The Serial LLC and Captive Insurance, Effective Risk Financing for the Real Estate Portfolio or Jurisdictional Competition Producing a Race to the Bottom?

The Serial LLC and Captive Insurance, Effective Risk Financing for the Real Estate Portfolio or Jurisdictional Competition Producing a Race to the Bottom?

David Chapman PhD

Assistant Professor of Finance, University of Central Oklahoma

Stuart T. MacDonald JD, LLM, PhD

Associate Professor of Finance, University of Central Oklahoma

Prepared for presentation at American Real Estate Society conference

Coronado (San Diego), CA

 April 1-5, 2014

Do not cite without authors permission.

The Serial LLC and Captive Insurance, Effective Risk Financing for the Real Estate Portfolio or Jurisdictional Competition Producing a Race to the Bottom?

            The world of risk management is increasingly governed by the concept of enterprise risk management, this model holds that in managing risks, a firm should not only strive to assure that risks are appropriately assessed, controlled, and financed, but also that risk management, much as every other aspect of firm operations, should strive to build value (KPMG, 2001). It is suspected that when most medium sized real estate investment firms purchase property and casualty insurance, these firms view this purchase as a variable cost subject to some level of adjustment based of raising of lowering deductibles, but it is also suspected that few if any see the purchase of property and casualty insurance as a device for building value for the firm’s contingent claimants.  Until recently this view of property and casualty insurance, except for relatively large concerns, was fundamentally correct.  However, recent developments in the business structure allowed for captive insurance and IRS guidance, issued in 2002, indicated that captive insurance can be an effective vehicle for financing property and casualty risk, transferring wealth, managing estate tax liability, and reducing the cost of risk. 

Introduction

            Markowitz demonstrated that the risk of holding a particular portfolio can be broken into two categories, market or systemic risk, and a second category of risk, often referred to as diversifiable risk that can be effectively eliminated through diversification (1952).  Typically, sophisticated investors will neither finance nor seek to control diversifiable risk, as generally it is most efficient to simply hold enough different assets that diversifiable risk is eliminated and only market or systemic risk remains.  For the portfolio that consists mainly of securities, this is fairly easily accomplished with a low level of transaction costs, and thus an efficient portfolio can easily be assembled.  However, the mixed portfolio that contains both real estate and securities, or a portfolio consisting only of real estate, can be very difficult to assemble. 

For real estate portfolios, whether held by the single investor, a corporation, or an investment fund, non market risk presents a significant problem (Bryne & Lee, 2001).  Unlike securities where empirical research has shown that a portfolio as small as eight or ten securities generally reduces risk down to market levels (Wagner & Lau, 1971), in the case of real estate it has been demonstrated that the number of properties that must be held to reduce risk to market levels is often in the range of 400-500 properties (Byrne & Lee, 2001).  As 400-500 properties will be beyond the reach of most individual investors, and beyond the reach of most institutional investors, risk control and risk financing techniques are critically important to most real estate investors whose portfolios fall beneath the efficient level identified by Byrne and Lee.    However, it has also been demonstrated that the transactions costs of risk control and risk financing are quite significant to small investors (Friedman, 1971).

One of the more significant nonmarket risks that a real estate portfolio generates by definition is an exposure to fire, natural disasters, and other property and casualty risks.  This produces a significant problem for most real estate investors; most real estate portfolios are below the efficient size where diversification has reduced risk to market risk.  The transactions costs of financing the non-market risk associated with property and casualty insurance are significant. 

