IRS Targets Micro-captives
Growth of the captive industry could be devastated if Congress moves ahead with a proposed law that would make it financially unfeasible for micro-captives to be formed.
In February, the Senate Finance Committee considered a preliminary bill that would add restrictive language to the regulation of 831(b) captives, or micro-captives, which are formed with less than $1.2 million in premium. The 831(b) tax election allows captives that qualify to be taxed on their investment income only.
“If you take 831(b)s out of the captive market,” said Dan Towle, director of financial services, Vermont Agency of Commerce and Community Development, “I don’t think there would be any growth in the marketplace. … All of the flash you have heard about huge growth [of captives] is all based on 831(b)s.”
He noted that 831(b) captives are “not a core market for Vermont.”
“Everyone is trying to fix a problem that no one can define,” he said. “We can’t put forth a solution if you can’t articulate the abuse you are seeing. — Dennis Harwick, president, Captive Insurance Cos. Association
On Feb. 10, the Senate Finance Committee briefly introduced the mark-up of a bill that would increase the 831(b) premium amount to $2.2 million, indexed for inflation, as well as add “very restrictive language” that would hamper the formation of micro-captives, said Dennis Harwick, president of the Captive Insurance Cos. Association, which held its international conference in Orlando, Fla., on March 10-11.
“It came from the IRS, which has this position that there is abuse going on,” he said, noting that the IRS has an “antipathy toward captives.”
On Feb. 3, the IRS listed captive insurance among its “abusive tax shelters” on the IRS “dirty dozen” list of tax scams. It cited “abuse involving a legitimate tax structure [involving] certain small or ‘micro’ captive insurance companies.”
The abuse comes in, it said, when “unscrupulous promoters persuade closely held entities to participate in this scheme,” which involves creating onshore or offshore captive insurance companies that should be used for insurance purposes but instead are used to shelter income for a wealthy entity by using “implausible risks for exorbitant ‘premiums,’ ” according to the IRS.
In the Senate Finance Committee, the restrictive language of the proposed bill was temporarily excised, pending more information about captive abuses from the Department of Treasury, but industry insiders are concerned the language will be reinserted. Sen. Chuck Grassley, R-Iowa, is the “moving force” behind the legislation, Harwick said.
“What they were trying to push through the legislature would kill the small captive industry entirely.” — David Snowball, captive director, State of Utah Insurance Department
David Snowball, captive director, State of Utah Insurance Department, said the proposed bill would require that no single owner have more than 20 percent of the premium, and that the captive can’t “assume” reinsurance or risk distribution pools.
“What they were trying to push through the legislature would kill the small captive industry entirely,” Snowball said.
Utah, he said, probably has more than 200 micro-captives, of the 417 captives domiciled in the state. He and others noted, however, that no one tracks the number of 831(b) captives, as it is a tax elective that is taken after the captive is formed.
“Most of the captives out there are legitimate captives,” Snowball said. “They are trying to take advantage of some tax opportunities but they fit within the guidelines the IRS has established for a good captive.”
States most likely to be affected by a change in IRS regulations would be Utah, Delaware, North Carolina, Tennessee and Nevada, among others.
Deca Penn, regulator for the British Virgin Islands, said the proposed change in the law is “a little concerning, but we are just monitoring because there is not much we can do. It’s difficult to say right now because the IRS has not put into place anything concrete.”
The majority of BVI captives are 831(b)s, said Alicia Green, marketing manager, BVI Finance.
“We would like them to leave the situation as it is right now,” Penn said, noting that proposals for captives domiciled in BVI have “to suggest there is a legitimate business.”
Harwick noted the National Association of Insurance Commissioners is trying to develop language for the legislation that would address IRS concerns about abusive captives and isolate offenders from captives formed for legitimate insurance purposes.
The process is difficult, he said.
“Everyone is trying to fix a problem that no one can define,” he said. “We can’t put forth a solution if you can’t articulate the abuse you are seeing. … It’s frustrating shadowboxing perceived abuses that no one has really defined.”
