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We formed and operate the first series LLC in Montana (named Aegis) for captive insurers. Several other firms provide key services such as accounting, audit and actuarial work. Please contact us at 832.330.4101 if you'd like to discuss forming a captive for your company.
To see the first post, click on this link. 3.) An Insurable Interest The third insurance element is an insurable interest—i.e., the existence of a relationship between the insured and the property that is insured such that any damage to the property will negatively impact the insured’s finances.[1] The concept of an insurable interest as an element of insurance developed gradually over a significant period and is best illustrated by the business environment of the life insurance business in the 1800s where people, despite having no familial relationship with an insured person, were able to purchase life insurance on celebrities’ lives and thus profit from their eventual death. Courts eventually realized that allowing insurance to be purchased by essentially disinterested parties was nothing more than gambling and was against public policy.[2] Ultimately, the doctrine settled to require that the insured demonstrate a strong enough relationship with the subject of the insurance to justify concluding that damage to that subject would directly hurt the insured. 4.) Risk Shifting And Risk Distribution Risk shifting and risk distribution, were both stated as requirements by the Supreme Court in Helvering v. LeGierse.[3] Risk shifting is a straightforward concept: the insured must transfer some or all of the financial burden of loss to the insurer. This element is accomplished via contract and is rarely in dispute, as attested to by the dearth of case law on point. Risk distribution requires a more in-depth explanation. Begin with the risk borne by a single homeowner who does not have property insurance. It is highly unlikely he will have sufficient financial resources to replace his home in the event it is destroyed by a fortuitous event. But if that individual pools his risk with other similarly situated homeowners who live across a geographically diverse area, a key development occurs--the possibility that the insured’s funds will return to him as part of the indemnification payment decrease, since all of the insureds are unlikely to suffer a simultaneous loss; while it becomes more likely that one insured’s funds (and any earnings thereon while held by the insurer) will ultimately support a payment to another insured who has indeed lost his home. It is this pooling of premiums in the insurance company, resulting in a distribution of the risk of loss (and potential for indemnification) across the entire pool of insured persons, that prevents insurance from being merely a reserve fund for tax purposes: this is the key difference between a reserve and an insurance company. In effect, the insured has shifted his risk of loss not only to a separate company but to other parties. 5.) The Difference Between A Reserve and An Insurance Company A reserve is an accounting entry, whereby a company will designate an amount of its funds in anticipation a particular contingency emerging.[4] For example, a business anticipates it will have to pay $1,000 for a potential loss. To account for this, the business establishes a reserve account in its general ledger which is then placed on its balance sheet as a liability. But most importantly, the person or company establishing the reserve ultimately uses his/its own monies to extinguish the reserve and pay the claim. The distinction between a reserve and an insurance company carries with it important tax ramifications: insurance premiums are deductible;[5] reserve payments are not. The non-deductibility of reserves developed over a series of cases before the Bureau of Tax Appeals in the early 20th century. In all these cases, the Bureau held against the taxpayers, citing a variety of legal theories:
[1] 3 Couch on Ins. § 41:1 (“An “insurable interest” may be defined as any lawful and substantial economic interest in the safety or preservation of the subject of the insurance free from loss, destruction, or pecuniary damage. An insurable interest need not be in the nature of ownership but rather can be any kind of benefit from the thing so insured or any kind of loss that would be suffered by its damage or destruction. Historically, an insurable interest was not a requirement for a contract of insurance”); 1-1 Appleman on Insurance Law & Practice Archive § 1.4 (“The term “insurance contract,” as used in this chapter, shall... be deemed to include … a material interest which will be adversely affected (insurable interest) by the happening of such event.” [2] Warnock v. Davis, 104 U.S. 775, 779 (1881) ("But in all cases there must be a reasonable ground, founded upon the relations of the parties to each other, either pecuniary or of blood or affinity, to expect some benefit or advantage from the continuance of the life of the assured. Otherwise the contract is a mere wager, by which the party taking the policy is directly interested in the early death of the assured. Such policies have a tendency to create a desire for the event. They are, therefore, independently of any statute on the subject, condemned, as being against public policy."); Hurd v. Doty, 21 L.R.A. 746 (1893) (“The learned counsel for the defendant cites numerous cases to the effect that one procuring insurance upon the life of another cannot recover upon the policy without proving an interest in the life assured. The theory upon which such decisions are based is that such a contract is nothing more than a wagering or gambling contract, and hence is against public policy, and is therefore void.”) [3] Helvering v. LeGierse, 312 U.S. 531 (1941) (An insured purchased both an annuity and a life insurance policy very close to her death. After she died, the estate filed an estate tax return and did not include the proceeds of life insurance in the estate. In analyzing the transaction, the court noted: “That life insurance is desirable from an economic and social standpoint as a device to shift and distribute risk of loss from premature death is unquestionable. That these elements of risk-shifting and risk-distributing are essential to a life insurance contract is agreed by courts and commentators.” The court simply used the two terms within the same sentence. Subsequent cases over the next 40-50 years would provide guidance as to the exact definition of each term.). [4] Downes at 446 (a reserve is a “segregation of retained earnings to provide for such payouts as dividends, contingencies, improvements or retirement of preferred stock.) [5] 26 U.S.C. 162(a); Treas. Reg. 1.162-1(a)(“ … together with insurance premiums against fire, storm, theft, accident, or other similar losses in the case of a business,”) [6] Appeal of William J. Ostheimer 1.B.T.A. 18, 21 (“The statute specifies what deductions are allowable and, except in the case of in insurance companies, no provision is made in the 1918 Act for the deduction of a reserve as such.”). [7] Pan-American Hide Co. v. Commissioner, 1 B.T.A. 1249 (B.T.A. 1925) ("The taxpayer's contention in effect is that it may take from its income in one pocket an amount equal to what it would have to pay as fidelity insurance premiums and put this in another pocket as a reserve and deduct it from gross income as an ordinary and necessary expense incurred in its business.") [8] Spring Canyon Coal Co. v. Comm’r of Internal Revenue, 43 F.2d 78 (10th Cir. 1930). See also Appeal of Consolidated Asphalt, 1 B.T.A. 79, 81 (“When estimating the reserve to set aside for a construction contract, the appellant’s accountant doubled the amount set aside for the years in question.”). [9] See Gen. Couns. Mem. 35340, (May 15, 1973) (“However, because anticipated casualty losses are contingent in nature, it is a firmly established principle of tax accounting that even an accrual basis taxpayer may not deduct amounts it adds to a reserve for insuring its own risks.”). We formed and operate the first series LLC in Montana (named Aegis) for captive insurers. Several other firms provide key services such as accounting, audit and actuarial work. Please contact us at 832.330.4101 if you'd like to discuss forming a captive for your company.