            Modigliani and Miller demonstrated that if a firm faces no taxes, no transactions costs, and the firm’s investment activities are fixed, the financial activities of the firm will have no impact on its value (1958).  However, much like the Coase Theorem, this was meant to be restated, and can be read to teach that if financial activity is to have any value it will come in the areas of reducing taxes, reducing transactions costs or changing investments.  It has also been demonstrated that innovation in business law, and in particular innovations in law that create new business vehicles, can be very significant in reducing risk and encouraging new methods of reducing the risk associated with business and those solving problems that are associated with conducting certain business activities.  The series LLC, coupled with established captive insurance law and practice, may present an effective method for real estate portfolios below the effective size to finance risk at a significantly lower cost.  This paper will argue that if effectively regulated, the serial LLC couple with recent innovations in captive insurance can provide far more effective and cost efficient risk financing than the standard property and casualty insurance market can for reducing diversifiable risk, but there are certain pitfalls that regulators must be careful to avoid. 

Captive Insurance

            Put succinctly, captive insurance is essentially a method of self-insurance that can receive favorable tax treatment (Hofflander & Nye, 1984).  A typical captive insurance arrangement would work briefly as described below.  A parent company seeking to self-insure through a captive would contact a state licensed insurance company that would agree to serve as a front company and issue a certificate of insurance to the parent.  This state licensed insurer would then be known as the front company, the parent would then form a reinsurance company, typically in an offshore jurisdiction such a Bermuda.  This reinsurance company formed in Bermuda is what is referred to as the captive insurer.  The front company would then pass the overwhelming majority of the risk it assumed in insuring the parent to the captive insurer and remit most of the premium paid to the front company, by the parent company, to the parent’s captive insurer.  The captive reinsurer would then retain most of the risk represented by the original insurance contract, but would also obtain an excess loss policy on the international captive insurance market which would be available should claims exceed what is expected in any given policy year.  What value remains in the captive insurer that is not paid in claims could ultimately be remitted to the front company or used to defray insurance costs in future years.  This arrangement just described, detailed in Figure 1 below, is the traditional captive insurance arrangement that began as a result of the hard market in the mid-1960s when, for many large firms, traditional insurance coverage for workers compensation and general liability was simply unavailable (Berthelsen, Elliott, & Harrison 2006).

Figure 1

Premiums        Loss Payments       

This has become a fairly standard form of self-insurance among large publicly traded corporations, with approximately on third of the fortune 500 utilizing captive insurers to one extent or another (Han & Lai, 1991).

            Type of insurance does provide significant advantages.  First, even during hard markets insurance is available, second, the investment income generated by the captive can be utilized by the parent company, and third, companies with better risk control programs are often commensurately rewarded by the loss experience ratings of  third party insurers, a captive may well lower long run costs, and captives may generate a profit which can be returned to the parent company of the direct insurer reinsurer relationship between the parent, the captive, and the front company because more effective claims management is often possible, and for a variety of reasons, significant tax advantages can be generated by the captive.  It should be noted, however, that the tax issues surrounding captive insurance are complex and tax planning surrounding captives should only be undertaken with the assistance of an expert on captive insurance taxation and offshoring income.

            What can be seen from the above is that captive insurance can provide a very attractive risk management solution for many companies (Schmitt & Roth, 1990).  However, what is also readily apparent in the transactions costs surrounding creating a foreign captive insurance company, obtaining the underwriting and claims management expertise and the process of dealing on the international reinsurance market make this a solution that entails significant transactions costs and it is unlikely that this will be a viable solution for entities whose cost of risk is less than seven figures.  However, once a legal development has been established and appears to be desirable, a jurisdiction competition almost invariable emerges that leads to what some would describe as optimal development (Tiebout, 1956) or what others describe as a race to the bottom (Sterk 2000).  Irrespective of whether one views the evolution of the law of captive insurance as a race to the top resulting in the optimal pricing of risk or a race to the bottom, it is undeniable that law has developed and changed significantly since first used by Gulf Oil in a response to the hard market of 1966.