From CICA’s perspective, he said, all captives must be legitimate insurance companies, with valid underwriting, risk transfer, risk distribution and “arm’s length pricing.”
“If it’s really just to transfer wealth,” he said, “our industry is very uncomfortable with that because it’s being called insurance and it’s not. … A bad apple hurts everyone.”
The Noticeable Ones
Corporate executives don’t want to hear about risk management problems. They want solutions. Solutions such as instituting a program that significantly reduces the cost of liability claims or making changes that decrease an organization’s workers’ compensation costs to a tiny fraction of its competitors.
These are the types of successes that build credibility with the C-suite and leaders throughout the organization. But in a Catch-22 situation, it often takes credibility to get the go-ahead to push initiatives through.
That may be difficult for risk managers who have difficulty selling themselves or their ideas, or those who wait for potential problems to come to them instead of stepping out to find possible exposures and offer solutions.
To get a better handle on strategies that really work, Risk & Insurance® talked to successful risk managers who shared how they got top management’s attention and built credibility within the organization, and some of the programs that helped make them respected leaders.
We learned in these conversations that getting the risk management message out is more difficult in larger organizations, with all of the layers and silos. Plus, all companies have politics to accommodate, and often, departmental goals and strategies compete for attention — and budget — with other departments’ priorities.
When effective risk managers get the ear of top leaders, though, they ask probing questions, and offer insights and solutions that impact their organization’s strategic decision-making. They have the answers at hand to questions that are posed. They don’t ask for invitations to meetings without knowing they can contribute.
When personal interaction is challenging, they use email or go-betweens as the channels for transmitting opinions and solutions, while working to establish relationships with the next tier of leaders, who carry out the organization’s strategy.
And when a natural disaster occurs or the latest cyber theft is announced, great risk executives take that opportunity to educate their senior leadership on how their own organization’s coverage would work in such a situation.
To be credible, our sources told us, risk management departments must add value to their companies by instituting programs that increase savings, reduce costs, educate the workforce or mitigate the risks that create the most exposure.
Focus on “yes”
One challenge for risk management, said Hala Helm, chief risk officer at the Palo Alto Foundation Medical Group, is that it is “one of those weird wastebasket categories that a lot of things get thrown into.”
“It’s difficult,” she said. “You have to explain it to people. You have to start from a position of assuming that people don’t know what you do. They don’t understand it or understand how you can help.”
In addition, too often, the risk management department is known as the “department of no,” which limits the reach and influence of risk executives. Operational and corporate leaders tend to tune out constant negativity.
“To have influence, you have to be a person of ‘yes, we can’ versus ‘no, we can’t,’ ” said Jeff Driver, chief risk officer at Stanford University Medical Center and the CEO of The Risk Authority LLC.
“I train all of my risk management professionals that it’s not their role to say, ‘You can’t do that.’ You have to find a way to do things and you have to be creative.”
One of the controversial systems Driver instituted at Stanford — which, he said, “turns risk upside down” — has been PEARL, a Process for Early Assessment and Resolution of Loss. It involves proactively disclosing adverse medical events to patients, apologizing and offering compensation, when appropriate.
“To have influence, you have to be a person of ‘yes, we can’ versus ‘no, we can’t,’ ” — Jeff Driver, chief risk officer, Stanford University Medical Center; CEO, The Risk Authority LLC
“We don’t wait around for a claim to come in,” he said. That differs from the traditional practice of waiting for an adverse incident to be filed and ultimately opting to deny, litigate or settle.
Stanford advertises the process to patients so they know they have direct access to the risk management department to discuss what Driver calls “a concerning act.”
“The fear was that by managing claims and matters in that way, it would increase frequency, potentially increase the costs,” Driver said. “The fact of the matter is we have not seen that.”
