By Jackie Banks, Senior Vice President, Participation Programs There are so many marketing pieces, articles, seminars, proformas and hearsays about Participation Programs. It is hard to see through the fog and understand what it all means.
In my 25 years of being in this business, I have seen and heard it all - some good, some bad and unfortunately, some misleading. Working for an underwriter, we do not promote one program over another, we underwrite them all. I care about our industry and our clients. I want to provide valuable information that will help individuals make sound business decisions in determining what program is right for them.
In this article, I will attempt to do just that – provide unbiased information and identify some potential issues that people do not always talk about. I also want to take away the mysterious fog that surrounds these programs and explain things simply.
Let’s get started by noting that Participation Programs can be put into 3 categories: Reinsurance, Warranty Companies and Profit Shares. Keep reading to find out more about each one.
Reinsurance
Reinsurance takes many forms, but essentially it is where a (re)insurance company
assumes insurance RISK from an insurance company. Reinsurance in the F&I industry has been around since the 50’s. It involves setting up your own reinsurance company or participating in another reinsurance company.
Types of Reinsurance Companies
| CFC – Controlled Foreign Corporation | Domestic Corporation |
| NCFC – Non-Controlled Foreign Corporation | Cell Company |
| PORC – Producer Owned Reinsurance Company | DORC – Dealer Owned Reinsurance Company |
| PARC/ARC – Producer Affiliated Reinsurance Company or Allied Risk Company | Captive Insurance Company |
These reinsurers have unique characteristics that should be considered when deciding which one is best for you. You will need an administrator/consultant to help you understand your options, along with the capital, costs and benefits of each one. They can also assist in setting up your reinsurance company or your participation in another company. Reinsurance is not a “one size fits all,” so consider all aspects before making your decision.
FOGGY Items
Reinsurance = Offshore Reinsurance is NOT required to be offshore. Reinsurers could be here in the U.S. or the Delaware Indian Tribe (sovereign nation). In the early days, most companies were formed in Arizona. People typically opt to go offshore because there are lower costs and less onerous regulation. Even if the reinsurer is domiciled in a foreign country (other than a NCFC), it files as a U.S. taxpayer and pays U.S. taxes. The funds do not go offshore; the funds stay in bank accounts here in the U.S. Reinsurers do not go offshore for tax reasons.
I paid a CLIP fee, so I have no liability You have all of the liabilities as the reinsurer. Reinsurance means you have assumed the risks and liabilities. A CLIP (Contractual Liability Insurance Policy) is the policy issued by the insurance company to the Warranty Company. The risks of the CLIP are transferred to the reinsurer. The “fee” that the reinsurer pays is to cover the insurer's costs, along with a small margin. It does not provide the reinsurer any coverage for losses. Reinsurance must have risk of loss to qualify as reinsurance. Risk of loss happens when your losses exceed premiums.
Reinsurance has very limited investments Investment options can be diverse. Assets held in trust to pay claims are typically more conservative, but still provide flexibility to maximize returns. This protects you from coming out of pocket to pay claims because of investment losses. Equities are allowed, with some companies allowing 30% or more. Don’t forget about your surplus! You can invest surplus without restrictions by using a “B-Account” and there is no tax impact from merely transferring funds from one account to another. Additionally, certain structures allow for loans as an asset, which also does not typically have tax impacts. Just be sure to have interest and a repayment schedule, as you would do for any loan.
Reinsurance has more fees There are fees for all programs. It is sometimes difficult to identify all of the fees in reinsurance, but it is very important that you have a trusted advisor find out what all of the fees are. Some providers have hidden fees (LAE) that one would need to know to look for. They are not listed in any agreement, nor are they clearly identified on any report. All providers charge fees; they just put the fees in different places and call them different things. When doing a side-by-side comparison, you should have your trusted advisor identify and list ALL fees for each program.
CLEAR Items
- Premium rates must be actuarially justified – one should not just add $100 to each contract without documented justification.
- Loans must be commercially reasonable – one should not take loans out for more than a normal business would allow; make payments; pay reasonable interest rates.
- Pay amounts due under the reinsurance agreement – one should not withdraw funds from trust and then not put them back when needed; reinsurance = risk of loss, not just gains.
- Have a business purpose for the reinsurance company and the ownership structure; a common reason to form a reinsurance company is to fully participate in the underwriting results of the business; the reason should not only be to avoid taxes.
- Have adequate volume – insurance does not work without adequate spread of risk; it would not make sense to establish a company to insure a small pool of risks; also, the IRS requires there to be “risk distribution” to qualify as an insurance company.
- Understand the risk of your investments and how that might impact your reinsurance position – there is potential market value volatility for all investments; we are seeing this today with both fixed income and equities; you may be able to withdraw funds today, but you could have to put funds back in tomorrow.
Highlights
- 100% participation in underwriting results
- Investment income
- Tax advantages for small companies (e.g., 831(b) companies with < $2.45M* annual premium only pay taxes on investment income)
- Simple setup and low initial/ongoing costs
- Opportunities to provide key employees long-term incentive plans
- Can be used with multiple providers
*Limit for 2022 tax year Warranty Companies
A Warranty Company (WC), or service contract company,
sells service contracts and pays claims. It is not a reinsurance company and does not assume nor transfer risks. It obtains licenses to issue service contracts to consumers in each state it does business in and is obligated to pay the claims to the consumer.