Jurisdiction Competition and Captive Insurance

            It was noted by Tiebout that preferences are ultimately revealed through voting with ones feet (1956).  One of the difficulties that public goods theorists have faced is that designing a voting system that causes the actors to reveal their preferences is difficult if not impossible and will lead to a system that is either utopian or unworkably complex (Mueller, 2003).  However, in responding to this problem, Tiebout suggested that different governmental entities and departments will naturally compete with each other to offer the combination of public goods that consumers find most appealing (Tsai, 2010).  Thus jurisdictional competition will develop the most efficient set of laws assuming that resources are mobile between jurisdictions, jurisdictions are able to select the laws they believe are most desirable, the number of jurisdictions is sufficiently large to allow for actual competition, and positive and negative externalities can hinder the efficiency of the result of the jurisdictional competition.  The first three conditions are clearly met in the case of captive insurance.

            The choice of a domicile for a captive insurer is not place-bound, since, at its inception, the insured has assumed that jurisdictional options exist for domiciling the captive insurer and the choice of domicile for the captive insurer has not impacted the headquartering or ultimate locations the parent choses to do business, thus the mobility of person’s condition is met.  Second, most countries that have developed any degree of financial services markets are acceptable jurisdictions for forming reinsurers.  This would include almost all of Europe, Canada, Australia, most of Asia, every state within the United States, and traditional offshore financial centers such as Bermuda, Cayman Islands, and the Channel Islands.  The fifty states within the United States alone would provide a sufficiently large number of jurisdictions for a jurisdictional competition to exist, so, adding to this, all of the offshore possibilities indicate that the second required condition is met.  Third, it is required that jurisdictions are free to adopt the laws that they believe would be most advantageous, when one considers the vast number of available jurisdictions and the constitutional political economy of the jurisdictions, therefore this condition also is clearly met.  It is difficult to argue that traditional offshore financial service centers, such as Bermuda, the Caymans, or the Chanel Islands, seem highly constrained in the financial services they are able to offer.  Finally, we need not deal with the fourth condition, the absence of significant positive or negative externalities. 

If one desires to consider the efficiency of the results of the jurisdictional competition, it is very important for a jurisdictional competition to emerge, however significant externalities can exist.  Sterk argued quite effectively that asset protection trusts had created a significant jurisdiction competition, but this competition had not produced an efficient outcome because the states creating the asset protection trusts were often able to capture the benefits of settling the trusts while the harm many of these trusts cause falls on individuals domiciled out of state (2000).  On the subject of captive insurance, it is clear that a jurisdictional competition for captive reinsures has emerged.  See Table 1 below for the distribution of captive insurance companies worldwide.

Table 1: Distribution of Captives World Wide

Jurisdiction

Number of Captives

District of Columbia

116

Montana

35

British Columbia

13

Utah

148

Nevada

126

Arizona

99

Hawaii

162

Cayman Islands

780

Barbados

22

Turks and Casco’s

203

Georgia

14

Kentucky

105

Vermont

560

New York

50

South Carolina

161

Delaware

49

Bermuda

885

British Virgin Islands

285

U.S. Virgin Islands

4

Barbados

225

Ireland

114

Isle of Man

145

Guernsey

355

Luxemburg

251

Switzerland

50

Gibraltar

12

Singapore

63q

Guam

New Entrant

Oklahoma

New Entrant

Number of Captives World Wide

5617

This compilation is too new for an accurate assessment of whether an efficient outcome will result, however, the authors will argue at the end of this paper that while no inefficient outcome has yet resulted, regulators will be faced with policy choices that could ultimately produce an inefficient outcome.

As has been discussed above, captive insurance can be a very effective risk management solution, but its utility is limited to really the largest of companies.  There are few insurance brokerages that would be unwilling to take on the insurance needs of the Fortune 500 but this is obviously a fairly limited pool of clients.  As can be seen from Table 1 above, when one looks at the 28 jurisdictions that have passed laws allowing for the development of captive insurance, and one notes the geographical diversity of the venues, it quickly becomes apparent that jurisdictions must see some advantage to gaining captive insurance business.  The advantages that jurisdictions see in attracting captive business are the tax revenues and employment opportunities that can be generated in the financial services industry which has a high multiplier effect in their jurisdiction (MacDonald & Farmer, 2013).  When one couples the desire of brokerages to expand their client base with the desire of jurisdictions to bring in captive business, the stage is clearly set for another form of jurisdictional competition to take place, and that is what public choice theorists have called interest group competition. 

