Should I Set Up a Captive Insurance Company?
What is a captive insurance company? How can I use a captive insurance company both to manage my risks and control the cost of insuring those risks? In a conversation with “Decision Vision” host Michael Blake, Matthew Queen of Venture Captive Management answers these questions and much more.
Matthew Queen, Venture Captive Management
Matthew Queen is the Chief Compliance Officer and General Counsel for Venture Capital Management. Venture Captive Management provides turnkey alternative risk financing services for middle market companies seeking greater control and profit in their risk funding solutions. The firm is a boutique provider of underwriting, accounting, claims management, and risk management. Solutions offered by VCM include the establishment and operation of single parent captives, group captives, association captives, risk retention groups, and managing general agencies. VCM manages insurance companies with three guiding principles: to provide asset protection for the beneficial owner, to control the process, and to provide profit to the beneficial owners. The captive is first and foremost designed to capture the underwriting profit that would normally stay with the standard commercial carrier under traditional insurance coverage.
Michael Blake, Brady Ware & Company
Michael Blake is Host of the “Decision Vision” podcast series and a Director of Brady Ware & Company. Mike specializes in the valuation of intellectual property-driven firms, such as software firms, aerospace firms and professional services firms, most frequently in the capacity as a transaction advisor, helping clients obtain great outcomes from complex transaction opportunities. He is also a specialist in the appraisal of intellectual properties as stand-alone assets, such as software, trade secrets, and patents.
Mike has been a full-time business appraiser for 13 years with public accounting firms, boutique business appraisal firms, and an owner of his own firm. Prior to that, he spent 8 years in venture capital and investment banking, including transactions in the U.S., Israel, Russia, Ukraine, and Belarus.
Brady Ware & Company
Brady Ware & Company is a regional full-service accounting and advisory firm which helps businesses and entrepreneurs make visions a reality. Brady Ware services clients nationally from its offices in Alpharetta, GA; Columbus and Dayton, OH; and Richmond, IN. The firm is growth minded, committed to the regions in which they operate, and most importantly, they make significant investments in their people and service offerings to meet the changing financial needs of those they are privileged to serve. The firm is dedicated to providing results that make a difference for its clients.
Decision Vision Podcast Series
“Decision Vision” is a podcast covering topics and issues facing small business owners and connecting them with solutions from leading experts. This series is presented by Brady Ware & Company. If you are a decision maker for a small business, we’d love to hear from you. Contact us at decisionvision@bradyware.com and make sure to listen to every Thursday to the “Decision Vision” podcast. Past episodes of “Decision Vision” can be found here. “Decision Vision” is produced and broadcast by the North Fulton studio of Business RadioX®.
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Show Transcript
Intro: [00:00:05] Welcome to Decision Vision, a podcast series focusing on critical business decisions, brought to you by Brady Ware & Company. Brady Ware is a regional, full-service, accounting and advisory firm that helps businesses and entrepreneurs make visions a reality.
Michael Blake: [00:00:23] And welcome to Decision Vision, a podcast giving you, the listener, clear vision to make great decisions. In each episode, we discuss the process of decision making on a different topic. But rather making specific recommendations because everyone’s circumstances are different, we talk to subject matter experts about how they would recommend thinking about that decision.
Michael Blake: [00:00:42] My name is Mike Blake, and I am your host for today’s program. I’m a director at Brady Ware & Company, a full-service accounting firm based in Dayton, Ohio, with offices in Dayton; Columbus, Ohio; Richmond, Indiana; and Alpharetta, Georgia which is where we are recording today. Brady Ware is sponsoring this podcast. If you like this podcast, please subscribe on your favorite podcast aggregator, and please also consider leaving a review of the podcast as well.
Michael Blake: [00:01:07] And today’s topic is a topic about captive insurance companies, and should you have your own captive insurance program? And I’ve only started to run into this about five years ago when I worked for another accounting firm, and we happened to have a partner that kind of specialized in captives. And I didn’t really realize that if you want to, you can start your own insurance company. Now, it’s not as easy as doing that. It’s not like you just sort of go on Amazon.com, and click buy that insurance company, and you get started. It is a fairly complex process. And we’ve got an expert to talk about that today.
Michael Blake: [00:01:46] But it is under the right circumstances, something that companies, high-net worth individuals and investors may want to consider. It is complex. It certainly kind of goes up and down in terms of reputation. There are accounting firms and law firms that specialize in captive insurance programs. There are accounting firms and law firms that will not touch them with a 10-foot pole. So, you sort of see the gamut. And I think that’s what makes the — one of the things that makes this topic so interesting is because it’s hard to find folks that know what they’re talking about and are willing to talk about it.
Michael Blake: [00:02:30] So, with that, I’d like to introduce Matthew Queen, who is Chief Compliance Officer and General Counsel for a company called Venture Captive Management. He is responsible for regulatory compliance, program development, and claims management for captive insurance companies and risk retention groups. Prior to joining Venture Captive Management, Matthew developed his knowledge base by defending multinational corporations and state, federal and administrative courts, and provided state and local tax minimization strategies for Fortune 500 companies as a tax accountant at big four consulting firm. Matthew holds an undergraduate degree in business management from the Georgia Institute of Technology, a school that I flunked out of as a PhD candidate, and Advanced Degrees in Law and taxation from Georgia State University.
