Tag Archives: cost of risk

How to Prevent IRS Issues for Captives

A regulator of captive insurance is responsible for many aspects of the business of captive insurance companies. He or she must coordinate the application process for obtaining a license, including the financial analysis and financial examination of each captive insurance company. The regulator is also a key marketing person in promoting the domicile as a favorable place to do business, thus fostering economic development for the state.

The captive regulator is not, however, a tax adviser. No statute and regulation in any domestic domicile requires an analysis of the potential tax status of the captives under consideration or under regulation. If the application complies with the stated statutory and regulatory requirements, the regulator must favorably consider the application and allow the new company to be licensed as an insurance company under state law.

That new insurance company may not, however, be considered an insurance company under federal tax law. The Internal Revenue Service recently listed captives as one of their annual “Dirty Dozen” tax scams, citing “esoteric or improbable risks for exorbitant premiums.” And at least seven captive managers (and therefore their clients) have been targeted for “promoter” audits, for allegedly promoting abusive tax transactions.

Yet all of these captives received a license from a regulator, mostly in the U.S. Obviously these regulators did not consider the pricing of the risks to be transferred to the captive, except perhaps at the macro level.

Should the domicile care about the potential tax status of licensed captives? David Provost, Vermont’s Deputy Commissioner of Captive Insurance, has said, “We do not license Section 831(b) captives; we license insurance companies.” While that statement is technically correct, this paper argues that, with respect to small captives, regulators should care about the tax implications of licenses in extreme cases, consistent, of course, with the laws and regulations under which it operates.

Small captives, i.e. those with annual premiums of no more than $1.2 million, can elect under section 831(b) of the Internal Revenue Code to have their insurance income exempt from federal taxation. This provision, combined with certain revenue rulings and case law, creates a strong tax and financial planning incentive to form such a captive insurance company.

This incentive can lead to an “over-pricing” of premiums being paid to the new captive, to maximize the tax benefits on offer. The premiums may be “over-priced” relative to market rates, even after being adjusted for the breadth of policy form, size and age of the insurance company and, in some cases, the uniqueness of the risk being insured by the captive. But “over-priced” in whose eyes?

Insurance regulators are usually more concerned with whether enough premium is being paid to a captive to meet its policy obligations. From that perspective, “too much” premium can never be a bad thing. Indeed, captive statutes and regulations generally use the standard of being “able to meet policy obligations” as the basis of evaluating captive applications or conducting financial reviews. And actuarial studies provided with captive applications generally conclude that “…the level of capitalization plus premiums will provide sufficient funds to cover expected underwriting results.”

These actuarial studies do not usually include a rate analysis, by risk, because none is required by captive statute or regulation.

Small “831(b)” captives, therefore, may easily satisfy the financial requirements set forth in captive statutes and regulations. If, however, the Internal Revenue Service finds on audit that the premiums paid to that captive are “unreasonable,” then the insured and the captive manager may face additional taxes and penalties, and the captive may be dissolved, to the loss of the domicile.

And, as has happened recently, the IRS may believe that a particular captive manager has consistently over-priced the risk being transferred to its captives and may initiate a “promoter” audit, covering all of those captives. Such an action could result in unfavorable publicity to the domiciles that approved those captive applications, regardless of the fact that the regulators were following their own rules and regulations to the letter.

It is that risk of broad bad publicity that should encourage regulators to temper the rush to license as many captives as possible. There should be some level of concern for the “reasonableness” of the premiums being paid to the captives.

One helpful step would be to change captive statutes or regulations to require that actuarial feasibility studies include a detailed rate analysis. Such an analysis would compare proposed premium rates with those of the marketplace and offer specific justifications for any large deviations from market. (Given the competition among jurisdictions for captive business, such a change would only be possible if every domicile acted together, eliminating the fear that a domicile would lose its competitive edge by acting alone.)

