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Establishing an insurance subsidiary.

The whys, hows, and key factors to consider before embarking on the most complex - but potentially most rewarding - of insurance ventures.

In today's rapidly evolving marketplace, association executives must continually ensure that they have the funding necessary to provide members with the unique products and services that separate their association from the competition. This pressure for revenue generation has manifested itself with the more established associations during the past several years. Traditional sources of income such as dues, education programs, and conventions have failed to produce all the needed revenue. Increasingly, executives have been focusing on unrelated business income as the funding mechanism for association activities. If your association is looking for a way to generate nondues revenue, establishing an insurance entity is worth consideration.

The structure of the insurance entity can take a variety of forms. Allen Haney, an ASAE Associate Member Fellow and president of JZA, Inc., Bethesda, Maryland, an insurance agent and brokerage firm, points out some options: An association might decide to simply endorse a program offered by a major carrier, making the association's involvement passive in nature, with the association itself receiving the revenue. Or the association might decide to form a subsidiary, independent of the parent organization. The subsidiary could establish relationships with multiple companies, with the agency staff selling the product and providing service to the policyholders. A greater degree of capital infusion and potential risk would be associated with the incorporation of a subsidiary.

Another alternative might be a joint venture with a broker or agent, allowing the subsidiary to realize a greater return than on an endorsement program, but with a significantly smaller capital contribution than required in the formation of an insurance agency. Of course, there are variations on all these options, too.

Ultimately the option you choose will be determined in good part by the amount of time, effort, and resources that your association is willing to commit and the amount of risk that your association is willing to take. The potential earnings of an insurance entity are likely to be proportionate to the financial and personnel resources allocated to the venture.

Additional factors will affect your choice of insurance options - and the results of whatever option is chosen. This article explores the key factors and offers guidelines for starting a subsidiary when doing so appears to be the best decision.

Timing isn't everything, but it's a lot

Two primary factors to consider as part of the decision-making process in determining whether to set up an insurance subsidiary are:

1. Will the insurance program provide a service needed by the majority of your members that is not readily available elsewhere?

2. Will the program generate a revenue stream to the subsidiary that will be consistent with the operational needs of the entity?

Responding to both questions involves analyzing whether or not the timing is right for launching a subsidiary. Findings indicate that more associations are developing insurance entities for a variety of reasons. The Association Insurance Program Guide and Survey Report, published by ASAE in 1996, noted that associations are becoming more aggressive in their involvement with sponsored insurance programs. According to the report, more associations are now operating their own insurance agencies or joint venturing with a partner in the distribution of insurance products to members.

Now, three years after that study was conducted, we are still in a soft insurance market that has endured throughout the 1990s. A soft market for insurance may be defined as one in which a product is readily available at a competitive price through a wide variety of insurance companies. Why would an association start a program specifically for members when the product may be readily available in the marketplace?

In the opinion of John Zink, partner in the law firm of Venable, Baetjer, Howard, and Civiletti, Washington, D.C., associations are able to offer opportunities to their members by negotiating for more specialized coverage and more favorable rates than are usually available. Association insurance programs are better positioned to give members more control over prices and coverage. Insurance companies are interested in participating in association programs that are fundamentally sound, and they are often willing to make concessions in price and coverage. If a subsidiary already has a strong program, an insurance company is now more inclined to add bells and whistles and lower prices, rather than risk losing the business to a competitor.

Insurance as a retention tool

The timing was right more than 40 years ago for Associated Builders and Contractors, Rosslyn, Virginia, to establish group health and life insurance programs for members, and Kathie Berry, CAE, an ASAE Fellow and vice president of finance and administration, considers the programs great member retention tools. "The programs provide the member hook that was desperately needed," she says, "because so many of our members are, or were, small, nonunion businesses that did not provide health coverage to their employees because it wasn't available to small employers." Berry reports that the programs have been warmly received by members. Of ABC's 20,000 member companies, 725 participate.

The programs are run by a subsidiary, ABC's Insurance Trust, Inc., that employs 18 staff and operates as a group trust with an independent board. The trustees have operated on a break-even basis in order to pump any surplus back into the programs as a means of maintaining low monthly rates, which helps keep participants happy - and helps retain them as members of ABC.

Investigating insurance carriers

While many risks are associated with starting a subsidiary, Deborah Lambert says that "the potential to harm the reputation of the association should be foremost in the minds of the decision makers," and she emphasizes the importance of working with a reputable insurance carrier. Lambert is partner, Johnson Lambert and Company, a Bethesda, Maryland, accounting firm that provides service to associations and specializes in the insurance industry. "There is also the chance of monetary loss," she notes, "but that is easier to control, because in most cases a third-party relationship with an insurance company is involved." In those cases, because the insurance entity does not own the program, the insurance company carries the greater risk (though also the greater reward).