Michael Blake: [00:03:19] Venture Captive Management provides turnkey alternative risk financing services for middle market companies seeking greater control and profit in their risk funding solutions. The firm is a boutique provider of underwriting, accounting, claims management, and risk management. Solutions offered by Venture Captive Management include the establishment and operation of single parent captives, group captives, association captives, risk retention groups, and managing general agencies.
Michael Blake: [00:03:46] Venture Captive Management manages insurance companies with three guiding principles: to provide asset protection for the beneficial owner, to control the process, and to provide profit to the beneficial owners. The captive is first and foremost designed to capture the underwriting profit that would normally stay with a standard commercial carrier under traditional insurance coverage. Matthew, welcome to the program. Thanks for coming on.
Matthew Queen: [00:04:09] Thank you for having me.
Michael Blake: [00:04:11] So, as I like to do with many of my podcasts, I like to start with the vocabulary lesson because we can very quickly get into terms of art, and acronyms, and jargon that will lose the listener. So, let’s start with the basics. What is insurance, and where do captives fit within the insurance universe?
Matthew Queen: [00:04:34] Thank you very much, Captive insurance is really not as complicated as you think. So, you’ve got your checking and your savings account. Generally speaking, you want to spend the money in your checking account relatively soon. The savings account, you keep over here just in case. While the money put into your savings account is no different the money put into a captive insurance company, except, now, by funding our captive, we get a huge tax deduction for the premiums that we put in there.
Matthew Queen: [00:04:58] So, at its basic level, all I’m really doing is helping people to fund for risk. Now, the risks that you look at in a worker’s compensation, you’ve got health care benefits you’re providing for your employees, general, professional liability, those are all just various risks that you can fund with either traditional insurance where you pay premiums over to AIG, let’s say, or you can form your own captive and take all or a part of that risk. So, at the end of the day, it’s just a very tax-efficient way providing for risk management.
Matthew Queen: [00:05:30] So, one of the things that really is fun about what I do is that captive insurance exists at the frontier of insurance. Now, back when I was in my traditional defense, I never really got to go to the frontier. So, you get a case. Ssome plaintiff’s attorney is trying to beat you up for support, sort of, a slip and fall. You may find an exotic case that helps you win the case in some sort of a novel way but at no point are you going to the frontier of legal thought. That is not the case with captives because captives are, in a way, the zenith of risk financing. So, you’re taking on board underwriting, accounting. And even there within accounting, it’s not just gap. You need to have some knowledge of statutory accounting. You got to understand the claims process. You’ve got to understand how to talk in re-insurances. You’ve got to be able to go out there and lay out the risks. So, it really does bring in some novel theories.
Matthew Queen: [00:06:27] Consequently, we get to develop custom insurance products that can insure literally anything. So, my joke I tell people when they’re asking about captives is I can underwrite a ham sandwich. Not me personally, I’m a terrible underwriter. But what you would look at is any sort of a risk may be a good idea for a captive. So, why talk about the boring things? Let’s go straight to the fun stuff. So, for example, you’re now doing business in the UK, Japan, and America. And let’s assume things go south with Brexit and something wacky happens with the currency exchange rate between the dollar and begin-
Michael Blake: [00:07:04] That’s a good assumption, by the way.
Matthew Queen: [00:07:06] Yeah. So, what happens if the pound goes crazy? Can you insure against losses that would manifest as a result of doing cross-border transactions? The IRS is going to sit there and say, “No, no, no. That is nuts.” And this exact issue is that they have some guidance from the IRS where they’ve said, “We don’t like it,” but in 2015, they had a case called the RBI guarantee case where people were essentially insuring against the unexpected bad value of a fleet of cars. Long story short, it kind of looks like a put contract in the sense that you had a fleet of cars that are X when you bottom, expect to be Y at the end of five years. And if some foolish guy gets into an automobile accident, it’s worth much less than Y. They had captive pay out a claim, and the IRS said, “We don’t like that,” took it to tax court, got beaten up. Long story short, you can now ensure a financial interest. So, the currency exchange interest would be analogous to that.
Matthew Queen: [00:08:05] The reason I’m telling you this is only to just bust down the barriers right off the bat that when you’re dealing with captives, general liability, workers comp, all day long, no problem. But then, when you have like a supply chain risk, so you’re now an oil and gas company, and you’ve got some sort of an oddball issue with Venezuela 20 years ago, the IRS would say, “You cannot take a deduction for the premiums paid for supply chain risk. It’s just not an insurable event.” Over time, a lot of these middle market and large companies that have supply chain risks said, “We’re purchasing this in commercial markets. It’s being offered from Lloyd’s of London. We demand that we have the right to do this.” And that sorted itself out in courts. So, that’s where we are constantly. Where the market breaks down or the market is heading, consequently, I get to basically sit at the frontier and look just a little further than I was normally looking back when I was doing insurance defense.
