EP7 – Matthew Queen, Author & Insurance Attorney on Insurance Captives For Pandemic Coverage

As the insurance industry and society meander through the conflicts of whether pandemics are an excluded or covered peril when it comes to business interruptions, the ability of companies to proactively plan and arrange for the risk management of pandemics will be top of mind and item #1 for every off-site (if they will exist) going forward. One tool that is underserved when it comes to risk management, is the captive insurer. Instead of stock buybacks or increased dividends, there will be a greater appreciation, now more than ever, for companies to use excess cash to buy insurance coverage to cover business interruption due to pandemics. The standard insurance companies are likely to completely back off…but what if, you could create YOUR OWN INSURANCE COMPANY and cover the risk with your excess cash???

In this episode, I spoke with Matthew Queen, Insurance Attorney and author on a book on captives. We discussed what is a captive, the advantages of captives, what they can be used for and how to keep them in regulatory compliance. [ed note: this episode will be the first of many where we explore the concept of captives and other risk management strategies to assist]

Watch here:

Connect:
Matthew Queen (LinkedIn)
Modern Captive Insurance (book) 

Some Useful Links:
The Early Days of Captives (through 1984) 
Frederick Reiss 
IRS Repulsed In Rent-A-Center Captive Case – Additional Perspective
 

Musical Credits:
Shadows by David Cutter Music:
https://davidcuttermusic.com
https://soundcloud.com/dcuttermusic
Free Download / Stream:
https://bit.ly/shadows-david-cutter
Music promoted by Audio Library:
https://youtu.be/qiBHOiEl9EI

Video Credits:
Intro Stock Footage by Videvo

Transcript

Nick
Actually, I'm hitting record now. We are live. And with Matthew Queen. Hello, Happy Friday.

Matthew
Happy Friday to you. Yeah,

Nick
we're gonna be talking about captives. And Matthew, why don't you describe what you do for your day job.

Matthew
I am the US vendor claims manager with Hiscox. I was Previous to that general counsel with Venture Capital Management as the which was functionally almost like a blend between an MGA and a captive manager. So in that role, I came I became somewhat of a subject matter expert in captives. I wrote a book called Modern Captive Insurance with my co author Light Townsend. And that role basically became almost like training for insurance carriers one on one. I think what's interesting about cap you know, they kind of come in to broad varieties, you've got the so called legitimate captives, which function like small insurance companies. And that's what we did. And then you also have kind of be tax efficient captives which, although technically insurance companies really don't function anything like the sort and have been pilloried by the IRS. So it's a pretty fascinating area, I would call it kind of the zenith of risk management. I think that whenever you are looking in the captain area, you have probably either run out of options in traditional insurance, or you decided to take your risk management to the next level, because traditional markets are failing you for some reason. Yep.

Nick
And that's exactly why I reached out to you on this, because I consider you a subject matter expert on it and given the environment that we're in...a lot of conversations that both you and I have participated with on Twitter and probably you have as well, you know, solely In other channels as well as the entire concept of business interruption, when it comes to pandemics generally not a covered peril. I'll I'll leave I'll leave the conversation to the the, you know, the drama around what the states are doing and whether it's, you know, civil ordinance or not. But it just gets down to I I had this conversation with someone who's very close to the San Jose Sharks. And he was he not being necessarily an insurance professional commented on, there's got to be a way that this never happens to us again. And the the fallout to something like this is this doesn't just affect the San Jose Sharks. This This affects all the vendors to those hockey games, the stadium owner, the restaurants and other things in other areas. The television and radio stations and I started to think of that I said, I wonder if there's a captive solution to this and I don't know enough. So let me go to the source. So as as we kind of kind of peel back the onions on this Matthew, maybe start off quickly and just talk about what is a captive you talked about taking it to the next level but in your if you could succinctly Twitter wise, 260 character, this thing. How would you How would you classify or describe define a captive

Matthew
Captive insurance company is a tax advantaged savings savings account. It's no more complicated than that. So, you know, if I put my money in the Bank of America account over here, and I put it in my captive insurance company over here, there's no difference except when I put it into a captive insurance company. Section 162 of the Internal Revenue Code provides for a deduction for business businesses to take for insurance. So if we can take the money that we're otherwise saving for a rainy day, and suddenly create a tax deduction for doing so, you're now winning in two directions. So all of the rigmarole in terms of I mean, it's relatively complex...this is my book, and all this...this is just a way to get a tax deduction. That's all it's, in fact, a way to think about captives is just their financing a self insured retention, or they're financing an extremely large deductible. So that's, that's probably the safest way to use a captive. You are looking at some problem, in this in this case, pandemics. And let's just let's just dive right into it. Like how would a captive work in the situation?

