Ted O. Hall
Property and Casualty Insurance
Accounting and Taxation
"I understand the ins and outs of the Captive Insurance Industry"
Reciprocal Insurance Exchanges*
Reciprocal insurance exchanges are little understood but not an uncommon form of insurance organization. Two well-known national carriers USAA and Farmers Insurance Group operates as reciprocals. Several medical malpractice companies around the country were originally organized as reciprocals, including The Doctors Company, Southern California Physicians Insurance Exchange, MEIC, Nation's Capitol Reciprocal Insurance Company, American Physicians Insurance Exchange, Washington State Physicians Insurance Exchange, Illinois State Medical Insurance Exchange, Medical Inter-Insurance Exchange of New Jersey and El Camino Insurance Exchange.
A reciprocal insurance exchange involves the organization of two separate entities:
- Reciprocal Inter-Insurance Exchange--
A form of unicorporated insurance company in which subscribers exchange policies through an Attorney in Fact (see item2, below) in transactions that share or spread their risk. The reciprocal insurer is overseen by a Board of Governors whose responsibilities typically include general oversight of the reciprocal, selection of the Attorney-In-Fact (AIF), monitoring the performance of the AIF, and approval of rates. The reciprocal may issue either an assessable or non-assessable policy, although the non-assessable policy is most common among reciprocals today. A unique aspect of a reciprocal is the multiple surplus accounts, each of which serves a distinct purpose but all of which are co-mingled and available to pay claims. One of the more important surplus accounts is the Subscribers Savings Accounts (SSA's).
- Attorney in Fact--
A separate leagal entity that typically runs the day-to-day affairs of the reciprocal insurer. The policyholdres of a reciprocal, usually called subscribers, provide a power of attorney to the AIF, giving the AIF legal authority to act on their behalf in managing and adminestering the reciprocal. The AIF is selected by the Board of Governors of the reciprocal to manage all its affairs. A formal magement contract is entered between the AIF and the reciprocal. The management agreement may be a contract in perpetuity or a contract for a specific term. The AIF may be owned by the reciprocal itself (a proprietary AIF) or by an independent third pary (anon-propritary AIF) or a combination of both. If a corporation, the AIF is governed by a Board of Directors that often include one or more members of the Board of Governors of the reciprocal.
The advantages of the reciprocal form of organization are principally to the AIF and are as follows:
- Owners of the AIF are not required to be policyholders in the exchange.
- Ownership in the AIF may exclude policyholders of the exchange.
- The AIF mantains its own value based on the future stream of income (less expenses)to be realized from its contractual relationship with the exchange.
- The AIF is shielded from the insurance risk and expenses of the exchange.
- Sale or exchange of the AIF can be accomplished fairly easily and without disturbing the insurance realtionships in the exchange
- Tax deductible accumulations to Subscriber Savings Accounts (see below.)
The disadvantages of the reciprocal form of organization are as follows:
- The insurance exchange may not be able to provide liquidity to physician policy holders or fund needed capital for expansion.
- Mantaining two separate legal entities may result in additional expenses and taxes that would not be present for a single insurance entity,
- Possible additional scrutiny by the insurance regulator around the contractual relationship between the insurance exchange and the AIF.
- The insurance exchange can be sold or transferred only with considerable reorganization of the entity.
Tax Advantages for the reciprocal:
The principal tax benefit of reciprocals over other types of insurance entities is their ability to deduct surplus credited to the Subscriber Savings Accounts (SSAs.) Amounts credited to the SSAs are vested to the policyholders but not required to be paid to them until after their withdrawal from the insurance program. This can represent a significant deferral of income taxes for an insurance company that maintains a healthy measure of income and a stable base of policyholders continuing in the program. Amounts deductible by the company, as credits to the SSAs are rquired to be reported as taxable income by the individual policyholders for the year that the company claims the deduction. Annual deductions for contributions to SSAs cannot exceed the total annual increase in the surplus of the exchange. The amounts credited to the SSAs are considered free surplus for statutory accounting purposes.
Another potential tax benefit of the reciprocal is the tax credit found in Section 835 of the Internal Revenue Code. Under general tax law the reciprocal is entitled to deduct payments to the AIF as long as such fees are ordinary and necessary. Under Section 835 a reciprocal may elect to limit its deduction for fees paid to the AIF in exchange for a taz credit equal to the income taxes paid by the AIF attibutable to the management fees it receives from the reciprocal. The tax credit election is effective only if the AIF has a marginal tax rate that is consistently greater than the marginal tax rate of the reciprocal.