Absent such a change, however, regulators still have the power to stop applications that do not pass the “smell test.” Most captive statutes require each applicant to file evidence of the “overall soundness” of its plan of operation, which would logically include its proposed premiums. If the premiums seem unreasonably high for the risks being assumed, the plan of operation may not be “sound,” in that it might face adverse results upon an IRS audit.

Regulators are not actuaries and often have had little or no underwriting experience. They, therefore, could not and should not “nit-pick” a particular premium or coverage. But some applications may be so egregious on their face that even non-insurance people can legitimately question the efficacy of the captive’s business plan.

Insurance professionals know from both experience and nationally published studies that the cost of risk for most companies is less than 2% of revenue. “Cost of risk” includes losses not covered by traditional third-party insurance, which are generally the type of losses covered by “small” captive insurance companies.

If a captive regulator receives an application in which the “cost” of coverage by that captive is, say, 10% to 12% or more of the revenue of the insured, alarm bells should go off. That captive certainly would have plenty of assets to cover its policy obligations! But in the overall scheme of things, including the real world of taxation, that business plan is not likely “sound.”

At that point, the regulator has a choice of rejecting the applicant, requiring a change in the business plan/premiums or demanding additional support for the proposed plan. We are aware of one case in which the captive regulator required the applicant to provide a rate analysis from an independent actuary when he received an application whose premiums did not appear reasonable.

A rate analysis is not, of course, a guarantee that the IRS will find the premiums acceptable on audit. No one can expect guarantees, but a properly done rate analysis has a better chance of assuring all the parties that the captive has been properly formed as a real insurance company and not simply as a way to reduce the taxable income of the insured and its owners.

Captive insurance regulators have a big job, particularly as the pace of captive formations increases. To protect the domicile from appearing on the front page of the Wall Street Journal, the regulator must consider all aspects of the proposed captive’s business, including, in extreme cases, its vulnerability to adverse federal tax rulings.

The Evolving Metric: Cost of Risk

Measuring the effectiveness and impact of risk management remains a challenge, and it is difficult to convince many C-suite leaders that the discipline is more than just buying insurance. Central to this question is how effective workers’ compensation reporting is and whether anyone has a truly helpful view into workers’ comp’s cost of risk (COR) and its related trends.

Based on numerous meetings with key risk and HR leaders throughout the U.S., I can confirm that many need more insightful risk reporting in many areas of exposure, most particularly employee injury and disability. They want to go beyond what most consider the “standard” risk metrics to those that truly reveal the trends.

Arguably, depending on your industry and the size of your company, employee injury costs may be the largest component part of the total cost of risk (TCOR). Because most risk managers measure their hazard-based risk costs using TCOR (among other techniques), it seems logical to look more closely at how worker’s compensation costs are specifically measured and how effective those data points are.

We should start with that very question: What is success in this realm, and how do we get key stakeholders to care more about these costs and their impact?

Hint: Think strategic priorities.

In my experience, senior management in many companies pay scant attention to this area of expense, even in larger companies with lots of employees. While it may be that the entirety of risk management gets similarly limited attention in these companies, we’ll leave that debate for another time. Let’s proceed on the assumption that TCOR matters to stakeholders and that workers’ comp is often the largest component driver of this measure for many risk managers. Can companies afford to ignore the direct costs of workers’ comp — an expense that may represent anywhere from 1% to 5% of revenue? One would hope not, but we should not stop there.

What about the cost of lost productivity from employees not available to perform their jobs, in whole or in part? It’s been estimated that this “indirect” cost component represents anywhere from two to nine times the “direct” costs in question. Translating that to more meaningful dollars, and using just the midpoints of those two estimated direct and indirect ranges, we’re working with 3% of revenue, with a multiplier of five and a half, giving us an estimated “total” cost impact of 16.5 cents per revenue dollar.