Michael Blake: [00:09:02] And where that frontier is – just I want to make sure I’m absolutely clear – is that some entities are now basically setting up their own insurance companies, their captive, because they’re captive to that one particular company they serve, I assume, one customer, the customer that sets it up. Is that correct?
Matthew Queen: [00:09:25] Yeah, generally speaking. So, what you’re describing is a single parent captive insurance company. And that was developed by Fred Reiss in the mid-50’s. And he had a mining operation where he was unable to get normal insurance. So, he said, “To heck with it, I’ll just go directly to the re-insurers myself. I’ll take the first, let’s just say, quarter million dollars of each million dollar claim, and then I’ll place reinsurance above that.” That is the tried and shrewd method.
Matthew Queen: [00:09:48] And then, he went back and forth with the IRS trying to be able to deduct the premiums to finance that quarter million dollar layer in an reinsurance premium, but that was actually not much of an issue. That worked out really well. That was the creation of captive insurance. But he got laughed out of every single American domicile. And in order to make that fly, he had to go get an insurance license from Bermuda. That’s why captives are huge offshore. Bermuda looked at him, and they said, “This isn’t crazy. This is beyond anything we’ve looked at.”
Matthew Queen: [00:10:18] Now, when he showed up, he had a couple of million dollars to put into a captive insurance company. I mean, it was no different than just starting a new subsidiary company. General Motors wants to start Pontiac. It went ahead and put some capital to do that. So, this mining company said, “We’re just going to start an insurance company.” So, the IRS looked at this, and they said, “I doubt this is real. I mean, at the end of the day, I get that the parent company’s balance sheet is not going to be affected by your losses in this subsidiary. But come on, it’s all on the same economic family. So, if you’re paying premiums into your own little insurance company, how can you deduct that?”
Matthew Queen: [00:10:54] And that right there, we have described the first 60 years of captives. So, that’s a bit of an exaggeration. But in 2005, ’06, ’07, there was a pair of case called Rent-A-Center and Securities cases. The least you need to know about those cases is the IRS had been basically just losing ground inch by inch as larger or smaller and smaller companies start adopting captives for any number of risks. Automobile liability, you’ve got a fleet of cars, you’re probably going to be overpaying if you go to AIG. So, they brought in a captive expert, sit there and set him up with a self-insurance solution. The health care industry, they’re constantly having to deal with issues of medical malpractice and professional liability, so they started adopting it.
Matthew Queen: [00:11:41] And eventually, the IRS started conceding bit by bit like, “Well, maybe if you have 12 subsidiaries, and you’re paying us between that, but we’d never let you to insure the parent company because for whatever reason, that was not allowed.” It just became more complicated and more complicated to the point where the tax court said “Enough.” We look at this right here, this group of risks — and by the way, this is now the new rule for captives. We look at this group of risks, if in that group you can achieve the law of large numbers, such that we can accurately forecast within a standard deviation or two, the frequency of risks and the general severity, then we’re probably going to have an insurance situation. And that’s the debate right there. Do you have enough risk within your captive to actually have insurance?
Matthew Queen: [00:12:29] So, what I like about what we do is we focus on middle market companies that are in areas that are either uninsurable in some periods or lack capacity in the market. So, our company, about 80% of what we do is skilled nursing facilities and assisted living. At one point in the late 1990’s, the rate per bed was over $10,000 per bed for assisted living facilities. So, we created a risk retention group to, essentially, become a new insurance carrier focusing only on professional liability for ALS across the country. And I mean, that’s the model. You see a market breakdown. It’s just basic business 101. So, we created a solution that was accustomed to the market.
Michael Blake: [00:13:15] So, you mentioned awhile back that single parent captives are one type of captive. What are the other kinds? And kind of succinctly, what are the differences between them?
Matthew Queen: [00:13:27] Okay. So, the two big things that you want to think about are single parent group, group captives, and association captives. It’s kind of all in one bucket. So if you have a large company, you probably don’t necessarily need a group captive. You might be able to create your own captive on your own. And that’s really going to be a function of the type of risks that you have running through your company. So, if you have 5000 employees, probably don’t need to be in a group. But if you have like 100 employees, you may need to be in a group. And the simple reason is if one loss is going to basically eat up all the capital in your captive, I actually agree with the IRS, you don’t really have a captive.
Matthew Queen: [00:14:08] So, we can get into the differences between those but what I like about that association group and single parent captives is you can underwrite literally anything. So, all those nut job things I was saying in the beginning, totally fine. 100%, I will defend those to the end of time. Now, there is another form of captive. It’s called a risk retention group. We have a very large one, and it’s operating in 11 states. And I love this because it’s a huge trade-off. You can only write liability through a risk retention group, but you only have to get licensed in one state.
Matthew Queen: [00:14:45] So, I’m going to bring you up to date on something called the McCarran-Ferguson Act. So, in 1945, the Supreme Court was essentially overruled by Congress. So, in ’44, there’s a case called SouthEastern Underwriters where the Supreme Court determined that the business of insurance, like basically everything else, is subject to interstate commerce. Consequently, now, the federal government can regulate insurance. And the Departments of Insurance in 50 states went nuts. And with a surprisingly quick response, Congress passed the McCarran-Ferguson Act 1945, and that restored the power of insurance back to the states.
