Insurance Risk vs Business Risk – Where is the line between risks that can and cannot be insured?

Contributed by ICCIE Board Member and Instructor, Michael Douglas of Aon

In the US there is no standardized definition of insurance which captive owners can look to in order to ensure that the risks they place with their captive can be properly defined as “insurance” for the purposes of achieving favorable accounting treatment.

What is and what is not regarded as insurance must be assessed on its individual merits and is a test of fact to ensure the transaction passes the tests of risk distribution, risk transfer and has been made using the usual notions of insurance.

For captive owners looking to place the more traditional lines of Workers’ Compensation, General Liability, Auto Liability and Property into their captive, the tests and parameters have been well tested and are generally understood by the industry. However, in the current business environment where new risks are emerging, the demand for ‘cutting edge’ lines of business to be placed into captives is beginning to blur the line between “insurance risk” and “business risk.”

Business risks which are so close to the day to day operation so as to be considered a cost of doing business are the ones that need the most attention.  An example would be if a manufacturer produced a product which turned out to be unpopular and does not sell or that becomes obsolete almost as soon as it hits the market. It would be very difficult to justify that such a risk of financial loss due to a dud product is properly insurable. Along the same lines, it would be difficult to justify insuring the value of a speculative investment in a new startup company for a new service which did not take off leaving the investor with a financial loss of its investment.

Less clear cut would be the risk of a contingent business interruption loss caused to a manufacturer in the mid-west following a supply chain disruption to its source of essential widgets in a foreign country that has suffered an earthquake. The manufacturer is not physically damaged but is now unable to produce or sell and suffers financial loss.

How then do captive owners thread that needle?

When faced with a new or unusual risk for a captive, assess whether it is likely to be classed as an insurance risk or a business risk. It is always best to start from first principals and look to see if the risk is indeed fortuitous, unexpected and quantifiable. Starting a new business in 2019 selling fax machines is very likely to fail and so very unlikely to be an insurable risk. However, the contingent business interruption risk sourcing parts from suppliers overseas that are not usually subject to expected interruptions in supply would be more likely to be acceptable as an insurable risk.

Every new risk is different and before placing into a captive it is best to talk the scenarios through with insurance, audit, regulatory and tax professionals to get a good cross section of opinion of whether the risk is likely to be treated as insurance for favorable accounting treatment.