Nick
Please? Yeah, please go.

Matthew
So we're doing we're dealing with something that is practically an uninsurable interest. So we have captives for earthquakes, you have captives for flood. So pandemic flu kind of fall in that general area. What you'd want to do is you would probably want to bring in an actuary to help you help you kind of scope out what is the cost of the risk. So here, obviously, business interruption is what we're talking about. So business interruption is going to be very difficult to finance. Business interruption insurance can be very difficult to find on the private markets or even an E&S space. So what you would do is you basically just calculate out, okay, what's the what's the cost of premium for, you know, financing our company for six months, 12 months, 18 months, and then you put it into a captive. So specifically, how do you do that? Well, you're probably going to need a minimum of a quarter million dollars of capital to put into an insurance company. Right. So that's up top. Yeah, yeah. So this is just common one, how about a quarter million at a minimum? So there are domiciles that'll let you get away with less but let's just talk about like a middle market, real estate Small businesses, small businesses want to come together, there is an opportunity here. So what you would need is what? To get your tax deduction, you'd have an insurance company which comes with two licenses. Number one, the corporate license number two, the insurance company license. So step one, get your corporate license, you can do that in literally any state. And not not exactly at every state. Some states don't have captive laws like California, but 35 or so states are available. And a handful of places across the world, I've got a lot of experience in the Caribbean, they are fantastic. And their minimum statutory capital down there is about $100,000. You don't want to go to the minimum, because you have to maintain something called your surplus ratio. At the end of the day, you need to make sure that your premium-to-surplus ratio is about five to one, you can start off at like a 10 to one where you essentially just grow your surplus over time. But then you're really rolling the dice open, you don't actually have a claim because all of a sudden you have an insolvent insurance company, and it's one of the very, very few things that can get regulated. angry at you in the captive space. So step one is set up the corporation which you can do, just like any other Corporation, I won't go through that. The insurance license generally speaking just requires you to have a bank account with a minimum statutory capital which would be, again $100,000 or smaller domiciled, in America can be as high as half a million dollars. So then you fill in an application, you do the paperwork, so long as you're a upstanding member of society, you get an every single time...problems, and this is unfair, if you've ever had a bankruptcy can be tough. I had a guy who got screwed in 2008. And I had to basically say, I'm sorry, we have to find someone else to step in as a Director and Officer of that captive. It wasn't fair. I mean, he just the way it is. So once you get your license up and up and running, we now have to protect that tax deduction. Because you can have a captive let's just say we established one in Bermuda, but the IRS doesn't have to recognize that those premiums and that's not real. is the driving factor here. It doesn't matter if your General Motors or some small business, if you go through the time and expense of an insurance company, you need to get that tax deduction. So what you do is you have to make sure that you have risk transfer, risk distribution, we can go into those rules later. But the quick and dirty way of getting there is make sure that you have an actuary calculate out the premium correctly. So that would require a reserve study and a rate study to make sure that you've basically got a real company. The actuary is going to be worth their weight in gold. There are some Chop Shop actuary to put together basically, phony baloney captives that right phantom risks. You know, we're talking about million dollar policy limits for a laptop, I mean, just just stupid things. And the IRS correctly looked at that and said, Okay, that's that's crap. Because there's another tax advantage to this. If your captive writes less than 2.3 million bucks in gross written premium. you don't have to declare any under profit, the only profits in the cabinet would be from the for the the reserves. So your bonds, the investment, that sort of thing. If you get really creative, you can have the reserves investment in your own real estate and go nuts with the tax advantages. So the IRS caught on to that real quick. And they said, okay, given the tax advantages here, we really do need to see some actual risk in there. So does pandemic qualify as actual risk? Well, yeah, I don't think there's any debate on that. So then how would we actually get this done? Like, is this worthwhile investment? I would say if your business cannot stand in interruption like this, and you want to put some money aside, a captive would be a really smart way of getting it done. Now, the startup costs for captives are no joke. So I've already said that you gotta have a hundy just just to play the game, and probably more like a quarter million if you're in the US. So what do you do? Well, this is where groups can come together. So maybe we find 10 or 20 Small businesses or medium sized businesses, and we can just basically all go all in. And if there is a claim, you know, we're all basically going to be pulling from the same pool. So that'll get to your to your risk distribution that that'll help out with diversifying so that, you know, if we do shut down one area of the country, maybe we've got enough in reserves that we don't think bankrupt the captive. I mean, there's a lot of advantages to working together as a group. I would say that is easier said than done. We've tried to put together group captives for things that are really hard to insure, like peos for workers comp. And just getting everyone to sing from the same hymnal is heavy lifting, but it happens. It happens all the time. We got risk retention groups...kind of a captive. You got mutual companies, not a captive but their generally, were in the same kind of vane where people are willing to work together. So I think there are some opportunities in the market out there for enterprising people who want to take a more aggressive stance on on pandemic. So then the question becomes, well, then how do I not lose money? Sure. So if we have, you know, let's say, the captive's is going to have policy with a million dollars, then how do you how do you actually implement that in such a way that we don't bankrupt ourselves to get a moral hazard everyone's going to be, you know, making claims on it all the time. So, what you do in a group situation is, first and foremost, you probably want to consider stop loss. So maybe the captive is really, like I said earlier is functioning is like a large deductible. So you'd have a cap to pay out the first acts and then insurance, you know, private insurance or a traditional carrier would pay up above, some attachment point, and you do that for both spec and acts. So frequency as well as shock risk. That's one way of doing it. Another way of trying to protect the capital is to do some swing rated plans, some creative underwriting where those who are creating all the problems end up paying a a bit more premium next year. You can do a catch up in the same year with with with proper underwriting. So the underwriter really needs to be kind of on their game to be able to enforce that. But there's there's definitely ways to get there. What I would would be skeptical of is just joining us in any old risk pool. Risk pools are us if you get the wrong one, you can end up paying a lot more in the long run than if you just short.

