The Use Of Captive Insurance Companies In The Financial Services Industry

The Legal Definition of Insurance All insurance transactions must have five factors, starting with a definite risk. Sometimes called the triggering event, a specific incident must occur before the insured can file a claim. For example, fire and lightning trigger coverage under a property policy. Second, the risk must be fortuitous. If the insured is aware of an upcoming incident, he can make adequate preparations to minimize its negative impact, thereby eliminating the need for coverage. Third, the insured must have an insurable interest; he must show that he will be personally hurt when the definite risk occurs. Court’s developed this factor in the 19th century, when individuals purchased life insurance on the lives of famous people as a way to gamble on the date of their death. Courts concluded this practice led to economic waste and was therefore against public policy. Fourth, there must be risk shifting which is accomplished through the issuance of a valid insurance policy.

The policy “shifts” the risk of loss from the insured (who is no longer responsible for the cost from damages) to the insurer (who will “make the insured whole” with its indemnification payment). The final factor is risk distribution, which requires a more in-depth explanation, best accomplished through an example. 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 insured parties are unlikely to suffer a simultaneous loss. At the same time, 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 creates insurance.

 How a Financial Services Company Should Utilize a Captive

To understand how to utilize a captive insurance company, it’s important to know a small amount of insurance coverage history. Beginning in the mid-1960s, the plaintiff’s bar brought four lines of high profile cases: product’s liability, medical malpractice, environmental claims and asbestos losses. Each line eventually ended with large multi-million dollar judgments that forced insurers out of these respective markets. Captives filled this coverage vacuum. To this day, it’s very common for all but the largest companies to implement an insurance “tapestry,” where they maintain their CGL and property policies while using a captive to underwrite “stochastic” (lower frequency, higher payout) risks that are excluded from their commercially available coverage. Financial institutions are no exception. For a relatively small sum, they can obtain generalized policies for generic business risk. But these policies contain large gaps in coverage for risks that could, should they occur, potentially place the company in financial jeopardy. Some of the more common policy gaps underwritten by financial captives follow.

Employment Claims Coverage

This is not a rarely used policy. Over 80% of companies with 500 or more employees have faced these claims. The suits are expensive, averaging approximately $125,000 to defend with median payouts of $200,000. Employers lose approximately 66% of these cases. Several recent cases illustrate the prevalence of these claims in the financial services industry. In Pennsylvania, a former JP Morgan VP is alleging wrongful termination. His lawyers are arguing, “… he was terminated when he refused to carry out directives from JPMorgan senior management that would have asked him to use his position as a director of Philadelphia nonprofit The Reinvestment Fund (TRF) to scuttle settlement of a pivotal high-profile housing discrimination case that was to be heard by the U.S. Supreme Court.” A second example involves a female Goldman Sachs analyst alleging discrimination and arguing that she was underpaid because she is female. Salary based cases should increase due to heightened publicity regarding the pay gap between men and women.

The standard Insurance Services Office (“ISO”) employment liability coverage form provides coverage in four separate areas, two of which are especially salient for financial firms. The first of these two areas is demotion (or failure to promote), which includes negative evaluation, reassignment or discipline of your current "employee," or wrongful refusal to employ. The second area is wrongful termination, meaning the actual or constructive termination of an employee in violation or breach of applicable law or public policy, or that is determined to be in violation of a contract or agreement, other than any employment contract or agreement, whether written, oral or implied, which stipulates financial consideration if such financial consideration is due as the result of a breach of the contract.

Commercial Crime/Employee Fidelity Coverage

Unfortunately, employee fraud is fairly common. According to a 2012 report conducted by the Association of Fraud Examiners:

• The typical organization loses 5% of its revenues to fraud each year.
• The median loss in the cases in their study was $140,000. More than one-fifth of these cases caused losses of at least $1 million.
• The frauds lasted an average of 18 months before being detected. 
• The smallest organizations suffered the largest losses because they typically employ fewer anti-fraud controls. In addition, fraud affected small businesses disproportionately because they have fewer resources to act as a financial cushion.
• Perpetrators with higher levels of authority tend to cause much larger losses. The median loss among frauds committed by owner/ executives was $573,000, the median loss caused by managers was $180,000, and the median loss caused by employees was $60,000.
• The longer a perpetrator had worked for an organization, the higher fraud losses tended to be. Perpetrators with more than 10 years of experience at the company caused a median loss of $229,000. By comparison, the median loss caused by perpetrators who committed fraud in their first year on the job was only $25,000.
• Most occupational fraudsters are first-time offenders with clean employment histories.

 Administrative Actions Policy

The financial services industry is governed by a large number of regulatory agencies, which depending on the specific industry may include the Federal Reserve, the Comptroller of the Currency, Securities and Exchange Commission, the Federal Deposit Insurance Commission and the Commodities Futures Trading Commission. This list does not include the potentially numerous state level organizations having similar authority. Each of the above institutions promulgates and enforces its own code of laws. This practice is referred to as “administrative law,” or “the procedures created by administrative agencies (governmental bodies of the city, county, state or federal government) involving rules, regulations, applications, licenses, permits, available information, hearings, appeals and decision-making.” In a manner similar to regulatory change coverage, it is likely financial services companies will have expend money to defend against an “administrative action.” 

Captives commonly issue administrative actions policies, which cover the costs of “… all losses resulting from or caused by an ‘administrative action’ that occurs during the policy period. The total calculation of losses will include ‘loss of income,’ ‘remedial measures,’ ‘legal representation,’ and ‘public relations expense,’ caused by ‘negative publicity’ if applicable and provided insured can demonstrate loss.” The policy defines an “administrative action” broadly, usually using the following definition: “an ‘administrative action’ is a formal legal event, proceeding or ‘suit’ commenced by an ‘administrative agency’ of any branch of government (including without limitation, federal, state, county or local), seeking to formally or informally adjudicate or enforce an administrative code.”

Conclusion

For years, the IRS fiercely resisted captive insurance companies on various grounds with overwhelming success. However, both the IRS and the courts now respect captive insurance as a legitimate risk management arrangement. In order to be respected by the IRS and the courts as such, a captive insurance arrangement must meet the legal definition of insurance, including risk shifting and risk distribution. Also, a parent company must have a legitimate, non-tax business purpose for establishing the captive arrangement.

Like many businesses, companies in the financial services industry can generally benefit from the flexible coverage available through captive insurance company arrangements. As discussed above, four out of five companies with 500 or more employees will face an employment claim of some type, costing on average $125,000 to defend, with a median payout of $200,000, and employers losing these cases twice as often as they win. Similarly, companies lose, on average, approximately 5 per cent of yearly revenue to employee fraud. Also, most companies could benefit from legal liability coverage to fill in the rather large gaps typically present in those companies’ current coverage schemes.

Financial services companies may have a higher degree of exposure to these risks. Large amounts of assets under management and the perception that such companies have “deep pockets” may make these companies an inviting target for fraudsters and litigious parties. Moreover, financial service companies in particular face various risks for which coverage may be commercially unavailable or unattractive due to prohibitively high premiums or large coverage gaps. For example, financial services companies may face heightened risk in the form of cyber threats, due to the highly sensitive nature of the information they accumulate and maintain. Also, financial services companies are particularly sensitive to an ever-changing regulatory and administrative landscape. Among other benefits, captive insurance companies offer the flexibility to underwrite these and other commercially reasonable risks. Executives interested in exploring advanced strategies to maintain competitiveness and security in today’s business environment may contact us for more information.