Insurance is a very important profit center for a car dealership. And in my opinion, insurance will only continue to grow in importance as more dealers capitalize on their market leverage, begin selling collision insurance with their gap, and then harvesting homeowners, boat and jet ski insurance as the opportunities arise. Over time, the recurring revenue of a growing casualty book can recreate the gross profit margins that you have only dreamed about since the ’80s.
Just as selling insurance is and will continue to be an important component of the car business, reinsurance offers enhanced profitability and personal liquidity opportunities that can be a very powerful succession planning tool. Before delving into the succession planning benefits, for the few of you that may not be familiar with reinsurance, allow me to explain the concept.
How Does Reinsurance Work?
There is more profitability from the insurance and maintenance products you are selling than the commissions you are receiving. The manufacturing and distribution of these insurance products is lucrative. If a dealer generates sufficient premium, the product providers—which are referred to as sponsors—will offer the dealer participation in the underwriting profit as a retention incentive. Financial participation in the underwriting profit is either paid through “retros”, accruals in a reinsurance cell position or outright ownership of an 831(b) “small insurance company.”
- What is a “Retro”? A “retro” is a simple, risk free payment of a percentage of the sponsor’s estimated underwriting profit. A “retro” is like a rebate of premium. The higher the premium written and the lower the claims percentage, the higher the potential “retro” payment a dealer can receive. However, the dealer generally does not care about those details if the “retro” payment is satisfying his or her need. “Retros” are popular to those who want their money now and do not want to delve into the details of reinsurance.
- What is a Cell? A cell which is sometimes called a “rent-a-captive” is a risk-bearing account in a licensed “non-controlled” insurance company with more than eleven dealer shareholder/participants, which is organized by a sponsor, not any one dealer. In a quid pro quo arrangement the sponsor “rents” the dealer/shareholder the capital to justify the underwriting risk being assumed for his cell (business block) and provides the actuarial certifications, regulatory reporting and claims administration for an assortment of fees, that partially make up for the underwriting profit they feel compelled to share. With eleven or more participants there are economies of scale benefits to the “cell structure” and there are no limitations on the amount of premium that can be written to each cell which makes this structure attractive to large operators. Referred to as Non Controlled Foreign Corporations (NCFC), these cells are usually positioned offshore to defer income tax until dividends are declared. A Board of Directors controls the management of reserves and most important the declaration of dividends and there is some, although limited, cross liability between cells, so it pays to know who your partners are.
- What is an “831(b)”? 831(b) refers to an IRS Code Section that provides for “small” insurance companies with annual premiums of less than $1.2MM. It’s called a captive because a dealer organizes his/her own independent 831(b) which insures his own (captive) policies under the “front” of the sponsor. The 831(b) qualification under the IRS allows the deferral of income tax on underwriting profit until the liberated reserves are withdrawn as qualifying dividends. Due to the capital and regulatory requirements of any form of insurance provider, the sponsor, typically sets up the 831(b) for the dealer and provides a Letter of Credit (LoC) for capital. In addition, the sponsor provides the actuarial certifications, regulatory reporting and claims administration for what we hope are reasonable fees. The 831(b) is an independent risk-bearing C Corporation owned and controlled by the dealer or his assigns which provides control over the investment of reserves and the opportunity to withdraw profits whenever the actuary declares liberated reserves. With respect to risk, the administering sponsor supervises claims management and regulatory compliance because they are at risk regarding the LoC. The 831(b) can be a U.S. domiciled corporation or a Controlled Foreign Corporation (CFC) taxed as a U.S. entity. Under both alternatives, attractive tax deferral is available on the underwriting profits until the cash hits your pocket.
- How to determine if fees are reasonable. Most significant sponsors, who include most manufacturers, offer all options because it would be a downer to lose an account because the sponsor lacked the ability to serve a dealer’s circumstances. The challenge for all of us who don’t make a living manufacturing insurance is confirming what reasonable fees are for reinsurance entities. Your only hope is comparison. You have to compare fees between sponsors to have any level of comfort and even then you must fight your way through the sponsor’s explanations that all too often sounds like double talk.