Instead, frequency declined, with annual reported claims over a five-year period, as of 2013, dropping from 23 to 15, and overall costs down by 38 percent.
In addition, PEARL, which was officially launched in 2007 and enhanced in 2012, saves Stanford $3.2 million annually off their insurance premium for medical malpractice, Driver said.
Those kinds of results build influence and credibility.
Listen more than talk
It also helps when risk managers listen more than talk, Palo Alto’s Helm said.
“I like for the organization to tell me what their strategy is,” she said. “What their tolerance is, what worries them, what keeps them up at night. You get much better buy-in if they tell you, rather than you dictating to them what it should be.
One solution Helm instituted was creating a physician-owned captive, which not only “moved a lot of money off the corporate books,” but helped drive the importance of risk management to physicians. Previously, the physicians were self-insured but the money resided with the corporate entity rather than the physicians.
“It wasn’t a good alignment of risk and incentives,” she said. “The physicians thought corporate would take care of losses.”
“Everything doesn’t necessarily have to revolve around what I think is right and how to influence the C-suite. I view my role as making sure they are truly educated about the risk and know how the company is impacted based on the risk.” — Ryan McGuinness, senior director, risk management, Rite Aid
The change required buy-in from the VP of finance as well as a lot of education for the physicians about the advantages and downsides of the captive, how it differed from the current arrangement, and what the impact would be on them.
“They are so much more engaged in the risk management function because they know the burden has shifted to them,” she said.
Often, building credibility comes down to finding the organization’s “pain points” — and devising solutions to mitigate those risks, said Bill Zachry, group vice president of risk management for Safeway, which recently merged with Albertsons.
“What’s your exposure?” he asked. “What’s your risk? What are your cost drivers? And then focus in on those so you are bringing down the exposure, and communicate, communicate, communicate to your senior executives.”
For Safeway, it was workers’ compensation costs. “It was so bad when I started, there was nowhere to go but up,” Zachry said.
After he joined the company in 2001, one of the first things he discovered was that the financial incentive structure encouraged managers to think more about workers’ comp charge-back costs than preventing accidents. With his boss’ OK, Zachry had an in-depth discussion with the CFO and got approval to change the incentive program.
“I found out later that the CFO had put that particular program in place and nobody had dared change it,” Zachry said.
But that was the beginning. “I started with the message: ‘Do the right thing for injured workers. Get them well and get them back to work.’ That was the primary focus.”
He also used evidence-based medicine, revamped the company’s settlement philosophy, and began lobbying for a change in California workers’ comp law, among other adjustments.
For the 10 years ended 2014, the industry saw a 112 percent increase in medical costs, he said. Safeway’s increase was 12 percent.
“That gives you credibility with the C-suite,” Zachry said. “That is a competitive advantage because we are paying so much less for the same potential exposure.”
Being able to communicate on the CFO’s level instead of trying to get them to understand risk management terms is necessary as well, he said. Put costs into the organizational framework — such as relating the cost of a claim to the gallons of milk that have to be sold to pay for it, he suggested.
“Money drives behavior,” Zachry said, noting that incentives and analytics are crucial as well.
It’s more involved than just data, though, said Ryan McGuinness, senior director, risk management, Rite Aid.
“Having data is one dimensional,” he said. “You have to know how the company operates. You have to understand how your decisions would impact the company’s operations. It’s not just data necessarily.
“Gaining credibility requires knowing how your decision-making process will affect the company’s operations,” he said.
“Everything doesn’t necessarily have to revolve around what I think is right and how to influence the C-suite,” he said. “I view my role as making sure they are truly educated about the risk and know how the company is impacted based on the risk.”
Priorities among departments are not always going to mesh, he said.
Business needs vary within an organization, noted Stanford’s Driver. Leadership is not always going to agree with risk management.
“You just have to chip away at it,” he said. But sometimes the risk is such that “you may have to put on your storm trooper boots and speak clearly and loudly about the problems with a strategy.”