Let’s stretch out that math and apply it to both ends of the range. On the low end, we can use an estimate of 1% of revenue in direct costs and an indirect cost multiplier of two, for a total of 2 cents per revenue dollar. But now let’s look at the other end: an estimated 5% of revenue in direct costs with a multiplier of nine — a total of 45% of revenue.

The tail of this range may seem absurd to many observers, but that is the point; we don’t often take into account the full impact (direct and indirect) of disabled employees and by extension the potential maximum impact their absence has on companies’ performance.

I would further suggest that key senior stakeholders, whether the C-suite, the board or operations management, often have limited understanding of the true cost of the worker’s compensation exposure risk, regardless of how often they see the typical workers’ comp metrics. Clearly, they need more information to make better decisions related to this risk.

While there are, of course, those who do a fine job of parsing and reporting on a lot of workers’ comp data and allowing for some comparison and benchmarking, some of these efforts reflect a more dated historical view and focus more on how states are performing against each other, rather than how companies are performing relative to their own short- and long-term strategies for maintaining a motivated, productive workforce.

Getting more to the specifics, let me suggest that the big opportunity may be to not only take full account of the indirect costs typically related to lost productivity but to find a more focused way to marry the myriad of workers’ comp cost data with the various exposure data so that, when paired and analyzed effectively, there is a more comprehensive and useful story.

For example, one large national retailer has achieved much success in telling its workers’ comp story to management through a selected group of metrics that include the standard traditional measures such as ultimate, incurred or paid losses as a percentage of gross revenue or payroll coupled with more progressive metrics such as claim frequency per 10,000 hours worked (excluding claims without payments). These and other metrics are developed on an enterprise-wide basis, a regional basis and a store-by-store basis with historical comparisons for each to show trend. This approach allows for focusing on controlling frequency and severity on a specific and targeted basis, as each focus would call for distinct reduction and control techniques. The approach also enables a drill-down into significantly underperforming units and specific causes of loss that may be aggravating trends.

There are many ways to measure workers’ compensation performance, and obviously the approach and design should be driven by the needs of the company, the type of industry it operates within, the culture of the company and, of course, the needs of management for information to make decisions that would support both their short- and long-term goals. This nexus between metrics and goals is often overlooked as risk managers can easily get distracted by micro-tactical issues that may not be significant to decision-makers.

A claim director client recently asked me how to respond to her risk manager boss about how managing the workers’ comp unit relates to managing risk strategically. The answer is as simple and as complicated as knowing what the strategic imperatives for her company are and then assessing and informing management on those elements that most affect those goals. Keeping this sight line will minimize the risk of risk-management irrelevancy.

Is Paying Small Work Comp Claims Out of Pocket Ever Smart?

Many of you are well-versed in the importance of medical-only claims to the experience modification rating process. In the vast majority of states, these claims, also known as injury or IJ code type 6 losses, are reduced by 70% for the purposes of the mod calculation. This reduction is known as the experience rating adjustment (ERA).The ERA was first implemented in many states in the late ’90s to encourage employers to report all losses, not just those involving lost-time claims. At that time, it was common for companies to pay, rather than report, their small claims to avoid having those claims count against the mod. NCCI and other stakeholders were interested in collecting all possible data for statistical actuarial purposes, so the ERA was introduced. More than 15 years later, a reduction of medical-only losses now applies in 38 states, but within the industry I still hear a fair amount of talk about employers self-paying small workers’ compensation claims — even in ERA states. The many responses to the March 9, 2014, question “Do Employers Have to Report First Aid Claims?” on the Work Comp Analysis Group on LinkedIn illustrate how complex this issue can be. (Claims designated as “first aid” often have a different connotation from “small medical-only claims” in some states and to some carriers, but the discussion definitely overlaps with this article.)

All of this talk raises the question of whether we can analytically show that it saves– or costs — the employer to pay small med-only claims “out of pocket.” With the help of ModMaster, that’s what I examine in this article. Before we look at some scenarios, let’s not forget the following points.

