Small businesses need actuaries’ support to protect against novel risks

By Peter Dawson

Right now, there is a significant gap between well-established actuarial science on the one hand and the IRS's perspective on captive insurance risk on the other.

The reason for this gap seems to be a fundamental lack of understanding of the nature of fortuitous risk at the IRS.

This is highlighted by the arbitrary 65% loss ratio the IRS set as a safe harbor threshold for microcaptive insurance companies to meet to deem the transaction nonabusive. This makes no sense from an actuarial perspective. One may take on significant fortuitous risk yet have little to no loss in any given year. This is necessarily exacerbated by the unique and specific nature of captive coverages.

Captives are facing tremendous regulatory and enforcement pressure from the IRS. The agency has argued certain captive arrangements do not constitute “real insurance,” proposed onerous regulations on industry participants and taken various enforcement actions designed to encourage captive closures or dissuade their formation entirely.

Commercial carriers generally have an enormous amount of data and accepted actuarial research to rely on when pricing their products due to the industry’s long history.

However, microcaptives insure novel or poorly explored risks. This leads to situations with a lack of data or actuarial studies to indicate how the premiums shouldbe priced.

If there were significant research behind issuing niche, novel or highly specialized products, traditional markets would have conducted it, and there wouldn’t be a need to establish captives. Congress recognized this issue when passing Section 831 of the Tax Code in 1986 and worked to ensure that small business owners had the tools necessary to protect against serious fortuitous risk(s).

Instead of serving as proof of the very need Congress recognized, the dearth of information in the captive realm is used by the IRS to support its case that micro-captives do not offer real insurance – if there is little data, it must not be real risk.

This is easily countered: How many times have we shut down the world in the last 2,000 years? I have a tally of once, during COVID-19.

It is difficult to extrapolate actuarial science and data to build reserves and policies that coincide with a catastrophic event like this. That doesn’t change the necessity of addressing it, because it is a real risk that can destroy a business overnight. What happens next time if the government can’t print trillions of dollars to bolster the economy? Will business owners have policies in place to ensure their business makes it through?

Regulation is needed, but the current language of the IRS’s proposed captive regulations widely misses the mark. I believe a new perspective oriented toward solutions is needed.

First, efforts to collect data and generate new research on the fundamentals of captives and other alternative risk mitigation are critical. The federal government could help with this. They have significant data (which could be scrubbed to remove sensitive information) that regular small business owners can’t access. Having this scientific backing to better price captive coverages would also go a long way toward helping the IRS better understand proper risk reserving for specialized fortuitous risks affecting small business owners.

Additionally, captive insurers covering novel risks should not be discriminated against by tax authorities with outdated models. While the insurance market changes rapidly, and business owners are encountering risks never envisioned, microcaptives are able to address these unforeseen risks.

Applying the outdated IRS models to captive insurance doesn’t work and will instead create unintended outcomes not foreseen by Congress.

To help shift the mindset of the IRS, I believe we need authoritative voices in the fields of actuarial science, insurance, law and finance to speak out.

Many prominent actuaries already support microcaptives. For example, Stephen Koca, chair of the American Academy of Actuaries’ Committee on Property and Liability Financial Reporting, published a letter to the IRS in June 2023 opposing the agency’s proposed captive regulations.

The letter detailed concerns about the proposed 65% loss ratio threshold and his support for specific and objective metrics, factors and standards that would allow better identification of potentially abusive captive transactions without catching law-abiding business owners in the same net. This is a concern that has been expressed repeatedly by other industry participants and experts nationwide.

Other professionals are stepping forward and insisting we implement regulations that eliminate bad actors while also promoting the development of innovative risk mitigation strategies to ensure small businesses can thrive. But more public voices, data and research are needed.

The captive insurance industry is a current focus of the IRS, but all traditional insurance must take note. If the agency is allowed to put junk science over the top of fortuitous risk, it will be to the detriment of everyone.

Peter Dawson is an attorney with an extensive background in tax strategy and risk mitigation. He currently works as the CEO of Dawson, LLC, and as an advisor to the 831(b) Institute. Contact him at [email protected].