Get out from behind the desk
The multifaceted demands of risk management require that risk managers sell their skills — in effect, sell themselves — throughout the organization. They must get the word out to every department manager and project manager that help is available to analyze potential risks and exposures.
“I never want to wait for someone to come to me. … If you wait, they will never come to you. If you wait behind a desk, spiderwebs will grow on you.” — Emily Cummins, director of tax and risk management, National Rifle Association
“You cannot sit behind your desk and do risk management,” said Carolyn Snow, director of risk management, Humana. “You can look at figures and look at trends but you can’t really do effective risk management from behind a desk. Being engaged at every level of the organization is really important.”
Snow has seen a lot of changes in senior management, including the CFO, and her immediate boss, since she joined the company 15 years ago.
As “people lined up outside his door for attention,” when a new CFO joined Humana in June, Snow emailed him some of the important risk management issues at the organization, and asked for a meeting.
“To his credit, he had a meeting right away. He was very receptive,” she said, noting that she now meets regularly with the CFO and that he attends meetings with underwriters as well.
But when the C-suite or other leaders are not responsive, it’s important to be “politely persistent.” If you can’t get an invite to the meeting, send an “informed” email about the issue, she said. “Sometimes you need to court other areas of influence and find a champion when you are trying to bring attention to an important issue.
“Don’t come with problems,” she said. “Come with what you think are solutions. … You have to be informed. You have to be credible.”
Rico Ferrarese, senior strategic risk manager at The Lego Group, noted that “credibility is built over the years and influence is something you are given due to the fact that you have experience. The C-suite is not giving you access just because they believe in risk. They believe everything is risky. You must support them in making better decisions or you have absolutely no credibility.”
Ferrarese is involved with between 40 to 60 strategic projects each year, helping the company decide, for example, whether to enter a new country, build a new factory or invest in a new product line.
“Our focus and approach is a little different [than traditional risk management],” he said. “We have to be focused on the opportunities, but we need to be the balance or the devil’s advocate. It’s not always happy faces.”
His role is to ask project managers the right questions to help “drive the conscious choice agenda around risk appetite,” since executives tend to focus more on their gut feelings than analytics, processes and research when making decisions.
“Sometimes I believe decisions are made because things are under pressure. … The closer the deadlines are, it is possible to neglect some downsides,” Ferrarese said.
It’s not just insurance
He is not involved in insurance placement at all, and in fact, several of the risk managers interviewed for this story said that insurance is the least significant part of their job.
Of course, noted Bill Getreuer, director, corporate insurance group, Pfizer, the risk manager’s “visibility and your influence in the C-suite become very, very evident when a claim occurs. … We become the go-to people.”
The C-suite also always takes an interest, he said, in directors and officers insurance because it affects them directly.
But, he notes, for larger companies like his, acting in an advisory role, reviewing contracts and managing claims take higher precedence than placing insurance, he said.
“I think in the normal course of our business, the importance of risk management becomes very evident. Very quickly your customers, your co-workers, your superiors and subordinates discover that you’ve got the knowledge and you have the specific answers to their questions,” Getreuer said.
“As a risk manager or risk management department, your role is never to prevent the business from doing what it has to do,” he said. “Your role is to assist the business by identifying all the exposures you possibly can and transferring as much of the risk to third parties as you possibly can.”
For Emily Cummins, director of tax and risk management for the National Rifle Association, the best way to “accomplish buy-in, cooperation and consideration is when everybody is on the same page.”
For her, that page is spelled out in the organization’s mission of providing safety education and training programs.
To gain insight into the potential exposures, she has traveled across the country to meet hunters and shooters. She has gone onto shooting ranges so she can understand the culture from the inside out.
“I never want to wait for someone to come to me,” Cummins said. “I want to go to where they are. If you wait, they will never come to you. If you wait behind a desk, spiderwebs will grow on you.”