Matthew Queen: [00:15:25] Now, McCarran-Ferguson Act, you cannot overstate the power of this act. It not only restored the power of insurance back to the states, but it also did so by incorporating an understanding of due process that as it existed in the 1800s. So, not only is it the business of insurance, it’s state law, but it’s that ridiculously strong state law that you had back way before the Interstate Congress clause became a flexible part of the Constitution.
Matthew Queen: [00:15:53] And that’s relevant. I won’t explain why right now, but the least need to know is that when AIG, or CNA, or Chubb, if they want to enter into Georgia, they have to get on their knees and say, “Please let me in. Here’s the filing. Here’s the rates.” And the commissioner has the ability to sit there and say, “You know, I just don’t know how I feel about this.” And that creates a significant amount of power in the insurance department. By the way, it doesn’t matter if AIG has got that exact policy rate and all the capitalization that you need up and running in 49 other states. The State of Georgia has the absolute right to say goodbye.
Matthew Queen: [00:16:31] Now, with the risk retention group, we have IRS domiciled in the District of Columbia. And because the Risk Retention Act was passed pursuant to federal law as one of the very few exceptions to McCarran-Ferguson, all I have to do is get chartered interstate. And chartered is just our legalistic way of saying you can’t stop me. So, I can march into Florida, Georgia, Alabama, Alaska, and I can write liability anywhere I want. It’s this huge loophole, and it allows us to undercut most of the carriers in the market because we’re just not as regulated. So, that’s what I love about the RRG. It’s like a curveball. But, again, I can’t underwrite a ham sandwich. It’s only liability. So, product liability, general liability, medical malpractice, all of those types of risks we can throw into an RRG, but property, no, no, no, no. Worker’s comp? Absolutely not. So, it’s just an interesting way of being able to add some value.
Michael Blake: [00:17:25] So, yeah. And it sounds like under the right circumstances, an organization may want to sponsor or be participant in one of these risk retention groups and may have their own separate captive entities as well, depending on what they want to insure.
Matthew Queen: [00:17:42] Yeah.
Michael Blake: [00:17:43] You have your own sort of portfolio, I guess.
Matthew Queen: [00:17:45] Yes. So a company like General Motors, they have their like multiple captive insurance companies. So, that would be your Fortune 1000 strategy. Most of your middle market companies, getting a captive up and running, it’s a sink of capital. So, you really do need to be in a situation where either you are best in class in what you do, and you don’t need to be paying as much in premium as you are, or you’ve got some sort of an unusual spot where the markets just can’t keep up.
Matthew Queen: [00:18:13] So, I mean, I’ll tell you an area in the market right now that if we could figure out how to underwrite a little bit better, we’d be able to become billionaires overnight. Coastal property anywhere is virtually uninsurable. I mean, it’s borderline uninsurable, and it’s industry non-specific. I don’t care if you’ve got a nuclear power plant, or an oil and gas facility, or a hotel, or anything in a REIT, the property rates are absolutely insane. That’s just because the past couple of years, the hurricanes have been really, really bad.
Matthew Queen: [00:18:43] Now, nobody’s come up with a solution for this quite yet because at the end of the day, there is some efficiency in the marketplace. Underwriters are doing the best that they can, but if we were able to sit there and use maybe insure tech to be able to get there and underwrite a little cheaper or get into a little bit better model of how the hurricanes are going to arise, then, yeah, we could roll out a captive tomorrow and bring in a whole bunch of different maybe hotels, for example, or municipalities, and basically custom write an insurance program.
Michael Blake: [00:19:12] That’s very interesting. So, I think, historically, one use of captives has been to insure risk that you couldn’t necessarily get out in the market. In the early days of my association with captives, I used to see cyber liability insurance because you couldn’t get it, or you couldn’t get in a conventional form. You see a lot of terrorism insurance as well. Are captives also being used to find kind of these holes in the market where you just cannot buy conventional insurance, or it’s just economically just not feasible to do it the normal way or the conventional way?
Matthew Queen: [00:19:53] Yeah. So, like the oil and gas industry, it has a huge loophole in its standard commercial general liability policy. The cyber risk for oil and gas is unusual, where if you can lean — I need an oil and gas expert here to walk me through it, but you can basically shut down safety valves in parts of the pipelines and turn these things into bombs remotely. Now, that’s a cyber liability, and it dovetails with terrorism, but it’s not going to be covered under property, and it probably wouldn’t be covered on your CGL. So, if that occurs-
Michael Blake: [00:20:25] CGL is what?
Matthew Queen: [00:20:25] Commercial general liability policy. So, you may be stuck with an uninsured exposure right there. And that, if you are covering an uninsured exposure, your broker and the underwriters, they should have caught that along the way. But what people don’t realize is that when you’re buying insurance, the insurance contract that you get is like a Tetris piece where each page or, really, each element of the contract is just put together. And each of the elements – let’s maybe just say we have 10 paragraphs over here that talk about the declarations and a couple more paragraphs over here that talk about the coverages and the exclusions, blah, blah, blah – that’s all been put together by teams of attorneys in different carriers that have worked together to come together with some sort of almost like Super Mario solution.