Types of Warranty Companies
| DOWC – Dealer Owned Warranty Company | AO – Administrator Obligor |
| DOOC – Dealer Owned Obligor Company | DO – Dealer Obligor |
| Hybrid – DOWC that assumes obligations of another warranty company | |
These also have different characteristics that should be considered when deciding the best fit for you. An administrator/consultant will form and manage the WC. There are capital and other costs involved with each one. It is important to note that not all products can be included in a WC. Excluded products include GAP and limited warranty. DOWCs/DOOCs have been around for a long time, but have become “mainstream” in the last 5-10 years. Hybrids are new to the market and have been offered in the last couple of years. WCs may seem to be the latest and greatest program; however, one should understand all of the facts and potential risks versus only hearing about the upsides.
FOGGY Items
WCs do not pay taxes WCs are subject to federal and state taxes. This is one of the biggest myths – they only have a deferral of taxes! The tax bill will come. Also, they pay state taxes in addition to federal taxes. Proformas normally show no taxes for 7-10 years, although they do not show or explain what happens when taxes become due.
WCs can transfer/assume risk WCs can only conduct service contract business, not risk transfer. WCs are licensed service contract companies. They cannot do business that an insurance company would do. The proper way to transfer risks and related “premiums” is with an insurance company. No matter what it is called (indemnity, risk transfer, etc.) - if it looks like insurance and works like insurance, it is insurance.
WCs are always cheaper than reinsurance WCs typically have more upfront costs than reinsurance. WCs have fees and costs that are not always less than reinsurance. It is true that there are not as many “types” of fees for WCs and that WCs do not pay premium taxes. Although, the costs of establishing and maintaining a WC are generally higher than reinsurance. Some examples are: initial capital requirement - $50,000 to $500,000; state and lender form filing costs - $500 to $2,500 per form, per lender, per state; annual expenses (financial statements, tax returns, state filings, etc.) - $10,000 to $20,000. You should have a trusted advisor to identify and list ALL fees and costs for the program.
WCs do not have investment restrictions WCs have investment restrictions on assets held for claims. A WC needs assets supporting claims invested in fairly conservative investments, similar to reinsurance. Typically, the FTP/XOL CLIP provider will require this to ensure adequate funds are available to pay claims. It is much easier (than it is for reinsurance) to access funds related to unearned.
CLEAR Items
- Do not shut down the DOWC in 7 – 10 years right when taxes become due; this could potentially cause serious issues. If all of the DOWCs do this, it will be a huge red flag for the IRS; one needs to have a strong, legitimate reason to support shutting it down at that exact point in time – why not earlier or later? Also, keep in mind that if you shut down the WC, you will need to find a new structure for the new business.
- Understand your obligations/liabilities/exposures and how a CLIP works; a WC is “first in line” on all liabilities; the FTP/XOL CLIP only pays if WC becomes insolvent or If inception to date claims exceed an attachment point (i.e., 125% loss ratio); WCs have exposures to CFPB, class action lawsuits, litigation, fines, etc. that are NOT covered by the CLIP.
- If you have a transaction, such as an indemnity agreement, that has the attributes of insurance or reinsurance, state insurance departments could deem it to be insurance; there could be penalties, fines, premium taxes and other financial impacts or consequences.
- If you access funds related to unearned, there could be contingencies, such as personal or corporate guarantees.
- WCs are not easily portable; some administrators require exclusivity or a term commitment or charge fees if it goes into run-off; WCs are difficult to “sell” or shut down versus reinsurance.
Highlights
- 100% participation in underwriting results
- Investment income
- Tax deferrals
- No limit on annual premium
- Moderate initial/ongoing costs
- Control over service contract offerings
- More flexible investment options
- Access to cash on unearned
Profit Shares
Profit shares are essentially
a commission payment based on the underwriting results of the business. There is no need to form a separate company. There are no risks, no costs, no obligations and no filings. You merely receive periodic payments.
Types of Profit Shares
| Retro – Retrospective Commission | Standard Profit Share |
| Contingent Commission | Advanced Profit Share |
| Guaranteed Retro | Accelerated Retro |
These all could vary slightly for things like payment frequency, participation percentage, products included, etc. These structures allow you to partially participate in the underwriting results, they typically have no or very limited investment income and do not have any tax benefits. Profit share may be the best fit for you after considering your options.
FOGGY Items
Guaranteed Retro is Reinsurance Guaranteed Retro is NOT Reinsurance. The provider may provide a “cession statement,” but it is not reinsurance unless there is a reinsurance agreement and you have formed a reinsurance company.
Profit Shares do not need to be monitored Profit Shares need to be monitored to ensure profit. To maximize the amount of profit share payments, one should monitor the performance of the business and take appropriate actions to ensure profitability.
CLEAR Items
- Profit Shares usually have volume requirements for payouts; find out how the tiers are set and calculated: period of measurement - calendar year, 12 months from effective date, each quarter and basis of the tiers – gross/net contract volume or gross/net written premium volume
- When you exit a Profit Share and it goes into run-off, there are typical impacts that one should be aware of: loss of all or a portion of future commissions, penalties, suspension of future payments until all contracts have expired, etc. Make sure you know these at the onset of the program.
Highlights
- Limited participation in underwriting results
- Small volume requirements
- No work (no setting up and managing a company), just collect payments
- No risk
In summary, all of these programs allow for sharing of profits, but each one has different financial and operational impacts. It can be difficult to see through the fog, but I hope I was able to lift some of it. If you have a lighthouse (trusted and experienced advisor), it will help you see the way to make the best decision for your financial future.
Jackie Banks joined the AmTrust team in 2017. Jackie is responsible for administering all of Specialty Risk’s reinsurance programs. Prior to joining AmTrust, Jackie was with Allstate for 19 years, where she held various officer roles overseeing the finance and reinsurance areas for its Dealer Services division. Jackie is a certified public accountant and is actively licensed in the state of Florida. Jackie received her Bachelor of Science in Accounting and Finance from the University of North Florida.