Recently, the NRA expanded the use of technology to educate members, creating three television shows, digital magazines and podcasts on top of its traditional print magazines. With technology comes “new [cyber risk] exposures along with compliance with existing laws,” Cummins said.
She’s been with the NRA for eight years, and wasn’t always included in strategic discussions. “It takes patience and time to earn it,” she said. “The opportunity to be making decisions didn’t come with my title. It came with the respect I earned over time.”
Credibility and respect are crucial because it can be easy for top leadership to overlook the contributions of risk managers.
Don’t wait to be asked
“So much of risk management is proactive planning and soft dollar savings, and that’s difficult for the financial C-suite people to hold that in their hands. To them, it’s an intangible,” said Dan Holden, manager, corporate risk and insurance at Daimler Trucks North America.
“Credibility is probably the single biggest issue that myself and my peers wrestle with because we tend to be invisible,” he said. “And that’s really the death knell to being a successful risk manager — having nobody know who you are, where you sit and what you do.”
Recently, Holden invited himself to a meeting on the design and construction of a new corporate headquarters that is targeted for completion in 2016.
If he hadn’t, the committee members would have gone on erroneously thinking that the company’s existing property and general liability coverage would protect the construction project against exposures, he said.
“Unless you do it every day, you are not going to know,” Holden said.
That situation with the construction project was a bit of an outlier, he said. When he started at the company eight years ago, it was not unusual for Holden to find out after the fact about a potential risk or exposure. That happens rarely these days.
“… That’s really the death knell to being a successful risk manager — having nobody know who you are, where you sit and what you do.” — Dan Holden, manager, corporate risk and insurance, Daimler Trucks North America
And when it does happen? Palo Alto’s Helm said such an event is rare, but sometimes it may be advantageous to let the situation play out “rather than always banging my own drum to be included. It’s always a bit more effective if you have a little bit of a fail and people say, ‘Maybe we should have listened.’ ”
Once risk management does outline the risks, the risk executives agreed that the final decision is up to the business leaders.
“My job,” Helm said, “is to help them make those decisions in an informed way so they are taking a calculated risk. I don’t tell [leadership] you can or you can’t do something unless it’s clearly illegal or just so incredibly stupid.
“I might disagree with their decision sometimes. I might strongly ask them to consider the potential downside, but if they hear that and make their decision in an informed way, I have done my job and I feel fine with it,” she said.
Insurer Required to Defend, But Not Indemnify
On July 27, 2005, Alex Sehat, a footwear company employee based in a Kmart store in Hollywood, Fla., helped a Kmart employee get a baby stroller down from a high shelf.
The stroller fell and struck Judy Patrick, a customer, in the face. She later sued Kmart for negligence, on May 17, 2006, but her counsel ultimately discovered that Sehat was actually an employee of Footstar Inc., which operated footwear departments in Kmart stores.
Footstar contacted Liberty Mutual on June 6, 2007 about the incident, and on Jan. 24, 2008, Kmart formally requested defense and indemnification from the carrier. Two days later, Patrick amended her complaint to include Footstar as a defendant.
Liberty Mutual denied defense and indemnification.
After Kmart settled the litigation with Patrick later that year for $300,000 and $10,000 in Kmart gift cards, the retailer filed suit against Footstar and Liberty Mutual for defense and indemnification. A magistrate judge ruled Liberty Mutual and Footstar owed a duty to defend (as of Jan. 24, 2008, when notice was given) and apportioned Footstar’s fault at 15 percent.
The judge also ruled that the insurer did not act in bad faith by denying coverage and Kmart did not breach the notice provisions of the policy. Kmart appealed.
On Feb. 4, 2015, a three-judge panel on the U.S. 7th Circuit Court of Appeals affirmed the duty to defend, but reversed the indemnification ruling. The opinion cited the “master agreement” under which Footstar operated inside Kmart’s stores. That agreement noted that “any injury had to arise ‘pursuant to’ or ‘under’ the Master Agreement to trigger indemnification, and the Master Agreement explicitly prohibited Sehat’s out-of-department action that resulted in the injury.”