Matthew Queen: [00:21:10] And what I mean by Super Mario is in Super Mario Kart sense where he is kind of good at nothing but kind of okay at everything. That’s your standard ISO forms that you get. So, they have unintentionally some exposures in there that people just overlook because when you’re trying to say, “Oh, okay. Well, you’re a certain type of company over here, you need all of this form, basically paragraphs, that we’re just going to shove in there like little puzzle pieces, it just leads to some coverage gaps.”
Michael Blake: [00:21:37] So, you’ve hinted, and I know this is true, the IRS has — I don’t know if oppose is the right word, but certainly is looking at captives very carefully.
Matthew Queen: [00:21:50] Yeah.
Michael Blake: [00:21:50] Is that fair? So, in general, how is the IRS reacting to them now? Would you say that they’re — right now, would you say they’re more or less welcoming? They’re unwelcoming? Is it purely a case-by-case basis, and you have to kind of look at precedent and make your captive look like something else the IRS has already kind of let pass? How would you characterize that environment?
Matthew Queen: [00:22:13] The IRS’s relationship with captive insurance is like a guy’s relationship with his ex-wife’s new husband. I mean, it is never good, and they are tolerant only because kids are involved. And to lose the metaphor for a second, the IRS looked at the whole concept of self-insurance as a sham. I’m putting money from my checking account into my savings account. You shouldn’t get a tax deduction for that, but at the end of the day, if you’re saying that you can’t get a tax deduction for that, what you’ve really said is you don’t have the right to form an insurance company.
Matthew Queen: [00:22:47] Now, fundamentally speaking, that trumps all over the Constitution, and there’s no way that the IRS could have ever supported that if the defense attorneys that time had been smart enough to just key in on that. But what happened was they had some ill-prepared defense attorneys who just really didn’t understand what was going on back in the 50’s, 60’s and 70’s. It wasn’t until the late 80’s, specifically with a guy who won the Humana case, where they finally started to cobble together the elements of insurance. Now, insurance, as I hinted at before, it’s not a thing. Like when you go out and buy insurance, this is illusory. You’re really entering into a contract. And the concept of insurance is more of an emergent phenomena that exists when you have a couple of elements present.
Matthew Queen: [00:23:32] So, this phenomena was outlined in a long, long, long ago case called [Health Review of the Gears], where they had four elements you want to see. You want to have insurance in a commonly accepted sense. So, right off the bat, standard is kind of nebulous. They also have an insurable interest. You want have risk shifting in risk distribution. So, insurance in the commonly accepted sense is as follows. Let’s say everyone in a room puts money into a pot, and the last man standing gets all the money that’s left over in the pot. But if there’s anything that happens during the course of our lifetimes, we will take money from the pot to indemnify you. But that’s a Totten trust. That is not insurance. So, you have to have insurance in commonly accepted sense, which, generally speaking, is going to involve premiums to a third party that are underwritten appropriately, have an actuary that assesses their appropriate rate and amount of reserves that you need to pay the claims. That’s insurance in the commonly accepted sense.
Matthew Queen: [00:24:25] Then, you have to have an insurable interest. So, going right back to what I was saying in the beginning, the concept of an insurable interest could be a balance sheet item like the residual value of your fleet of cars, or it could be a fleet of workers to whom we owe coverage for worker’s comp. I mean, it could be anything that is a quantifiable loss.
Matthew Queen: [00:24:45] Then, you have the next element or elements, depending on how you look at it, risk shifting and risk distribution. I like to think of it very simply. Risk shifting is making sure that a loss on the captive insurance’s balance sheet does not travel up to the parent company. So, just capitalize that thing. How much you put in there? Whatever the actuary tells you to do. So, they say half a million bucks, there you go. Anything less than that, you’re wrong.
Matthew Queen: [00:25:10] Then, you’ve got risk distribution. And this is the one where we could just argue about angels dancing on the head of a pin. Nobody knows what risk distribution is. And if you hear differently, they’re lying. The IRS doesn’t know. The tax court certainly doesn’t know. And it’s never gone beyond tax court. So, everyone’s kind of up in the air. My personal thought is this. When I’m working with the actuaries, we can reasonably say that in the course of a year, based off of your lost history, you’re going to have X claims, you’re probably going to be okay because you’ve got enough different points of risk in there. So, how do you calculate that? Do you look at it just under your — we’ve got 500 employees in the worker’s comp policy. Is that risk distribution? Or what if we have a general professional liability policy with 500 beds that are insured plus 500 points? Now, do we have 1000 points of risk? Nobody knows.
Matthew Queen: [00:25:57] So there’s a lot of ways of creating this distribution with reinsurance, and I’m probably going way too far in underwriting, but that’s kind of the fun part of what we do. Like everything comes to us is a little puzzle, and it’s my job to say either you have a solution to your puzzle, or you know what, you maybe better serving commercial insurance.
Michael Blake: [00:26:14] So, can we boil it down to two or three things that can help a listener understand what are the gates that we need to think about as to whether or not they should seriously consider a captive insurance program?
