Self-Funded w/ Spencer - Episode 28 - Phillip Holowka - Captives Part 1

This video provides an in-depth exploration of Captive Insurance, focusing specifically on Medical Stop-Loss Captives as a sophisticated risk financing mechanism for employers. The discussion, led by Phillip Holowka, COO of Complete Captive Management Services, begins by establishing the history and core definitions of captives, tracing their origins back to a mining company needing to place its own insurance. The primary motivation for employers to engage in captives is gaining control over their risk management and participating in the potential underwriting profits traditionally captured by commercial carriers. Holowka frames joining a captive as a "participation sport" and a long-term, five-year investment, not a quick transactional fix for high premiums.

A significant portion of the analysis centers on the structural differences between Group Captives and Single Parent Captives. While Group Captives involve multiple employers sharing one tax ID, the speaker’s firm transitioned to a Single Parent model, where each employer owns their own captive. This structure is preferred because it allows for favorable financial statement consolidation (as the employer owns >51% of the entity) and better alignment of incentives, particularly for larger employers who might feel their risk mitigation efforts are diluted in a mixed-size group pool. The Single Parent model employs a "FIFO" (First In, First Out) accounting methodology, ensuring that an employer's own stop-loss premium cash is used to pay their claims first, leading to rigorous scrutiny of every claim payment.

The conversation delves into the critical regulatory and financial components, including the role of the Captive Manager (handling regulatory affairs and accounting) and the necessity of the Border Row Report, which details the flow of premiums and expenses. Crucially, Holowka addresses the IRS scrutiny surrounding the 831b micro captive election, which allows smaller captives (under $2.3 million in premium) to avoid taxing their underwriting profit. To maintain compliance and avoid abuse flags, captives must strictly adhere to the "three-legged stool test": ensuring policies cover fortuitous risk (employee health claims, not business risks), maintaining arm’s length policy pricing (set by an outside actuary), and demonstrating actual claims payment (risk distribution). This focus on transparency and strict adherence to legitimate insurance principles is essential for the long-term viability of the captive structure.

Key Takeaways: • Captive insurance is defined as a private insurance company that can only sell policies to its owners or members, offering employers a mechanism to retain risk and capture underwriting profits typically held by commercial carriers. • The ideal captive participant is a "Type A control freak" employer who is frustrated by the lack of transparency and inability to measure return on investment (ROI) in traditional fully insured or commercially stop-lossed plans. • Single Parent Captives offer a significant advantage over Group Captives by allowing for financial statement consolidation, treating the premium paid as an expense offset by an equal asset, which streamlines financial reporting. • The Captive Manager's role is primarily administrative and accounting-focused, acting as the regulatory liaison between the captive and its domicile (the state or jurisdiction where the captive is licensed). • The Fronting Fee (often 5% to 15% of gross premium) is charged by commercial carriers in group captive models to cover their administrative services and replace the underwriting profit they forgo when reinsuring risk back to the captive. • Collateral, or additional paid-in capital, is a required entrance fee set by the regulators and actuaries to capitalize the captive entity, ensuring members have financial "skin in the game" and are committed to the captive's success. • To qualify for the favorable 831b tax election, a captive must demonstrate that its policies cover fortuitous risk (unpredictable events like health claims) and that policy pricing is determined by an outside actuary to avoid the IRS accusation of over-pricing for tax deduction purposes. • The Border Row Report is a vital internal document that provides members with radical transparency, detailing the exact accounting of premiums received and expenses paid by the fronting carrier, allowing the captive to monitor operational efficiency. • The single-parent model utilizes a FIFO (First In, First Out) claims payment strategy, where the client’s own captive funds are used first, incentivizing employers to increase scrutiny on claims to ensure they are legitimate and correctly priced. • Collaboration among captive members, facilitated through annual meetings and committees, is essential for sharing best practices in cost containment (e.g., PBM selection) and collectively mitigating severity risk, ensuring all members benefit from improved operational efficiency. • The trend of domiciling captives has shifted away from offshore locations (like the Cayman Islands) back to US states, largely due to changes in US tax law that removed the previous financial incentives for offshore incorporation.