Under interest group competition, one views not only the jurisdiction but the legislature as a marketplace in which interest groups compete for benefits (O’Hara & Ribstein, 2008).  As O’Hara and Ribstein explained, groups that are able to organize cheaply and effectively prevent others from entering the group to usurp the benefits the group obtains, and minimize competition between groups that tend to dissipate the rents achieved through the regulatory competition.  These conditions are clearly met when one considers captive insurance.  The insurance industry is already highly organized and quite effective at lobbying and the persistence of the antitrust exemption contained in the McCarran-Ferguson act that has defeated all attempts to overturn it and has effectively blocked all attempts to either repeal or modify (Committee on the Judiciary, United States Senate, 2007).  Furthermore, captive insurance, and especially the taxation issues surrounding captive insurance, are of sufficient complexity that they provide a sufficient barrier to new entrants into the market.  The startup costs of becoming sufficiently conversant in these issues to effectively advise clients are high enough that one is not likely to bear them unless one is very certain of the ability to procure new captive business.  The legal complexity surrounding captive insurance and the obscurity of the subject also create a situation in which most of the rents achieved through jurisdiction modification of captive insurance will in all likelihood remain concentrated in the group that bore the cost of influencing the legislative change. 

At this juncture, it is important to note that a case has been made that enough incentives exist to allow for a competition to develop thereby causing a legislative competition for captive insurance, but nothing is said about whether this competition will create an efficient outcome.  For a legislative competition to tend to deter bad laws and lead to an optimally efficient legal structure, it is also required that three further conditions be met.  One can divide the interested competing interest groups into three categories: groups that will derive benefit from the regulation and will thus tend to support it; groups that will derive a cost from the regulation and thus tend to oppose it; and an anti-exit coalition that will derive a cost should the regulatory business exit the jurisdiction.  This competition will tend to deter bad laws and encourage efficient laws to be passed.  It is frankly less clear whether this condition will be met in the case of captive insurance.  Captive insurance has not naturally organized opponents, those generally opposed to complex financial regulation are unlikely to coalesce around an issue as obscure as this, and an anti-exit coalition does not exist for regulatory business that has yet to be attracted.  So, as will be discussed below, the authors are not arguing that an inefficient result has been reached in this competition, but will warn that certain regulatory choices could lead to an inefficient outcome. 

Essentially captive insurance’s limited appeal was linked to the extraordinarily high transaction costs associated with forming a captive insurer.  Furthermore, a firm that is not normally involved in significant overseas business dealings, but is essentially a domestic firm forming an insurer in an overseas jurisdiction, is thought to be an audit flag.  Thus only larger companies were interested.  This means that what was required to increase the market for captive insurance was a way to reduce the entire transactions costs attendant with using a captive insurer.  These transactions costs can basically be divided into two categories: first, the initial funding requirement for the captive could be significant and secondly, the creation of a captive finance insurance arrangement is a complex financial transaction that cannot be safely undertaken without access to significant expertise in law, taxation, actuarial sciences, underwriting, and claims management.  Furthermore this is not a short term commitment; this is a long ongoing commitment permanently increasing the complexity of the firm’s financial, legal, and tax status.   This level of expertise is available and should not intimidate large publicly traded corporations, but could clearly be problematic for smaller firms.  Secondly, the large upfront costs and the costs of managing all of this complexity can deter entry by smaller firms.  What was needed was a business vehicle that would allow small firms to share the costs of all the expertise required to create a captive insurer without sharing risk.  One might argue that small firms could band together and create their own captive insurers, and within certain industries this has been done to a degree, but this type of risk pooling arrangement has not proved entirely satisfactory, generally because of incentive incompatibility.  Once risks are pooled the efficient amount of risk control decreases (Lee and Ligon, 2001).