Reinsurance and its impact on Succession Planning
From a succession planning perspective the versatility of financial participation in a reinsurance structure offers a very powerful succession planning tool. As an example, both the cell and the 831(b) create independent income streams that can be titled any way the dealer chooses. This versatility provides countless opportunities to create equity which can reconcile a variety of succession planning challenges.
Financial Security Independent from the Business
Probably the most obvious utilization of reinsurance is the creation of liquidity that is independent from the dealership. The average dealer has 80% of his/her net worth tied up in the operating company and real estate. Although that structure optimizes income production, it greatly restrains the freedom to turn over control of the store to successors and not worry about lifestyle and financial security. The utilization of reinsurance projects liquid capital outside of the dealership that can be utilized as a no-strings-attached source of retirement liquidity.
For those who think gifts are only fun for the recipients, another nifty technique for creating that same retirement security and/or estate liquidity is for a dealer to enter into a stock purchase agreement with successors with funding provided by the reinsurance that is titled in the name of the successors and formally pledged to the funding of the stock purchase. The retirement and/or estate liquidity is created while the estate tax exposure on the reinsurance proceeds is avoided. To capitalize on both of these opportunities the dealer would title all or more likely a portion of the reinsurance in the successors name or a “Buyout Trust” with the reinsurance proceeds formally pledged to the funding of the stock purchase agreement.
Reinsurance companies can serve as alternate banks, especially when primary banks turn their backs. More than one dealer was pulled out of the grease through reinsurance loans back in ’07 and’08 when the commercial banks deemed them persona non grata. These loans must be serviced in a legitimate arms length fashion, but none the less serve as a welcomed opportunity for business succession when all other sources are dry.
Fund Estate Tax Liability When Dealer Dislikes Life Insurance or is Uninsurable
If draconian estate taxes are an impediment to succession planning and the dealer hates life insurance or is uninsurable, a portion of the reinsurance profit could be positioned in an irrevocable trust with specific instructions to the trustee to use the proceeds to fund the estate’s tax liability. There will not be the immediate liquidity of life insurance but after a few years there could be a buildup of impressive cash through liberated reserves. When the estate taxes become due the trustee could generate liquidity by selling the cell position or 831(b) to the sponsor at favorable income tax rates. For those of us who can tolerate life insurance but hate the premiums, the trustee could utilize reinsurance dividends to fund the purchase of both income tax and estate tax free life insurance inside the same irrevocable reinsurance trust.
Provides Opportunities for Equitable versus Equal Estate Planning Issues
The equitable versus equal estate asset challenge could also be facilitated by reinsurance. If a dealer plans for one of their children to get the business but won’t have sufficient independent assets to treat their other children equitably that work outside the business, the reinsurance could become fabricated estate equity. The dealer could either direct the reinsurance company to the non-successor children or for estate tax efficiency again utilize an irrevocable reinsurance trust. This proposed structure should not complicate family dynamics after the dealer’s death. The successor who assumes responsibility and ownership of the dealership could discontinue writing policies to the established reinsurance company and create a new company. This allows the children who now own the reinsurance company to retain the profits that the original reinsurance company generates.
Key Manager Motivation and Retention Tool
Reinsurance can also be a powerful key manager motivation and retention tool. No doubt key managers understand the reinsurance game and would covet an opportunity to participate. You could enter into an agreement with a key manager that immediately or after a stipulated number of years of service would award him/her a position in the reinsurance program. The key manager would receive dividends when declared. If the key manager owned a position in the cell or 831(b) a repurchase agreement would describe the terms and value of the reinsurance position in the event the key manager terminated employment due to retirement, death, disability, voluntary termination or termination for cause. The repurchase agreement would serve as a form of golden handcuff and be as simple or all inclusive as you deemed necessary based upon the tenure, history and circumstances of the Key Manager.
Both reinsurance and succession planning are complex undertakings that demand focus and the involvement of trusted advisors. When you combine the two, admittedly the complexities can make your face hurt. However, hopefully your take-away here is that reinsurance is a great opportunity and a versatile succession planning tool for dealers who are willing to deal with the details and frustrating ambiguity associated with sponsors, actuaries and regulators.