It noted, however, that Sehat’s actions were “potentially covered,” and therefore, the insurer had a duty to defend dating to Jan. 24, 2008, when Kmart made an official request for coverage.
Scorecard: The insurance company was required to provide a defense to the retailer, but did not have to contribute to the $310,000 settlement paid in the case.
Takeaway: Because the Footstar employee violated the scope of the company’s agreement with Kmart, the insurer did not have to indemnify the retailer.
Fraud Negates Coverage
On Dec. 21, 1998, Cigna Corp. revamped its retirement plan, converting its traditional defined-benefit plan to a cash-balance plan.
It assured plan participants that the conversion would not affect benefits accrued as of Dec. 31, 1997 and presented the change as “an enhanced benefit.” In 2001, plan participants filed a class-action lawsuit on behalf of about 27,000 employees, and courts have since ruled that such communications were “downright misleading.”
In a separate but related action in 2012, Cigna filed suit against two of its professional liability and fiduciary liability insurers, Executive Risk Indemnity and Nutmeg Insurance Co., seeking coverage. Each of the insurers had issued excess policies of $10 million.
The other primary and excess carriers settled separately.
The Court of Common Pleas of Philadelphia County dismissed the lawsuit, which was then appealed by Cigna to the Pennsylvania Superior Court.
The main issue before the higher court was whether the policy’s “deliberately fraudulent acts” exclusion precluded coverage, as the lower court had ruled in dismissing the case.
Cigna contended that the policy would cover its conduct as a “wrongful act,” defined in the policy to include “any actual or alleged … misstatement, misleading statement, act, omission … .” It argued the wrongful act provision negated the fraudulent acts exclusion.
On Feb. 3, 2015, the state Superior Court disagreed, ruling that the “plain meaning” of the policy in its entirety is contrary to that argument. In addition, the company’s conduct “would clearly qualify as fraudulent under Pennsylvania law,” which requires as a matter of public policy that insurance coverage not be provided for fraudulent acts.
Scorecard: The insurance companies are not required to indemnify the company up to the $20 million total excess coverage.
Takeaway: Fraudulent activity bars insurance coverage.
Insurer vs. Insurer
On Aug. 15, 2010, before an International Kart Federation race event at the Grand Junction Motor Speedway in Colorado, a 9-year-old go-karter was killed during a practice event when his go-kart collided with a maintenance/recovery vehicle.
The parents sued the Speedway, its employees, the International Kart Federation (which was the sanctioning body for the race event) and others in state court. Mt. Hawley Insurance Co. defended IKF as its insured, and Speedway and its employees as additional insureds.
On June 24, 2013, Mt. Hawley filed suit against National Casualty Co., which provided commercial general liability coverage to members of the National Karting Alliance (NKA). Speedway was a member of the NKA.
The policy covered bodily injury, property damage and personal and advertising injury liability “caused, in whole or in part, by your acts or omissions or the acts or omissions of those acting on your behalf … .”
National Casualty denied coverage, saying the Speedway and its employees did not qualify as additional insureds under the NKA policy. In court, it sought a summary judgment.
The U.S. District Court for the District of Colorado ruled that a summary judgment was warranted, basing its decision on the key term of “acting on your behalf” found in the policy. It cited case law that determined that coverage was not available when a member’s acts are “for his own private actions done for his own pleasure” or “completely personal and voluntary” actions.
“Although Speedway had liability insurance through NKA’s policy, Speedway acted voluntarily and for its own benefit on the day of the accident and not at the direction, request, or benefit of NKA,” the court ruled on Jan. 30, 2015.
Scorecard: National Casualty Co. did not have to contribute a pro rata share of Mt. Hawley’s defense costs incurred on behalf of Speedway.
Takeaway: Merely being a member of an organization will not trigger the organization’s insurance coverage.