Lambert urges associations to investigate any insurance carrier before beginning a relationship. How does this vendor rate with its association clients in terms of service, pricing, and product coverage?

In checking out carriers, discuss whether the insurance program will be experienced rated or retrospectively rated.

* Experienced rated. With these programs, the underwriters and sponsor meet each year to determine what premium will be charged the following year, based on the performance of the program. At that time the sponsor could decide to buy down the rate by writing a check for the required amount to the insurance company, or decide to inform the membership of the new rates for the program for the coming year. Participants always know up front what they will be charged.

* Retrospectively rated. This means that the subsidiary can be charged at the end of the year for any shortfall in the program. The only retrospective program that an insurance subsidiary should endorse is one limited to the sharing of profits, not losses.

Another discussion item with a carrier is the underwriting for the program, which will determine the premium charged to the member. It is imperative that the underwriter understands the industry, so that the premium is neither too high nor too low.

Projecting revenue

To provide the correct perspective on the subsidiary's chances for survival, you must pinpoint realistic member participation figures and revenue benchmarks. As is the case with most start-up ventures, you must allow for several years of potential losses before the subsidiary begins to generate the surpluses that are hoped for. Up-front costs will usually be greater than expected and thus prolong the advent of positive cash flow.

Lambert recommends creating an extremely conservative budget and then cutting it in half. The reason for this action might be found in the experience of JZA's Haney, who states that despite the special affinity that an association has with its members, participation in an insurance program will not be as significant as expected. Based on his findings, with a typical association, 20 percent of the members will be a poor underwriting risk for the program, while 20 percent of the members will be too big for the program. Already reduced by this 40 percent, the subsidiary's starting point for developing a realistic figure of market potential will continue to shrink.

This advice regarding projecting revenue begs the question, Does the association have the critical mass necessary to sustain growth and profitability for the program? What are the specialized needs of the members?

Ed Armstrong, vice president, ASAE Services, Inc., says that "the program must be specialized enough that the insurance subsidiary has a competitive advantage in the marketplace." If the program is not readily available elsewhere and delivers the benefits it promises, its probability of success is high.

Ready to begin?

Some final words of advice:

* Make sure that the program is charging the right premium for the risk being insured. The program must allow the premium to adjust, up or down, based on market conditions and the loss experience of the program. Loss experience is what the underwriters determine needs to be charged for the program to generate a profit to the insurance company. The greater the loss ratio (claims divided by premium), the greater the premium to be charged to the customer. The lower the loss ratio, the lower the premium.

* Market the program extensively. Keep members aware of the benefits available through participation in the program.

* Consider calling an insurance consultant to assist you. The intricacies involved in establishing a subsidiary generally merit the assistance of a specialist. A consultant is particularly beneficial in investigating the best type of program for your members' needs and in negotiating the best rating (experienced or retrospective). If you decide to use a consultant, make sure that he or she is selling a service and not a product. It's highly advisable that you hire a consultant to help you design a program tailored to your members, rather than ask a consultant to tweak an off-the-shelf product. Be prepared to spend a minimum of $20,000 to get the program design you need.

Keep in mind that the performance of a subsidiary is mirrored by the amount of risk that the association is willing to assume as well as the investment in capital and personnel that is provided to the program. If you assess properly your risk-taking ability and invest wisely in a program that is tailored to your members' specific needs, you may generate an important new revenue stream.

Steering Clear of Trouble

Federal and state laws, regulations, and tax rules create a complex legal web for associations establishing insurance subsidiaries. Here are key areas to watch carefully.

State regulations

Jeff Tenenbaum, of Counsel, Venable, Baetjer, Howard, and Civiletti, Washington, D.C., cautions associations to ensure that they are in strict compliance with state insurance regulations and that all organizational documents, contracts, and other operational materials of the subsidiary are reviewed by experienced legal counsel. In addition, the proper drafting of organizational and operational documents can have important federal tax implications for the association and subsidiary.

Insurance is an industry that is regulated almost exclusively at the state level. Therefore, employees who sell or service the insurance product need to be licensed as agents or brokers by the state or jurisdiction where the association or subsidiary is headquartered. In addition, these employees generally must be licensed in every state where the program is admitted for sale to the association's members. Depending on its organizational structure, the subsidiary also may need to be licensed in each state.

ERISA regulations

Kathie Berry, CAE, an ASAE Fellow and vice president of finance and administration, Associated Builders and Contractors, Rosslyn, Virginia, warns that "it is very important to be acutely aware of ERISA [Employee Retirement Income Security Act] regulations. Make sure you know what fees the trust may pay out for either the management of the program or for the betterment of services to the trust beneficiaries. Severe penalties and fines are applied for the misuse of these funds."

