White Paper Explores Key Concepts in Insurance and Reinsurance for Captives

A new white paper, Insurance Concepts for the Non-Insurance Practitioner, provides a comprehensive exploration of key insurance and reinsurance concepts, such as risk pooling and the circular flow of funds, along with the associated accounting practices. Authored by industry experts including Alan J. Fine, CPA, JD (tax partner at Armanino LLP); Brian Johnson, ACAS, MAAA, ARM (managing director at Risk International Actuarial Consulting); Donna Eldridge, CPA (chief financial officer at The Intuitive Companies); Kerrie Riker-Keller (chief compliance officer at The Intuitive Companies); Michael W. Teichman, JD (director at Parkowski, Guerke & Swayze, P.A.); and Rick J. Eldridge (president and CEO of The Intuitive Companies), the white paper offers an essential framework for understanding the complexities of commercial insurance and captive insurance, including the actuarial and legal dimensions.

The white paper emphasizes how multifaceted insurance can be, especially when combined with tax regulations. One of its highlights is the discussion of risk concepts such as exposure units, risk shifting, and risk distribution. These fundamental concepts are crucial in evaluating how risks are insured, priced, and mitigated within both commercial and captive insurance contexts.

For instance, the white paper delves into exposure units, which quantify the risk that an entity faces. This is a critical factor in the underwriting process, which is based on the distinction between possibility and probability. The authors explain how costs of exposure—such as rebuilding or material costs—can fluctuate, thereby impacting the premiums required to provide coverage. One example shared in the white paper is how mileage is often used as an exposure unit for automobile insurance.

The white paper also explores risk shifting, which occurs when an insured transfers the financial burden of a potential loss to an insurer. As the white paper outlines, a key point in determining risk shifting is whether the insured has entered a legally enforceable contract with an insurer—one that includes elements like an offer, acceptance, and consideration. This contractual foundation is at the core of legitimate insurance transactions, whether commercial or captive.

The third significant concept discussed is risk distribution, which occurs when an insurer pools a large number of independent risks. The goal of distributing risks is to mitigate the impact of any single, costly claim by spreading it across a larger pool. The authors point to the well-known principle of the law of large numbers to explain how insurers can more accurately price risks when they are shared over a sufficiently large pool of independent risks.

Additionally, the white paper highlights the importance of risk pooling, particularly for mid-sized businesses, which may not have the volume of risks necessary to qualify as an insurance company under federal guidelines. These businesses often enter reinsurance pools to distribute risks, a practice common across the industry.

Finally, the white paper touches on the circular flow of funds, especially in the context of reinsurance pools. This concept is essential for the proper accounting of premiums, losses, and claims across pooled risks. The white paper highlights that managing these funds correctly is critical to avoiding misperceptions about circular cash flows, as demonstrated in various tax court rulings like Rent-A-Center and Swift.