I. Introductory Concepts
“Life is risk,” or so says King Benny in the movie Sleepers in response to Dustin Hoffman’s character’s attempt to avoid becoming involved in an underworld conspiracy. The point may be a cliché, but it’s true: risk cannot be avoided. Nonetheless, ever since the Renaissance when merchants created insurance to mitigate the damage of lost cargo on voyages to the Far East, business has relied on indemnification from insurance to prevent financial ruin should a risky event occur. Like most common-law concepts, it has taken many individual cases and much time for a settled view to develop of the necessary elements for a valid insurance policy. Put simply, these elements are the following: (i) a definable risk, (ii) a fortuitous event, (iii) an insurable interest, (iv) risk shifting and (v) risk distribution.[1] Each of these elements must be present for a policy to be valid. In addition, there is a very important legal difference between a reserve[2] and an insurance company.[3]
Furthermore, because the law of contracts applies to the formation and interpretation of insurance policies,[4] the basic elements of contract (i.e., offer, acceptance, and consideration)[5] must be present for a court to uphold an insurance agreement. The insured pays a premium to the insurer, who then offers to indemnify the insured in the event a specific risk occurs. Key to the contract is for the risk to be specifically enumerated and clearly defined. As an example, the standard property policy provides coverage in the event of 11 specifically named perils: fire, lightning, explosion, windstorm or hail, smoke, aircraft or vehicles, riot or civil commotion, vandalism, sprinkler leakage, sinkhole collapse, and volcanic action.[6] All other insurance policies contain similar language for their respective underlying coverage. The occurrence of the risk is a condition to the insurer’s performance, and therefore must be clearly evident from a plain reading of the policy or contract.[7]
But the occurrence of a specifically defined risk gives rise to the second required element of valid insurance policies -- fortuity.[8] Indemnification from insurance only occurs if the happening of the loss cannot be predicted. This is because non-fortuitous risks are foreseeable and either planning can mitigate damages or the foreseen risk can be avoided altogether, thereby eliminating the need for insurance. The unknown or unforeseen element of the fortuity definition is best explained by the three primary fortuity-related defenses offered by insurers to deny a claim – defenses which have a certain amount of conceptual overlap.[9] The first of these is the “known loss” defense in which an insurer argues either that the loss had already occurred or that the insured should have known the loss would occur at the time he purchased the policy.[10] The assumption in the latter case is that the insured could and should have taken appropriate steps to mitigate the foreseeable damage. The second defense is the “known risk” defense where the insurer will assert that some type of advance preparation was warranted because the possibility of loss was so high as to make the event essentially unavoidable. Finally, the insurer arguing the third fortuity related defense will aver the loss was ongoing when the insured purchased insurance.[11] The one common element to all of these defenses is the assumption that the insured knew or should have known that a loss had either occurred or was so likely to occur as to warrant some type of preventative action. [1] See 1-1 Appleman on Insurance Law & Practice Archive § 1.4 (which explains in detail three different tests to determine if insurance exists: the substantial control test, the ancillary test and the regulatory value test). See also 1 Couch on Ins. § 1:6 (which defines insurance as “a contract by which one party (the insurer), for a consideration that usually is paid in money, either in a lump sum or at different times during the continuance of the risk, promises to make a certain payment, usually of money, upon the destruction or injury of “something” in which the other party (the insured) has an interest” and also provides additional definitions) [2] John Downes et. al, Finance and Investment Handbook, Third Edition © 1990 Barron’s Education Services, pg.446 (a reserve is a “segregation of retained earnings to provide for such payouts as dividends, contingencies, improvements or retirement of preferred stock.) [3] Id at pg. 320 (“In a broad economic sense, insurance transfers risk from individuals to a larger group, which is better able to pay for losses”). See also 1 Couch on Ins. § 1:9 (“It is characteristic of insurance that a number of risks are accepted, some of which will involve losses, and that such losses are spread over all the risks in a way that enables the insurer to accept each risk at a slight fraction of the possible liability upon it.”). While a reserve is only used by one company, an insurance company pools risks from multiple sources. [4] 1 Couch on Ins. § 1:10 [5] See Prof. James E. Byrne, editor, Restatement 2nd of Contracts and UCC Article 2 © 2007, Chapter 3 (Mutual Assent) and Chapter 4 (Consideration) [6] Douglas G. Houser and Thomas W. Rynard, Insuring Real Property, Section 1.06(b) (Mathew Bender 2010). [7] Byrne at Section 224 (“A condition is an event, not certain to occur, which must occur, unless its nonoccurrence is excused, before performance under a contract becomes due”). [8] 1-1 Appleman on Insurance Law & Practice Archive § 1.3 ("Fortuity is another key element in determining what constitutes insurance for purposes of legal classification. It would be foolhardy for insurance companies to sell insurance that would pay for losses strictly within an insured’s control. Obviously, whenever an insured needed money, there would be the temptation to cause the insured event to happen to get the pecuniary insurance benefit. This is the point where the concept of fortuity comes into play. Insurance is designed to cover the unforeseen or at least unintentional damages arising from risks encountered in life and business: injuries and damages caused by negligence and other similar conduct where the insured stands to sustain a real and palpable loss (generally pecuniary) as a result of the event for which the insurance has been purchased."). [9] 7 Couch on Ins. § 102:10 (“The known risk, known loss, and loss in progress defenses are generally considered to be part of the “fortuity” requirement that runs throughout insurance law.”). [10] Id. [11] Id. We formed and operate the first series LLC in Montana (named Aegis) for captive insurers. Several other firms provide key services such as accounting, audit and actuarial work. Please contact us at 832.330.4101 if you'd like to discuss forming a captive for your company   The maps above show two important data points related to tornadoes. The top map shows the number of tornadoes per 1,000 square mile area. There, Arkansas, Oklahoma, Missouri and NE Texas have the highest concentration. But in reality, the entire country east of New Mexico, Colorado, Wyoming and Montana are exposed to some level of tornado risk.