Matthew Queen: [00:26:31] So, what I’m always looking for are people who are in high-risk industries. So, anyone who’s getting sued all the time should probably consider a captive. We’re in health care, and the doctors are getting sued all the time, skilled nursing facilities are getting sued all the time. Anything like that is a perfect candidate because 9 times out of 10, with a captive, you’re going to do just a little bit better risk management. And then we can select our own defense counsel. And then, rather than relying on the insurance companies’ hammer clause that just says “Fine, I’ll settle the whole thing for three quarters of a million bucks,” you work with your own defense counsel that says, “You know what, let’s push back, let’s punch him in the nose. And you know what? We may lose this thing, but I bet we won’t lose it for 750 grand.” And you can make that decision when you own the insurance company.
Matthew Queen: [00:27:16] So, that’s one area I look at. Others are just best in class. At the end of the day, there’s winners and losers in the insurance marketplace. And if you’re a loser, stick with commercial insurance. And what I defined by loser is if you are taking more money from the insurance companies than you’re paying in premiums, you probably won’t be insurable for long, but a captive would not be right for you. But there are people out there that are just better than the industry average in terms of the frequency of claims. Consequently, you are now a source of profit to your carrier of choice.
Michael Blake: [00:27:48] So, if you’re, in effect, a good driver, right-
Matthew Queen: [00:27:50] Yes.
Michael Blake: [00:27:51] … insuring yourself makes sense.
Matthew Queen: [00:27:53] Absolutely. And then, I guess the last area I would look at is just anyone who’s in a novel industry. So, we do get calls about once a month on cannabis and hemp. We haven’t really found a good way to do a captive in that situation. But that’s just an area where the market’s breaking down because the underwriters haven’t really figured out what those kind of risks look like. So, any sort of a new industry where you’ve got a lot of more unknowns than knowns, that may be a situation that may be a good fit for captives.
Michael Blake: [00:28:26] So, let’s say now that somebody has kind of heard enough, they say that, “I want to look into a captive,” what does it take to set one up? Because, first of all, is there a kind of a pile of cash you have to have available as a minimum to kind of see that captive, A? And then B, once you pass that threshold, what does that process look like from an expertise in time and expense perspective?
Matthew Queen: [00:28:54] So, the good news is that when you start the process, it’s no different than any other insurance submission. So, if you’ve ever had to go through that, you have to accumulate a couple of years of lost history. You guys sit there and send people in your current policies and the declarations page to see what’s currently being insured. Then, what I do is I take all that info, and I hand it off to the underwriting department. And then, they assess whether or not they think that they can put some layer of the risk within your captive.
Matthew Queen: [00:29:21] So, let’s assume, for the sake of argument, you’ve got some sort of a lender or maybe a landlord that requires you to have 1 million, 3 million commercial general liability limits. Well, you would never put a million bucks of exposure into your own captive. But guess what? Neither does AIG. That’s the joke. AIG, when they look at a risk, why even screw around with AIG? Space X, they have a captive insurance company and limits on their policy are $100, $300 million dollars a piece. And that’s because the FAA has something to say about that. When they were using AIG before, AIG only took like the first couple of million bucks of that claim. And then, they went to the reinsurance markets and said, “Who wants a piece of this?” And that’s a real skill set, by the way, learning how to layer those risks on the back end.
Michael Blake: [00:30:05] Sure.
Matthew Queen: [00:30:06] Now, the piece of paper there, it’s an AIG but that’s not true. At the end of the day, it was a village of insurance carriers all came together for this risk. Now, essentially, all you’re doing with the captive is just taking some layer of that. So, again, going back to the one mill, three mill example, maybe you take the first quarter million dollars because, right now, your capital is such that you can only really put like 100,000 or maybe 250,000 to a captive. Then, over time, theoretically, you don’t have too many clients because you’re a good operator. And instead of taking dividends out of your capital, you let it grow.
Matthew Queen: [00:30:42] Now, we’ve got half a million bucks of capital in the captive. And now, we can write a little bit more risk. We can take, instead of maybe first quarter million per claim, we take the first 350, and so on, and so forth. You expand vertically, and you capture more of that underwriting profit, and you basically cut out the reinsurers or the excess carriers along the way. And eventually, over time, may expand into another line of captive of insurance. So, maybe we started with professional liability. And then, we say, “Oh, man, I’m really getting beat up on health care. So, why don’t we put some benefits through there?” So then, that’s the way we model it. You always want to just start with the biggest problem that you’ve got, and then just slowly expand from there.
Michael Blake: [00:31:17] Okay. So, you figure out what you need to insure. Then, I guess, you figure out kind of what number of dollars makes sense to start that first layer of the insurance pool. And then, you got to arrange, in effect, a syndicate of reinsurers, right? And that’s what you guys do, at least, in part.
Matthew Queen: [00:31:36] Yeah. Yeah. So, I mean, I don’t pretend to know enough about captive insurance to actually do the accounting behind it. I’m not really an underwriter, but we have them on staff. And I think that’s really important. A captive manager should have someone on staff who can underwrite anything. And you need a really experienced accounting — either accounting expert or team, that can sit there and handle these things, because it’s not rocket science, but it’s just not normal accounting.
