What Is Controlled, Unaffiliated, Insurance Business in a Captive?

831(b) Captives

Some US domiciles, especially the newer ones, have been attracting 831(b) captives. These are small captives, limited to $1.2 million ($2.2 million as of January 1, 2017) in annual premium, and used as tax-advantaged wealth transfer vehicles. Rarely are they used primarily to insure risk, although they must do so in order to qualify as a bona fide captive. They must be domiciled onshore in one of the captive domicile states.

Specialty firms calling themselves captive managers are the primary promoters of 831(b) captives. These firms are different from traditional captive managers in that they are true captive purveyors; it is their business to sell captives, the majority of which are of the 831(b) variety. Traditional captive managers do not sell captives per se—they sell captive management services to captive owners. These specialty firms also sell management services, along with a wide range of captive-related services not usually offered by traditional captive managers. They are "one-stop shops" for captives.

For the domiciles, attracting 831(b) captives individually would make no sense, as they're very small and wouldn't represent much revenue to the state or to state service providers. The key is to find 831(b) aggregators—the specialty firms described above.

You'll recall that, for a captive to be a bona fide insurer per the IRS, it must satisfy certain tests regarding risk shifting and distribution. You might wonder how a small captive, owned by a single corporate entity, could come close to satisfying these tests on its own. The answer is that it doesn't satisfy the tests by itself; it joins a pool consisting of a large number of 831(b) captives that share risk. This arrangement is meant to satisfy the risk distribution requirement through insuring third-party business.

As the requisite amount of third-party business is 50 percent as suggested by the IRS, each 831(b) reinsures 50 percent of its risk with the pool. The IRS has not yet examined this arrangement, but an audit of one of the major specialty captive firms is under way as I write this article. Each of the major specialty firms manages a reinsurance pool; without one, there would be no reason for anyone to form an 831(b) captive because they would have no way to share risk.

"Controlled" Unaffiliated Business

Now we will turn our attention to the idea of "controlled" unaffiliated business. To review, unaffiliated business is business that is not owned or controlled by the captive owner—also known as third-party business; this is what satisfies the IRS risk distribution test (as long as the captive has at least 50 percent third-party business). The term "controlled" appears to contradict the meaning of unaffiliated, but many states (captive domiciles) only allow third-party business written in captives if the captive owner controls it.

We must remember that the point of having "controlled unaffiliated business" is to satisfy the IRS risk distribution test. This is accomplished when the captive owners' risks are pooled with the risks of companies not affiliated with the captive owner, thus mimicking the way commercial insurers operate. The following is the paraphrased definition of "controlled unaffiliated business" from one such captive domicile state:

Controlled unaffiliated business means a business entity:

• in the case of a pure captive insurance company, that is not in the corporate system of the parent or the parent's affiliate;
• in the case of a pure captive insurance company, that has a contractual relationship with a parent or affiliate; and
• whose risks are managed in accordance with Subsection 123–456–789 (not the actual citation).

The subsection cited above states: establish one or more standards to ensure that a captive parent or an affiliated company of the captive parent is able to exercise control of the risk management function of a controlled unaffiliated business to be insured by a pure captive insurance company.

According to this state's statutes, there must exist a pure captive before there can be any controlled unaffiliated business, because without a pure captive, why does anyone need the unaffiliated business? Here is how the specialty captive firms deal with this issue: they apply to the regulator for a license to operate a pure captive, but instead of a single-parent owner (typical of a pure captive), these captives have multiple owners—831(b) captives owned by their clients.

While licensed as pure captives, these are in reality group captives through which the members share risk with one another. An analog to this arrangement is a cell captive owned by a third party unaffiliated with the captive's cell residents. However, unlike cell captive owners, the specialty captive firms place a small amount of their own risk into the captive to satisfy the regulator's requirement that a pure captive must be the basis for "controlled unaffiliated" business.

The main idea behind the concept of "controlled unaffiliated business" is to make sure that single-parent captives that need third-party business are in a position to mandate that certain risk management standards are followed by all of the captive's policyholders. This makes sense, because in the absence of any control, the loss experience of the unaffiliated business could undermine the captive's financial well-being by diluting the parent's good loss experience, which is what regulators are trying to avoid.

The specialty captive firms claim that, because each captive member's parent must agree to a standard of risk management, the pooling captive is a proxy for a pure captive. In the majority of cases, the coverages insured in 831(b) captives are claims-made, which does not require that the captive retain loss reserves until a claim occurs.

The majority of these pooling captives do not collect premiums until the end of the policy term, often 30 days prior to the expiration of the extended reporting period. This allows the captive to bill each of the 831(b) captives the difference between the premium due and each member's portion of shared claims. After this reconciliation, the pooling captive will distribute dividends to qualified members. Theoretically, this all happens simultaneously.

One of the problems with this arrangement is that pure captives, including pure captive proxies, must collect the premium at the onset of the policy period. Neither the 831(b) captives nor the pooling captive is fronted, meaning that no collateral is required, and there's no fronting insurer demanding premium payment at program inception. Likewise, the pooling captives are never rated by any of the rating agencies (A.M. Best, for example).

This means that the pooling captive cannot fulfill the state's credit for reinsurance model. In this case, most state regulators require that the captive employ the "funds-withheld" model.

In other words, the premium must be collected, and held, by the ceding entity, at the beginning of the policy term, and not distributed as dividends back to the 831(b) captive owners until the policy has expired and run the full course of its extended reporting period.

Cash Flows

There are two separate cedes in these programs. First, the 831(b) cedes 50 percent of its risk and premiums to the pooling captive. Next, the pooling captive cedes an equal amount of risk and premium back to the 831(b) captive. The second cede is a shared layer retrocession supported by all of the other 831(b) captives in the pooling captive. Because the risk is split 50/50, the premiums are mostly the same, which keeps things simple. The difference between the premiums is that the first cede includes an additional charge (6 percent is typical) that is paid to the specialty captive firm.

The pooling captive is considered a virtual entity used solely for the purpose of sharing risk among the member 831(b) captives. It is a virtual company because theoretically it never actually holds any risk; the risk and premiums are immediately retroceded to the membership. But is this correct? Does the pooling captive have any exposure to the member's risks? From a regulatory perspective, none of these pooling captives is required to register with and report annually to the National Association of Insurance Commissioners.

Conclusion

This article has posed more questions than answers. Is it reasonable for regulators to allow a specialty captive firm to form a pure captive to serve as the pooling mechanism for 831(b) captives? Should the pooling captive be required to collect its premium at the onset of the policy term instead of at the end? And, if the premiums must be paid at the beginning of the policy term, should the pooling captive be regulated as a commercial reinsurer? Should the specialty captive firms act as proxy to a theoretical owner of a theoretical pure captive for the purpose of satisfying the state's risk management requirement for controlled, unaffiliated business?

Good questions all, but there is one aspect of captive regulation that pertains to the definition of "controlled, unaffiliated" business, which we have saved for the end. Most (if not all) of the US states' captive domicile regulators are provided with fairly wide discretion relative to what constitutes risk management (which is the linchpin of the regulation relative to whether or not an arrangement may be deemed "controlled, unaffiliated business"). Put another way, if the regulator agrees with the specialty captive firms' argument that they are capable of satisfying the risk management regulation, everything else falls in line.