The bottom map shows the potential wind speed of tornadoes. Again, the center of the country is susceptible to very high tornado speeds. But that’s not to say the rest of the country faces no danger, just lower potential tornado speeds. If you own commercial real estate (or have a triple net lease) in the eastern 2/3 of the US, you should consider using a captive to underwrite tornado coverage. We formed and operate the first series LLC in Montana (named Aegis) for captive insurers. Several other firms provide key services such as accounting, audit and actuarial work. Please contact us at 832.330.4101 if you'd like to discuss forming a captive for your company
Commercial General Liability Policies (“CGLs”) either provide no coverage for employee theft or have a very low maximum payout. This is unfortunate, because embezzlement is common. Consider the following points from a 2012 report by the Association of American Fraud Examiners:
The conclusions raise a number of disturbing possibilities, such as:
Employee fidelity is a very common captive insurance policy for all the above stated reasons. If you would like to learn more, please contact us at 832.330.4101. The US Tax Code divides insurance companies into two sub-types: life and “non-life.” The former underwrites risks on people while the latter insure risks associated with property. Historically, the 831(b) market has largely focused on property insurance because it’s easier to create and manage these companies. But with the increasing costs of health care and, in some cases, workers comp, captives that insure the risks associated with people are growing in popularity.
Two recent articles highlight this growing trend. The first focuses on the general trend: For certain lines of coverage, such as group-term life insurance and long-term disability, the cost savings — compared with buying the coverages in the traditional market — range from 15% to 25%, panelists said. “The captive earns the underwriting profit and investment income earned” on premiums paid to the captive, said Kathleen Waslov, a senior vice president with Willis Towers Watson P.L.C. in Boston. Another advantage to the approach — compared with buying coverage in the commercial market — is that the captive sponsor has greater control over the design of the benefits offered to employees, Ms. Waslov said. One of the most common statements I hear from potential captive owners looking at a workers comp or health care captive is, “I pay “X” in premiums and have rarely filed annual claims above that number. We’d like to earn that profit.” If a company is able to effectively manage its risks, then the savings will build-up in the captive. The second article looks specifically at health care captives: Health care liability captive insurers can be a key tool in improving the quality of patient care, captive experts say. The volume of claims data that can be accessed through a captive, in the right hands, can help health care institutions improve safety practices and ultimately save lives, they say. And working in partnership with captive reinsurers, captive owners can drill down into even more extensive data and improve medical processes, they said Tuesday during a session of the 2016 World Captive Forum, being held in Boca Raton, Florida. A key benefit of forming and managing a captive is the ability to obtain a large amount of data. For example, suppose the employee census shows 15% of the workforce regularly purchases cholesterol lowering medication. The company could use this information to tailor various wellness programs such as dietary seminars and sponsored gym memberships. The possibilities are endless. Who would most benefit from this strategy? Here are a few factors to look for:
Please call us at 832.330.4101 if you’d like to learn more. |
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