The solution that was agreed upon, and many jurisdictions have adopted, is the series LLC.  Under the series LLC structure, a brokerage can form an LLC and provide all of the expertise required for setting up a captive insurance arrangement inside that LLC.  This LLC, that houses all the expertise, assumes none of the risk of any insurance arrangement.  Then, under the LLC, the brokerage can sell other cells in the series to individual clients (Gattuso, 2008).  Each cell, which can be charged its prorated share of the expenses, wholly contains the risk of the insured.  This then allows brokerages to develop turn-key products that can be marketed directly to smaller firms as insurance solutions.

For the smaller firm, this type of insurance solution could contain several advantages. First, just like with the Fortune 500, problems with hard markets can be overcome. Secondly, and perhaps more attractively, claims should be less than anticipated, the money paid into the captive can be invested tax free, and the income deferred until later.  This could prove particularly attractive to the small closely held corporation, as this can be used as a wealth management device for the retirement of the holder of the small corporation.  All of these features could prove particularly attractive to the small to medium real estate investor who holds a portfolio of properties subject to property and casualty risk. 

The Applicability of the Serial LLC Captive to the Real Estate Investor and Particular Regulatory Issues

In areas such as Oklahoma, that are subject to catastrophic weather events, the real estate investor holding multiple properties subject to property and casualty risk may find himself facing a hard market where property and casualty insurance is simply not available (Nell, 1996).  Therefore, the wealth management aspects of this particular product could be very useful.  However, both of these issues bring up some perhaps unique problems that regulators must deal with.  Most real estate portfolios are not highly geographically diversified (Byrne & Lee, 2001).  It has also been noted that even when insurance portfolio managers intend to diversify, they often do not, as real estate investment by portfolio managers is more heavily impacted by market sentiment than many other forms of investment (French, 2001).  This is problematic in two ways. First, catastrophic weather events could be devastating because of this lack of diversification, and, secondly, as years pass without significant claims, large amounts of cash will accumulate within the captive cell and it is certain that some of the holders of these cells will wish to invest the money on behalf of the captive in more real estate in the same geographic location.  It would be hoped that regulators would stop this, as this activity would magnify the down side of catastrophic weather events.  However, it is exactly the type of situation where a jurisdiction could win the regulatory competition by allowing an insured to make exactly these types of investments.  This is particularly possible in the case of captives that are domiciled in a jurisdiction different from the location of the insured property.  This is the type of negative externality that can easily lead to an inefficient set of laws being developed.  Also, all risks entail the incurred, but not reported, loss.  That is, a loss that has occurred that the insurer will ultimately be liable for, but which the insurer is currently unaware (Brethlesen, Elliot, & Harrison, 2006).  This type of loss can be reported years after it occurs and because many statute of limitations are based on the standard of what they knew or should have known, the insurer can be liable.  The Fortune 500 that regulators are used to dealing with, have a time horizon of unknown duration and thus have an incentive to wish to have tail risk covered.  If I have sold a business, as many small investors desire to do, and used proper liability limiting business entities to contain the business, they are far less concerned with tail risk and may wish to empty the captive too soon.  This is not meant as an indictment of either captive insurance for small entities or of small investors, it is simply meant as a warning to the regulators that the incentives of the small investor are different from those of large publicly traded companies and their captive insurance entities must be regulated with that difference in mind.

Conclusion

We believe that new developments in captive insurance can make this an attractive option for small to medium real estate investors and would encourage them to learn more about this product.  However, we also caution regulators to be very aware of the change in incentives as the type of insured changes.  It is our hope that lenders will step in and provide the countervailing weight to see that an efficient competition for the captive insurance market develops.  Based on the evidence to this point, we see captive insurance for small real estate portfolios as a positive development in commercial law, but not as a development without possible pitfalls. 

(Author’s note: For a complete discussion of the introduction’s theories, see Markowitz’s seminal work Portfolio Selection, Journal of Finance 7:77-91 and Modigliani and Miller, The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review 48:261-297.)

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