Cell Captives And The Recycling Of Capital

A captive insurance company is an insurance company that is owned as a subsidiary by the parent company. The captive typically exists to provide insurance only to other subsidiary businesses owned by a common parent. The idea is that by using the captive, the parent will retain the insurance underwriting profits that would otherwise have been lost to third-party commercial insurers.

Captives are now commonly used by nearly all large businesses; indeed, it is increasingly difficult to find a top-1000 company that does not have a captive insurance company. Largely because of this saturation of captives in large businesses, much of the new captive formation activity is now in smaller businesses.

But how small is too small? Because of the initial formation costs and annual management costs (at least if you are doing it right), it is unusual that a new standalone captive is formed where the annual premiums paid to the captive will be less than $500,000 per year. That obviously provide a significant barrier to entry to many smaller businesses that would like to take advantage of a captive.

In Revenue Ruling 2008-8, the IRS gave guidance on Protected Cell Captive Insurance Companies, known simply as a "Cell Company". This paved the way for smaller businesses to essentially share captives in a way that their losses were their own, thus yielding many of the benefits of a standalone captive without the larger expenses.

The best way to think of a Cell Company is as a big, single piece of honeycomb, with many hexes (the "Cells") in it. Usually, a professional captive manager sets up and owns the Main Company, i.e., the honeycomb, but then sells or leases the Cells out to businesses that need it. The business owner who needs a captive, but can't afford it, can instead buy or lease a Cell.


Typically, Cell Companies are set up so that the owner of the main company, known as the Sponsor, owns all the shares in the main company, and all the common stock in the individual Cells. A person desiring to use a Cell will buy a preferred share or something similar, which equity is structured so as to give the Cell User the effective control of the Cell.

In a nutshell, the IRS ruled in Rev.Ruling 2008-8 that Cell Company arrangements can work, so long as each individual Cell meets the same requirements for Risk Shifting and Risk Distribution as standalone captives.

Risk Distribution means that the Cell has spread its risk among many insureds. I'll leave that one aside, as my focus here is on Risk Shifting.

Basically, Risk Shifting is easy enough and has two components: First, as the phrase sounds, the risk of loss has actually moved from the insured to the insurer, i.e., from the operating business to the Cell. Second, the Cell must have enough capital to cover policy losses, i.e., claims in excess of the premiums paid to the Cell.

It is the latter component where problems are arising: Inadequate Capital.

By way of comparison, let's first examine a situation where the individual Cells are adequately capitalized. In the following diagram, the Main Company is not contributing any capital to each of the Individual Cells, but the Individual Cells have been capitalized with $200,000 to support risk based on $1M in total premiums (and which we will assume to have been determined to be actuarially sound):


In the above situation, each Individual Cell is adequately capitalized, and need not be concerned with the amount or quality of capital provided by the Main Company, if any. But let's say that an Individual Cell by itself lacks sufficient capital; what then?

Rev.Ruling 2008-8 expresses that an individual Cell can be capitalized by a loan of capital from the Main Company. In other words, if the Cell needs, say, $200,000 in capital to back policy liability arising from $1 million in premiums, the Cell can get a portion or all of this needed capital by borrowing it from the Main Company, by the Cell owner contributing capital into the Cell, or some combination thereof -- such as the Cell owner injecting $100,000 in capital and then borrowing the other $100,000 from the Main Company.


Thus, risk shifting would be met in the foregoing diagram. Each of the individual Cells is capitalized for $100,000 and the Main Company allows each of the Cells to use $100,000 of its capital, for a total capitalization of each individual Cell of $200,000.

The problem is that the Main Company may itself only have some small amount in capital, say for example $250,000 -- but host 50 Cells. Obviously, that same $250,000 cannot be used over and over and over as capital for each of those 50 Cells. If just one Cell taps that capital to pay policy losses, it will no longer be there for other Cells -- as to them, that capital is illusory.

In the following diagram, the Main Company only has $250,000 in capital, and the individual Cells have no capital, meaning that the Main Company's capital could only support one cell.