Michael Blake: [00:32:04] It isn’t, right? Statutory accounting is a little bit different. It’s not quite the same language as GAAP.
Matthew Queen: [00:32:10] That’s right. And whenever you’re dealing with a risk retention group, in particular, you have to be able to present things like that to the regulators. And then, you’ve also got to have somebody on staff that knows something about risk management, litigation, and somebody has to actually get the licenses. So, it really does take a team to actually make these things work. Some people can do it on their own.
Matthew Queen: [00:32:29] So, we were talking with a very, very large grocery store chain not too long ago, and they could just do it on their own. They have an accounting department, but we haven’t talked about that. I know for a fact, Amazon, they do not use a captive manager. They do it on their own. They have a whole risk management department. And within that, they just went out and purchased the best minds from Marsh, and Aon, and Willis, and they’re just doing it on their own. Most people do not have the resources to do that. So, that’s where people like us do really well. That’s why we’re middle market specialists.
Michael Blake: [00:33:04] So, in putting all these specialists together, it sounds like one of the things that you bring to the table is you can be a one-stop shop. And I think that’s fairly new. I’ve normally seen where a client has kind of had to go out, and get an account, and get a law firm, and get an underwriter, and kind of pull all those resources individually, and kind of put that puzzle together. But whether it’s through you or through somebody else, what kind of fees are we looking at or are we looking at fees? Maybe there’s a different structure. I’m just not — I don’t understand. But what is the cost of kind of putting together a — let’s call it a basic plain vanilla captive insurance program?
Matthew Queen: [00:33:46] Yeah, there’s no question about it, captives are not cheap, but they only get expensive when the time is right. So, when I look at a captive, I will look at your lost history. Look, first and foremost, if you can’t get me the right data, you’re not serious enough to even worry about. So, that’s one level of screening. But if someone goes through the process of saying, like, “Hey, I want to use a captive with this. Would you look at it?” I say, “Okay, all right, let’s get a good underwriting submission in.”.
Matthew Queen: [00:34:11] And then, when we look at the underwriting submission and if we can assess the true rate, not what you’re getting charged by the markets, but if your true rate is going to be favorable, and we look at the pro forma that we develop internally, we say kind of — with, then, let’s just say, many standard deviations, if we generally think we can earn a profit for you, that’s when we ask for a little bit of money to actually get off to the races. But by that point, we’re all on board with this thing is going to require for like quarter million in capital, maybe a half a million in capital, depending how much you want to insure. And then, our fees are going to be baked into that, just on the front end to get this thing up and running because we really do have to spend some time going off to reinsurers.
Matthew Queen: [00:34:52] For example, so you’ve got maybe a group captive. All of us are stronger than some of us. And we’ve determined that our little insurance company could probably serve the needs of Georgia. All right. So, maybe all the car dealers come together, and they have some sort of a policy that you have to self-insure the property they have that’s at risk from hail. That’s just one thing we saw in Texas. So then, you go to the reinsurers, and you sit there and say, “Well, any one of these guys, you’re just going to to take your crappy reinsurance policy, but I’ll bet you, you’ll like this aggregate amount of premiums so much that you’ll make a deal.”
Matthew Queen: [00:35:24] So, we’ll get something like a swing rated plan where if we have fewer claims than we expected, then the reinsurers owe us money at the end of the year. You will never get that deal on your own unless you’re absolutely enormous. That’s where group captives can work really well. But that’s not something that I can just wake up and say, “Hold on. Let me just go call my broker real quick.” No, that’s like a whole project that will probably require three to four weeks of work. And then, we go out, and we basically sell to reinsurers on just how much money they’re going to make because we’re just so safe.
Michael Blake: [00:35:52] It’s like putting to their co-op basically?
Matthew Queen: [00:35:53] 100%, yeah. So, there aren’t that many great captives out there. You don’t need that many. What we saw and what we like to laugh at are what I call the 831(b) enterprise risk captives. So, you’ll have like 14 lines of insurance, and it’ll be like one line of insurance will be for computer equipment, and you own like a laptop. So, the IRS looked at this, and they said, “Well, that doesn’t seem like insurance to us.” And it doesn’t to me, either. And that’s where you see some of these. There are some managers in the market who’ve kind of poisoned well a little bit because they were promoting that tax swing.
Matthew Queen: [00:36:27] So, in an 831(b)election, you don’t have to pay taxes on the gross revenues of your captive, just the investment income. So then, what happens is you can basically throw a bunch of premium into a captive, never pay taxes on it, and then dividend it back out, and live the high life. Well, the IRS woke up to that scandal because of the world’s stupidest captive manager. So, if you’re going to do a tax shelter, don’t tell anyone about it.
Michael Blake: [00:36:50] That’s right. The IRS understands there’s tax shelters out there but don’t trash talk about it. They really have a bad sense of humor about that.