Key factors to keep in mind

  • Self-payment of small claims is not legal in all states, or may be subject to fines or penalties. Specific rules are determined by state workers’ compensation statutes. For example, the Missouri Department of Insurance specifically suggests taking advantage of the state’s Employers Paid Medical Program to reduce the cost of work comp coverage. Clearly, it’s important to know the rules in your state.
  • Self-payment of claims also has implications at the federal level if injured employees are eligible for Medicare.
  • Employer access to state or “reasonable and customary” fee schedules is an important consideration in the cost of self-paid claims.
  • Perhaps most important, employers paying small claims out of pocket may risk liability if those claims should develop into something more costly.

A sample scenario in states where ERA is approved

For this analysis, I’ve imagined a relatively small business, Mike’s Machine Shop, operating in Missouri and Indiana (both ERA states) with these attributes:

  • An effective date of 1/1/2014
  • Approximately $1.7 million to $1.8 million in payroll each year, in codes 3632 and 8810, generating a minimum mod of 0.73
  • Three itemized losses, all type 5: $8,000, $12,000 and $45,000
  • The assumption that the shop had one $1,000 med-only claim per month in 2012, for a total of $12,000 in type 6 losses. (I chose $1,000 as a value that’s clearly med-only and yet above what might be considered a first-aid-only claim in some states.)

The good news is that self-paying creates a lower mod and therefore a lower premium. In 2014, Mike will save three points on his mod and $1,500 on his premium if he doesn’t report those 12 small claims. And, because those claims aren’t hanging around on his mod for two more years, he’ll save about $1,500 in 2015 and 2016, too. But we’re not done with the story! The bad news is that the self-paid claims costs add considerably – in this case $12,000 – to Mike’s Year 1 total cost of risk.

Let’s look at Year 2 of this scenario and imagine that Mike has instituted some safety improvements so that the shop has had just one small claim per quarter in 2013, for a total of $4,000 in type 6 losses. Let’s also imagine, for the sake of this analysis, that payroll and the other itemized losses have stayed exactly the same, as have rating values.

If Mike is not reporting small losses, then his mod and premium are the same as in 2014. If he is reporting the small claims, then the new claims in 2013 drive his mod to 0.99 — one more point than the 2014 mod. Cumulatively, the 2012 and 2013 small reported claims are responsible for four points, or approximately $2,000 in premium. Because Mike’s self-paid claims costs are considerably lower this year — $4,000 — then the Year 2 total cost of risk differs only by $2,000 between reporting and not reporting losses. Still, though, Mike has a financial advantage to report claims, especially when considered over the cumulative two-year total cost of risk.

The same scenario in a non-ERA state

If Mike were operating in a state that has not approved the ERA reduction, then the impact on the mod of small med-only claims is certainly more significant, and it’s easier to see how the scales could tip in favor of not reporting. However, in this example, using all the same assumptions as above, the overall cumulative cost savings still favors reporting of claims.

In states that have not implemented the ERA reduction, the total cost impact of paying work comp claims out of pocket requires especially close analysis.


These, of course, are just a couple of scenarios, and there are myriad reasons that ultimate costs could vary from these simple examples. However, in all the scenarios that I’ve constructed (many more than discussed here), paying small claims out of pocket seems hard to justify in ERA states. Even in non-ERA states, deciding whether to pay small claims out of pocket demands a detailed analysis that accounts for all associated costs, such as any fines and applicable medical fee schedules. In all cases, knowing your state rules is imperative. Refer to your state’s Department of Insurance or to the NCCI’s Unit Statistical Reporting Guidebook for more information.

As an analytics enthusiast, I tend to believe that claiming all losses results in better data — not just for the bureaus or insurance carriers but also for employers. And better data, of course, leads to more meaningful analysis opportunities. If an employer is working with an agent, broker or other risk management professional to analyze and act on their mod data, then why not have the complete picture and reveal all trends and drive the most appropriate operational initiatives toward improvement?