Nick
Yeah, so there's a there's a couple aspects there I kind of want to dig into which is you talked about limitations. And you mentioned something about limitation of premium. Is that a limitation of what can be deducted? Or is that actually a limitation on the size of the program? of the captive?

Unknown Speaker
Okay, so the premium limitation of getting out earlier is for the 831 b elections. So my stance on that is it is an incredible tax advantage to not have to pay any indirect taxes on your underwriting profits. I mean, the duh...but you don't want the tax tail to wag the dog. So I wouldn't even consider The 831 b election at first, I think that when you're talking about business interruption for pandemic insurance, most of your gross most of your players are probably not going to have greater than $2.2 million in gross written premium. It's just it's not reasonable. Most most of your mid market companies, I don't know what the premium would look like, but what do you think's reasonable 350k to $400,000. I mean, that's, that's, that's probably a pretty big chunk right there for a lot of people to swallow. So I think the 831 b election will probably be in effect for most of these people. But it's not a limit per se. It's just the tax thing. So you can make the election you can you can unwind the election, it's all just it's just accounting.

Nick
Yeah. So but uh, what about like a, you know, fortune 1000 or 2000 company that has a significant exposure. Let's go back to the San Jose Sharks. You know, they canceled their season. So we're talking potentially 10s of millions of dollars of lost revenue for that. So what would be the limitation for larger than the mid sized companies?

Matthew
There is no answer there is none. I mean, fundamentally speaking capitals are about capitalism. So if I come to you and I say that do you want make an insurance company? I hope the answer yes. And we have a number of options. We have mutual, we have reciprocals, we've got all sorts of exotic types of insurance companies, and a captive is just one of them. So General Motors, for example, I know for a fact has multiple captives over in Bermuda, because you know, I mean, General Motors had Cadillac, and Chevrolet and blah, blah, blah. And within each of those units, they have a whole bunch of companies I've never even heard of like their R&D Division may actually be its own C corporation owned by someone else, blah, blah, blah. They all have a bunch of self insurance. Because I mean, they just have unique risks. So they're, they literally will poach talent from large carriers, and then bring them in house to basically just run a bespoke insurance company and get some additional tax advantages per taking, essentially the working layer of risk within their captive and then they lay off the rest of commercial markets.

Nick
Yeah, I see. So how about, you mentioned, risk pooling with groups? I bet traditionally, that's done with, like, kind of quality. But what about the example that I described where, you know, again, San Jose Sharks, you have the stadium owner, you have the vendors, you have the local community, you have the television and radio stations, with that with a disparate group also potentially qualified to form a captive for an event cancellation?

