KCIC is pleased to present this guest post by Daniel Chefitz, a partner at Morgan Lewis. He is an expert on establishing and maximizing the benefits of captive insurance companies to insure both developing and legacy liability risks.  

Long-tail liabilities, often arising from discontinued operations, continue to affect U.S. businesses, from many perspectives: income, balance sheet and management. Companies need to analyze and revise reserves, often on a quarterly basis, and devote key management time to focusing on discontinued operations in addition to their core businesses. For example, KCIC’s recently published report “Asbestos Litigation: 2015 Year in Review” noted that while claim filings were down slightly last year, the number of defendants being named on average in each lawsuit increased. Companies are seeing claim values increase, while other companies find themselves as an asbestos defendant for the first time. Many of these companies have limited historical insurance remaining to respond to claims that are expected to continue to be filed for at least the next 30 years. For many of these same companies, discontinued operations have resulted in environmental and toxic tort claims, with a similar horizon in terms of continuing obligations.

At the RIMS annual meeting in San Diego this past April, I co-presented at the Thought Leader Theater on the topic “New Uses for Old Captives”. One of the captive insurance options we discussed was how to strategically use a captive insurer as part of a comprehensive plan to effectively manage long-tail liability. Captive insurance can supplement and/or replace historical general liability insurance that is no longer sufficient or available to address all future legacy liability. It also can serve as the centerpiece of a legacy liability management plan.

How It Works

Captive insurance — meaning coverage issued by a wholly owned subsidiary to insure risks of affiliated brother/sister entities — is a proven risk management tool that has recently re-emerged in popularity. While traditionally used to address a company’s high-volume, low-dollar claims that can be managed more effectively by the insured or by a third-party administrator on behalf of the insured, captive insurance can also effectively insure risks that cannot currently be insured in the commercial marketplace. Third-party insurers today will not insure, at any price, unknown future asbestos or environmental liability arising from discontinued operations. This is precisely why pre-1986 general liability policies that covered such risks are so valuable. Unfortunately, many policyholders now find that their historical insurance is exhausted or unavailable due to prior settlements with insurers or insurer insolvencies.

Using a specially tailored insurance policy, a captive can insure known and unknown future claims arising from prior operations or sale, manufacture or use of products, or discontinued operations. The captive will fill in the gaps and supplement any remaining historical insurance coverage. Captive policies are drafted to ensure that existing coverage responds first, while ensuring that all future claims are covered. A third-party actuary familiar with long-tail liability and insurance underwriting techniques establishes a one-time premium for the captive policies with a sufficient risk margin to cover all future claims. A new fully funded, self-contained dedicated structure may also be used in conjunction with the captive insurer subsidiary to run off all long-tail liability and free the parent company to focus on its ongoing business.

Key Advantages

As the centerpiece of a legacy liability management plan, a captive offers several benefits, such as:

• Independent actuary-based feasibility study supports sufficiency of premiums and limits available for legacy liabilities
• Oversight and approval by captive regulators provides another level of independent support for structure and funding
• Facilitation of future transactions by avoiding indemnities by parent

In addition, if the captive is established in a manner that qualifies the captive as an insurance company for IRS purposes, additional ancillary benefits may be achieved:

• Existing reserves on a company’s balance sheet typically are not deductible for tax purposes until paid (all-events test is met), giving rise to a deferred tax asset
• By insuring the reserves with a qualified captive insurance company, the reserves are moved off of parent’s balance sheet and onto the captive’s balance sheet
• Loss reserves of a qualified captive insurance company should be immediately deductible for tax purposes, thus accelerating the tax deduction within the parent’s consolidated group and monetizing the associated deferred tax asset
• Premium paid to a qualified captive insurance company is tax deductible under IRC Section 162 if certain tests are met
• Increased cash flow as a result of the accelerated tax deduction can be invested in a tax efficient manner and used to support the treasury goals of the organization

Conclusion

Captive insurance is not just for workers compensation claims or deductibles anymore. If used as the dedicated funding source for a self-contained discontinued operations structure, captive insurance plays a key role in segregating asbestos, environmental and other long-tail liabilities from assets related to ongoing business operations of the parent. Captive insurance can supplement existing insurance coverage, or fill in any gaps, in a tax-efficient manner, while maximizing the value of any remaining historical insurance coverage. A captive-funded structure, together with a dedicated discontinued operations management team, can offer long-term defense efficiencies, while mitigating or re-directing legal liability potentially flowing to the ongoing business.

Daniel E. Chefitz, a partner at Morgan Lewis, represents policyholders in insurance recovery disputes with a focus on product liability, asbestos, environmental, and toxic tort claims. Daniel advises businesses on establishing and maximizing the benefits of captive insurance companies to insure both developing and legacy liability risks. He also counsels clients on their insurance rights in bankruptcy proceedings and reorganizations, including those associated with Section 524(g) injunctions.