Matthew Queen: [00:37:00] So, I was talking with a guy named Jay Atkinson, and he’s one of the early proponents of captives. And he told me the inside story of how the IRS got clued into the captive tax shelter. So, I won’t name who it was, but this poor guy, I mean, he made a very bad mistake. So, the IRS just lost the Securities in Renaissance cases, which were two enormous companies that got legitimate captive insurance companies together and beat the IRS so badly that it really raised the question as to whether or not the IRS still needed to have a captive insurance unit. So, obviously, that bureaucrats inside the IRS went to the Commissioner of Insurance and said, “I don’t think you need us anymore. So, why don’t you go ahead and give a severance package? We’ll go to private industry.” Obviously, that did not happen. So, what they were doing is they were looking for any reason.
Matthew Queen: [00:37:46] Now, back in those days, they had some sort of a conference that occurred once on the West Coast and once on the East Coast on a rotating basis. On the East Coast, in 2005, ’06 or ’07, somewhere in there, they located in Washington, DC. So, who shows up to the DC Captive Insurance conference? Every single guy who just gotten his butt kicked in this case. And then, this fool gets up there in front of the audience and says, “This 831(b) tax election is,” and I quote, “the best tax shelter in the history of the Internal Revenue Code.”
Matthew Queen: [00:38:16] So, then the IRS got real smart, and they just waited like a snake. And quite frankly, I think they got this right because there was a problem with these guys for a while crafting these. The insurance policies are written in crayon, and I don’t want to speak in a metaphor, I’ll tell you exactly what they’re doing wrong. You have this one manager, in particular, when her captive management blew up, I was looking at some of these policies, they were confusing claims made and occurrence-based language, which is a huge deal because under the current policy, your insurance covers you forever during that period of time. Under claims made, your insurance policy ends whenever you get a new insurance contract. So, if you don’t buy tale coverage to cover all that previous period of time, you could be uninsured, but if you combine that language into one policy like an idiot, a court’s going to say, “I have no idea what’s going on here. This is stupid.”.
Matthew Queen: [00:39:04] So, she was doing that among many other problematic things. So, the IRS found the world’s stupidest GAAP manager, and just ran them through the ringer, and then used that as an example to create the 831(b) election transaction of interest. So, that’s called Notice 2016-66. So, they waited over 10 years just looking. And when they finally found the right case to take to court, it was an overwhelming victory for the IRS. And then, they used that under Notice 2016-66 to essentially audit the entire industry. And this was right around the time I started with captives. So, I got real intimate with all my clients real quick because I essentially had to audit everyone right on my first day of work. And it was a tremendous gift, by the way. I mean it couldn’t have been timed better.
Michael Blake: [00:39:46] Sure.
Matthew Queen: [00:39:47] I mean, for me, selfishly speaking. But then, we then started to hear some rumors. Like the IRS had sent secret agents into — I can’t name the name of this guy but it was a huge Southwestern captive manager owned by a Fortune 500 company. And then, they were also sending agents in disguise down to Caribbean domicile, sit there and talk with captive managers and got them on record openly promoting tax shelters through the guise of insurance. And then, they brought another case called Reserve. I know you have two more that are in the hopper right now. And then, I checked the tax docket just the other day, there’s literally hundreds of cases against this one captive manager just waiting.
Matthew Queen: [00:40:28] It all started because one guy was foolish enough to sit there and just openly brag about running a tax shelter in front of the IRS. Now, it took him 10 years to get there, but for these captive managers who are promoting these slipshod insurance companies, their first problem is going to be with the IRS. Now, we’ve already seen the class actions start to pile up.
Michael Blake: [00:40:48] Right.
Matthew Queen: [00:40:49] And there’s this one. I guess it’s the same manager that’s sitting there, just got a hundred tax court cases against him, sat there and said to the plaintiff’s firm, “We are not going to toll the statute of limitations on this class action. The reason being is we don’t believe that you even have a class action because we have this arbitration agreement.” Unfortunately, for them, their defense counsel was a little, let’s just say, overzealous. He didn’t really understand that good plaintiffs firm can rip apart an arbitration agreement that’s already occurred. And now, in addition to having many hundreds of case against the IRS, you now have hundreds of really angry clients all banding against you. And I mean, it’s just falling apart. But to a certain extent, that was to our benefit because there are a number of actors that just kind of need to shrivel off the vine and find their way into the Maltese pension plans in the next tax shelter.
Michael Blake: [00:41:41] So, Matthew, this is obviously a very deep topic. We’ve already gone pretty deep. We could go many more layers deep, but we’ve got to wrap it up because of time. If somebody wants to reach out to you and learn more about this, maybe explore if becoming a captive sponsor is right for them, how can they do that?
Matthew Queen: [00:41:58] So, I work for Venture Captive Management, and we’re located at venturecaptive.com. My phone number is 770-255-4907. And you can reach me at mqueen@venturecaptive.com.
Michael Blake: [00:42:13] Well, that’s going to wrap it up for today’s program. I’d like to thank Matthew Queen so much for joining us and sharing his expertise with us. We’ll be exploring a new topic each week, so please tune in, so that when you’re faced with your next business decision, you have clear vision when making it. If you enjoy this podcast, please consider leaving a review with your favorite podcast aggregator. It helps people find us that we can help them. Once again, this is Mike Blake. Our sponsor is Brady Ware & Company. And this has been the Decision Vision Podcast.