Matthew
Yeah, as a matter of fact, there's there's called a homogenous and heterogeneous captives. And there's absolutely nothing wrong having a bunch of people in there who are not extensively in the same business, but if they're in the same general area. I think it makes a lot of sense, of course, my concern there would be it's not an academic like risk aggregation. So like, I mean, like, you don't want to insure to a whole bunch of houses in Florida, you want to diversify a little bit because God forbid you have hurricane. So the problem, the problem is there, it is a bit of an academic concern. You don't want to have all of your eggs in one basket, but we're talking about pandemics where the basket is planet Earth. So theoretically, distributing the risk would be pretty hard to do. Yeah, yeah.

Nick
What about, you know, the situations where, you know, I'm thinking of why almost seems like this is a mutual. So why not just mutualize or how how's the what is the distinction between the two because, you know, mutual insure, is, you know, like a Factory Mutual would be factories that kind of get together so they can get economies of scale, and learn from within themselves the risk management that's required to manage against fires. For instance, this seems like almost The exact same thing. What's that? What is that thin dividing line that kind of separates those two.

Matthew
So when captives are created by a guy named Fred Reiss, back in the late 50s, they were captive, they were essentially a company of a company. So it was captive to a larger company. So the initial thought was that a commercial insurer, so there, yes, there. Okay, so the the the commercial insurance markets, failure would require us to self insure for some reason. And the IRS was dead set against this. They looked at it as kind of the same economic family. And like I said earlier, a savings account over here...now, it's magically a tax deduction if we put in this other bank account. So there was literally decades of fighting over whether or not a captive could exist. Eventually, in Humana case in the late 80s, the IRS was blown out of the water. There's absolutely no question about it. captive insurance is a legitimate thing. And that's I'm going back to the concept of capitalism. Who the heck are you to tell me that I cannot create my own insurance company? Just because I independently...I mean I can make my own bank? Why can't I make my own insurance company? And eventually, although that wasn't necessarily stated, in the opinion, that element of entrepreneurship is definitely pushing the entire engine of captive insurance. So then moving forward to how does it differ from a mutual? The answer is as the concept of a captive that has expanded over the years, because now I could theoretically create a captive apropos of nothing, some domiciles will allow an outsider of like you can raise funds and create an insurance company under the captive statute. So where does that differ from mutual The answer is not as much as it used to. It is it is it is separate and distinct. Now Mutual's are different, okay, at the end of the day when you purchase insurance policy from mutual You are a policyholder of the mutual but you're not really calling the shots. Practically speaking and this is kind of exiting the courtroom again, it's more like street wall. Practically speaking, if you're in a captive, you can call the shots because you're gonna own a significant chunk of it. Or if you're in a group captive, you're owning your own little fiefdom of the captive. So you can appoint counsel, you can appoint the loss adjusters, you can do all sorts of crazy things and underwriting so like, here's, here's a good one we did...we were dissatisfied with the way that risk will work in between these various healthcare facilities. So we started using the captive, we would actually charge more premium to it within a quarter, maybe like on a quarter by quarter basis, we would basically punish these facilities that had way too many accidents. And wouldn't you know it, that increase in premium to those facilities went directly to the administrator of that facilities bonus. Consequently, accidents vanished overnight. That's the kind of flexibility you have with the cafe that you just won't have a with a mutual.

Nick
Like the mob Is there a ability if the captive is successful to go legitimate and become a mutual or standard carrier?

Matthew
Yeah, look at Allstate. It was a Sears & Robock captive. Okay.

Nick
How in your book, How much? How much do you go into, like the historical aspects of this?

Matthew
Um, a quite a bit as a matter of fact. I mean, I really look at when you look at the history of captives, you see not only the history of kind of like American entrepreneurial spirit, but you also see the zenith of risk financing. I mean, it's, it is probably one of the most interesting places where you can really manipulate the concept called risk. Now, how does it flow to an organization let's talk about what's insured, what's not insured? You know, I feel like in every other aspect of the industry, we just get so caught up in a form is it covered is it not covered, a-side, b-side all that stuff, you know, So important you have to know that but at the end of the day, are you just are you just pushing paper? In with in with the captives...you're not. I laugh about coverage and captives all the time. And I openly say I don't know anything about captives or coverage, because then the captives who cares about coverage, I mean, it's your own insurance company will paper up to make sure that you know it looks good, but we're really pluggin risk. So what what's what's the biggest problems that keep you up at night? So, I mean, right now obviously pandemics on the top of everyone's mind. But you know, another thing we've been seeing is, you know, hail insurance and they were basically from Texas all the way up to Colorado is virtually uninsurable. So if the deductible that the carriers are asking for is greater than the replacement cost of your roof, you ought to put that self insured retention into a captive so that if you do have to pay the deductible, all of a sudden you've already pre-financed, they've got those tax deductions and then your captive's one that actually paying the insurance company that enormous deductible,

Nick
or better yet, in that example you just described, it puts the incentive on now the owner of the captive to enhance risk management. Yeah, set up a reserve. So you never pay a claim and you have full control. And now you're you're able to really leverage against the insurance companies and keep more of the premium that you would have been spending.

