How did you come to form Capstone Associated Services, Ltd.?

"It takes a village" to properly undertake captive planning. A captive manager leaving it to the client to hire accountants, financing lawyers, tax and corporate lawyers, auditors, etc. predestines the likely failure of the planning. Work put on the client is unlikely to be done. For certain, it won't be done efficiently and timely and likely not by experts in the field. And few captive managers take overall responsibility for the captive planning by including tax, corporate, and audit defense in their "turnkey" offerings. We saw the need to offer the client a bundled alternative—like a PPO or HMO in the health insurance area—where the client can benefit from a whole team in place for one fee or if they preferred, an unbundled service. Thus, in 1998 we formed Capstone, which works cooperatively with its law firm affiliate in the planning, both at the design and formation phases and on an ongoing operational basis. Our success in operating the planning over the last 20 years is evidence that this approach works for our clients. And it has resulted in more than 55 successful IRS reviews of all sorts and a much larger number of reviews by the domiciles.

It would appear from your numerous articles that you strongly believe that captives make sense for both midsize and small businesses? Walk us through your rationale, and how do you convince owners and entrepreneurs concerning the benefits of captive insurers?

Firstly, we don't try to convince clients of anything. The process is one of examining the operating businesses, the proposed insureds, the risk profile of the businesses, and then examining such against captive options. There are various approaches to take in terms of risk mitigation. Alternative risk planning is not limited to captives. Our approach joins together the CPCUs (we have six on staff), the accountants (of which six have held CPA certificates and have practice experience), the ARMS, and the lawyers, etc. in examining and analyzing the client's issues. We then educate the client on its options and present alternatives and recommendations. Sometimes the result is a captive assignment; sometimes the result is something else.

Obviously the IRS continues to scrutinize the captive insurance market. What are the issues that captive owners and boards of directors should be aware of in this regard? Any particularly salient matters you think management should be looking at?

The reason the IRS continues to scrutinize the captive insurance market is that it is a fruitful area for IRS examination. Much of the planning that we've seen is half-baked. There are hundreds of captive cases pending in the Tax Court, many of them centered around a few managers. The IRS has identified managers that produce what it considers is an inadequate captive program. Unfortunately, this is much of the industry. This is the focus of the IRS's attention. One captive manager, which certainly had the ability to do the planning right, chose instead to undertake incomplete work by having a knowingly inadequate insurance team in place. More than 100 captives have failed and are being wound down with significant consequences to the clients. Another captive manager, part of a large broker organization, disclaims legal and professional services and found itself subject to the client list turnover in a US District Court subpoena issued by the IRS, including the turnover of the names of all clients and email communications. The IRS obtained emails of this insurance brokerage openly marketing its program essentially as a "tax shelter." A tax court decision is pending, which is expected to be adverse, having consequences potentially for that captive manager's other pending cases.

Those involved in the industry well know that not all captive managers are created equal.

Capstone believes the preferred approach is with a team captain or a quarterback leading the project, not merely ignoring necessary work or deferring to others with the hope that the client will follow up. Otherwise, a serious problem is festering.

The main issue that prospective captive owners should be concerned with is understanding that "captive management," as carried out in the industry, is clerical and ministerial in nature. Rarely is a "captive manager" doing or capable of doing work other than administrative. In fact, 90 percent of "captive management" agreements disclaim tax and legal responsibility, which guts the heart of the planning. It is a bit like a hospital disclaiming medical services! The only matters not disclaimed are clerical and administrative in nature or that the captive manager will "cooperate" with a tax audit.

I recall walking a client through a "captive management" agreement from a commercial bank that oddly entered the "captive management" business. Reduced to its basics, the bank's 20-page agreement said that it was a mail drop service, offering a conference room in Wilmington, if needed, and delivery services. Underwriting, actuarial, corporate law, regulatory law, tax, and other services were disclaimed. Essentially provided were the services of Mailboxes, etc. Clients wrongly assume that that "captive management" has some magic all-encompassing meaning in the industry, such as calling for the services necessary for the success of the planning. And clients assume that the "captive manager" is both professionally capable of performing the necessary planning and, in fact, is doing so and is financially capable of defending the planning. This is rare in practice.

What's more troubling is that the ability to clean up past inadequacies in the planning is limited.