But that is exactly what goes on with many Cell Captives! Effectively, the Sponsor is recycling the $250,000 in the Main Company, and telling each individual Cell (and the IRS) that the Cells are adequately capitalized with $250,000 -- but they are not. To the contrary, one Cell may be adequately capitalized by the $250,000 but the rest are not capitalized at all and thus fail the test for risk shifting (and thus this arrangement is not considered "insurance" for purposes of the deductibility of the premiums paid to the undercapitalized Cells).

The problem for a business desiring to use a Cell Captive is that it must either itself post adequate capital within Cell, or it must rely upon the Main Company to supply that capital. If the latter, the business must make sure that the Main Company is not recycling its capital, and indeed has adequate, otherwise uncommitted capital (known as "surplus") available to provide capital to the Individual Cell.

Caution Sophistry

To get clients into their deals, Sponsors will often make a variety of representations -- that aren't always correct.

One representation is that the Main Company is "loaded with capital" because it owns the common stock shares in the Individual Cells. While this may be true, whether these shares have any significant value is largely determined by whether the Main Company has access to the underlying assets of the Individual Cells. If not, then these shares are probably not worth much.

On the other hand, if the Main Company does have access to the assets of the Individual Cells, then the other participants in those Individual Cells need to be concerned that their capital can be tapped to pay somebody else's claim!

Which is to say that the complexity of Cell Companies makes them quite dangerous for both participants and the advisors who put them into such arrangements, for the simple reason that so few professionals truly understand them.

The general rule of thumb is that if a captive arrangement will have more than $500,000 in annual premiums paid to it each year, then a Pure Captive (i.e., the client who sets it up owns the totality of the captive) is the better than a Cell Captive, since a Pure Captive owner has complete control over the Pure Captive's assets and operations and need not worry about the complexity of a Cell Captive. Indeed, having large amounts in a Cell Captive and thus potentially exposed to the unknown complexities of a Cell Captive is usually a very bad idea (and probably professional negligence by advisers who suggest such a thing to their clients).

Conversely, under $500,000 in annual premiums, the ongoing expenses of a Pure Captive may be too high for the arrangement to make economic sense, and a Cell Captive may be the only viable option.

What often happens is that a new captive participant will start off in a Cell Company in Year #1, but then in Year #2 will transition to their own standalone Pure Captive. To accomplish that, their new Pure Captive will reinsure the risks of their Cell Company, and take over all of its risks and remaining assets after payment of claims and expenses. It is often a good way for new captive owners to "dip their toes into the captive waters", without going whole hog in the first year.

What you don't want to do is to get stuck in a Cell Captive for a long period of time. As mentioned, Cell Captive agreements are so complicated that only the most sophisticated advisers even understand them, and it is quite easy to draft the documents in a way that the money in a Cell Captive is either outright embezzled, or negligently made available to pay claims in other Cells.

If the amount of money in a Cell Captive is small, i.e., less than $1 million, then the downside of some calamity happening is correspondingly small. However, if a Cell Captive accumulates a lot in the way of assets, it starts becoming a tempting target for somebody -- and thus should at that point be a standalone Pure Captive.

The bigger problem with Cell Captives is that far too many of them are sold as tax shelters, with the premiums amounts being determined by "How big of a deduction do you want?" instead of anything like sound underwriting and actuarial analysis. These arrangements are most often sold by tax attorneys and CPAs, not property-casualty insurance agents or other captive professionals, with the focus almost exclusively on the tax deduction and how much will be returned to the client presuming no claims.

The IRS is well aware of the abuses of Cell Captives as tax shelters, and their effective shelf time as a purely tax tool is counting down. Like anything else of this nature, the best defense to it for clients is a second-opinion, and -- again, like anything else -- if somebody tells you, "this is too sophisticated for other advisers to understand", then run.


This article at http://onforb.es/1ea97Vo

and http://goo.gl/v3dKTR