Matthew
At the end of the day, the goal of a captive is to expand north on the limits. So let's say we're keeping at first on a 1 mil/3 mil policy, we'll keep the first quarter million. And then with good risk management, we don't too many claims. So then you can have enough reserves to capture a half million, 750k, and a million. And as you grow That's exactly right. You're kind of pushing the traditional carriers away, as you're finding more efficiencies through your own captive. It is very difficult for captives and carriers to play well together. That is something that I think probably works very well for the consumers. Because at the end of the day, where the market fails, the captices are really supposed to be in there, kind of picking up the pieces.

Nick
Yeah. Yeah, that's interesting. So this is a great message, right? And I think a lot of folks that are listening going to be like, why didn't I know about this? I want to learn more. So I'll put the show notes in the show notes. I'll put access to your book and a few a few links that I found on this. But there is a bad side to this. Like if you if you google captives and start reading about it, you'll see that the IRS is coming down hard, and there are people out there there that may not necessarily have your best interest at heart. Can you talk about that other side that is sort of giving this a little bit of a bad name over the past few years, so we can kind of clean that up. And potentially get people focused on who's doing the good work here and how to get that done.

Matthew
Yeah. The, the tax, the tax deduction expert I expressed earlier was wild! I mean, you talk about I mean, that's sucking sound, you know, dollars of taxable wealth, both on income tax side and on the estate planning side that got transferred from, let's just say, early 2000 to about 2015. So that was a long time. And there were some people in the industry who made a lot of money doing that. The best time to get into a tax dodge is before the IRS finds out about it. And IRS is very slow when they finally figured it all out. And circa 2012-2014. They didn't win a case in it until 2016, the Avraham case now Why am I telling that to you? I'm telling that to you because the riffraff has pretty much been kicked out of the industry. But, man, it was, it was it was wild, and the The way the IRS figured it all out. It was subsequent to a case called rent-a-center in security, there's these two different cases Rent-a-center & securis, long story short, the IRS had a very specific way of looking at this concept called risk distribution. Everyone else disagreed. They got their butts handed to them. And then they're looking there was there was a tax conference in in Washington DC in 2014, where a captive manager got in front of the whole audience and basically just started trumpeting, what a great deal the 831 b election was with the IRS in the room, and it wasn't a mystery there in the room. There's a tax conference, the service shows up all the time. And this guy just outlined the world's greatest tax dodge in front of that service that had just gotten his butt kicked in two separate federal cases. They went back and immediately sent out and this is not a joke..private, like plainclothes investigators to go down to the Caribbean start investigating this stuff, figure out who's the big fish, who's the small fish. And then they and then they were very smart. They bided their time until they found the world's stupidest captive manager up in up in Manhattan. She, as far as I can tell, has no business in the insurance industry. She was just an LLM, which is it's like a Master's for a lawyer. It's she's super good at tax. But she was just running this disgusting risk pool. It was total fraud. And the IRS just made an absolute smart play with that. They used her as the poster child for bad captive insurance. They beat the tar out of them in court. And then they went after a whole bunch of other big fish, these risk pools that were essentially just tax dodges. So from 2016 through probably I mean, I'd say it's pretty much over now. But for about four years there, these risk pools just got audited, and I mean, we're talking probably another decade of class action litigation from these very wealthy, very angry primarily doctors and and those kinds of people who, you know, they're just having they're having to pay millions of dollars to the IRS.

Nick
Wow, that is a drama. I think that needs a screenplay.

Matthew
Yeah, yeah. Well. I mean...<laughter>

Nick
You're an author.

Matthew
It's like what have you learned? And I never figure out how to beat the market. Don't Don't tell people so I mean, I don't know why they were bragging about a tax dodge that brazenly...

Nick
This is great. Thank you, Matthew Queen, I will put a...can you share...your book again?

Matthew
Ah...no...I have a plug in my phone and I'm on the other end of the room.

Nick
Ah, geez, you're so mobile. What's the name of it again?

Matthew
Modern Captive Insurance.

Nick
I will put the links up for that. A few other links as well. Thank you for the quick education on campus. Appreciate it. Cool, man.

Matthew
And I'll talk to you soon.