When a business owner moves forward with the planning, he/she should fully vet the prospective captive manager and determine if it has the expertise to handle all aspects of the work. The business owner should consider whether an existing feasibility study properly supports the planning or whether the "study" was a mere telephone interview of limited consequence. Astonishingly, we've even seen handwritten "feasibility studies." You can imagine the poor quality of the work product.

The feasibility study serves as a baseline for identifying proper coverages and premium levels. Looking at what existing risk coverages are versus what risks remain uncovered relative to the operations on the ground of the proposed insureds is the heart of the planning. Captives are bona fide insurance companies, meant to insure the risks of an affiliated business. From the onset, if there isn't an insurance need, then the captive shouldn't be formed. If a business owner already has a captive in place, reviewing the process followed is similarly important. Weak planning should be identified early on and corrected.

Looking into your crystal ball, how do you see captives evolving in the next 10–15 years? Are there any areas of risk transfer that you think are particularly well suited for captives not being exploited today? Conversely, any risk that you think captives would be well advised to steer clear of?

Given the passage of Dodd-Frank, as further captive legislation is passed by the states, and as more state domiciles put in place captive regulators (and not merely have skeletal legislation and little else), I believe we'll see an accelerated migration to the home states to minimize IPP taxes or the risk of imposition of an authorized procurement tax. Already, the prominence of the well-rooted Caribbean domiciles has ebbed as domestic domiciles have geared up over the last decade. The next migration may be to the home states.

In terms of coverages, one of the places that captives shine best is in supporting evolving areas of risk. Several decades ago, these evolving risks began including product liability, where coverage was problematic. Then there was pollution, terrorism, and now cyber-risk. This doesn't mean that these are exclusive to the captive market. Rather the difficulty in obtaining adequate coverages led to their being commonly placed in captives. No doubt as new business risks become prominent and the commercial markets don't respond cost effectively, the captive market will step in as a partial solution.

The continued growth of the captive market faces headwinds from the antipathy of IRS, whether reporting under section 831(a) or (b). As weaker managers withdraw from the industry, leaving capable players, this problem will self-correct. The impact of the IRS's imposition of Form 8886 and the resulting many tens of thousands of filings have yielded no apparent result, perhaps because the requested information was already largely available to the IRS in independent audit reports, state domicile filings, and Form 1120-PC filing.

Captive managers who are committed to doing the planning properly, with the right talent, will survive to serve the many thousands of businesses which are ripe for captive planning but haven't been through the education process.

We have asked many of our interviewees this question—given the need to attract top-quality talent, how does the captive industry compete?

Captives remain a niche industry and as such, the available talent pool is limited. Similarly limited is the demand for talent. The commercial insurance industry will remain the recruiting pool for the captive industry, with that talent then developed through a multiyear apprenticeship. Programs like the CPCU series of exams and the Vermont ICCIE are helpful as well, but much of the learning, like law and medicine, will be on-the-job training, building upon a solid foundation of education.

On the law and tax side, years of experience in corporate, financing, and tax law are fundamental to then applying these skills to the multidisciplinary demands of captive planning.

Any closing thoughts or comments that you would like to share with our readers?

Doing captive planning right is a whole lot more involved than many believe. Unfortunately, only when challenged do many realize their shortcomings.

Photo above courtesy of Capstone Associated Services, Ltd.

For more than three decades, Mr. Feldman has been the CEO, managing partner, and principal owner of several businesses based in Houston, Texas, where he has lived for 35 years. These businesses currently include Capstone Associated Services, Ltd., The Feldman Law Firm LLP, and RSL Funding, LLC. Mr. Feldman draws upon a strong tax, financial, and accounting background, dating back to a career in public accounting (CPA—Ohio, 1975, and Texas, 1980) following his completion of graduate business school.

In 2007, Mr. Feldman was chairman of Northstar Healthcare, a cross-border roll-up, which was the largest initial public offering on the Toronto Stock Exchange that year. Mr. Feldman was also admitted to practice before the US Tax Court in 2017. As a graduate of the Wharton School at The University of Pennsylvania and The London School of Economics, and as Capstone's CEO and general counsel, Mr. Feldman is considered an expert on tax issues affecting middle-market companies in relationship to captive insurance companies.

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