Unrelated business income tax issues

Many associations have viewed their insurance programs as a fundamental benefit of membership, not as unrelated business income. But be aware that recent actions by the IRS provide every indication that association insurance revenues will continue to come under heavy scrutiny. If you house a significant insurance program in the association and you're not paying taxes on the program, chances are good that the IRS will eventually stumble over it. If the program is run by a subsidiary, you will have greater control over the expenses assigned to the subsidiary.

Case Study: Glassco

"Our traditional sources of revenue had hit the wall, and I was not satisfied with the service we were receiving from the carrier of our endorsed program," says Philip James, CAE, president and chief executive officer, National Glass Association, McLean, Virginia, in describing why he set up an insurance subsidiary. For a number of years, NGA had endorsed a program offered by a carrier in the property and casualty market. James reports that, without a lot of effort on the part of the carrier, the book of business (the total insurance sales) grew rather quickly to $23 million. The association was paid a royalty based on a graduated level of sales, which meant a royalty of $180,000 in NGA's last full year with the former carrier. Yet, says James, the penetration achieved in the industry was less than 9 percent, and he was concerned by the fact that the carrier's most junior employees were responsible for selling and administering the program. "1 had a great deal of concern about the manner in which members were being serviced," he says, "and I was particularly unnerved by the apparent lack of knowledge that the underwriters possessed about the glass industry." The final straw for James was discovering that many of the companies insured under this "members only" program were not members of NGA.

With this information in hand, James began to meet with industry brokers to discuss a new program. He decided to form a company that would offer a variety of property and casualty insurance products to NGA members. The company, Glassco, has a chief executive officer and has plans to expand staff as business grows.

The biggest source of frustration for James has been the lengthy approval process that both the program and the company itself have had to contend with at each of the state departments of insurance. To date, the program has received approval from only nine states that are not consent-to-write states. In consent-to-write states, an insurance carrier that is approved to do business simply has to submit the program to the state, then can begin selling. In the other states, every program must be approved by the department of insurance before selling can begin. Says James, "You have to be prepared for tremendous inertia from the state regulatory agencies. They perform like a herd of turtles stampeding through peanut butter."

While these administrative problems have been difficult to contend with, James is happy with the progress the company has made. Sales recently passed $1 million, and Glassco has already earned more commission income than NGA did under the old royalty agreement.

Advice from having been there

If you're considering a similar venture, James offers the following counsel.

* Determine what product your members need that it is not readily available, then aggressively pursue sources within the insurance industry to create a market.

* Use a for-profit structure to house the subsidiary to allow for more creative tax planning. All costs associated with running a subsidiary are expenses that can be used to offset the revenues generated. If the funds come into the association and not the subsidiary, taxes must be paid on the total revenue, as the association is not allowed to offset expenses against the revenue.

* Be prepared to provide superior service to your members and make the product available at a competitive price, or you will not achieve the market penetration necessary for success.

* Work with a consultant who clearly understands the work of the association, and be ready to pay a significant sum for this assistance. For the advice of a consultant, Glassco was prepared to pay up to $60,000 per year for the first two years of operation. While the company did not have the capital up front, it negotiated with its consultant a fee that would be paid from the revenues of the program.

ASAE Can Assist

* Programs and services: ASAE understands that many associations will need assistance in developing profit-making insurance and financial services programs. ASAE has charged ASAE Services, Inc., with providing that assistance.

The newly restructured ASI is already hard at work developing profitable, turnkey programs that associations can make available to their members. It can also provide focused, professional consulting at below-market rates.

To learn more, contact ASI Vice President Ed Armstrong. Phone: (202) 626-2869; fax: (202) 408-9652; e-mail:

* Publication: The Association Insurance Program Guide and Survey Report (1996, ASAE) discusses association-owned agencies and offers practical advice for selecting the most appropriate and cost-effective insurance program for your association. This publication (product AMR213712) is available at $59.95 for ASAE members and $69.95 for nonmembers, plus shipping, through the ASAE Member Service Center. Phone: (202) 371-0940; fax: (202) 371-8315; e-mail:

Douglas S. Culkin, CAE, is executive vice president and chief executive officer of the National Apartment Association, Alexandria, Virginia. Culkin is an ASAE Fellow and a certified insurance counselor. E-mail:
COPYRIGHT 1999 American Society of Association Executives
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1999, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:associations; includes related article on federal, state and tax laws related to establishing insurance units and Glassco's experience in setting up an insurance subsidiary
Author:Culkin, Douglas
Publication:Association Management
Date:Oct 1, 1999
Previous Article:Movin' on up.
Next Article:Guiding responsible discussion about ethics.

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