Ask Bob Cockerham about his reinsurance program and he’s quick to say it was his dealership’s one glimmer of hope.
“This is as rough as it gets in the car business, and a reinsurance company is one way to manage through these rough times,” said Cockerham, owner of the Santa Fe, N.M.-based Car World Kia, and client of SouthwestRe. “A lot of dealers are going to be wishing they had one.”
Ask Pat Baxter about his program with Resource Automotive and the president of Kayser Auto Group in Madison, Wisc., will say it was a “real life saver” for his dealership last year.
“It’s been helpful in the last three to four years because the car business has been tough,” he explained. “It’s nice to have a reinsurance company sitting out there that has built up significant value.”
Allowing dealers to share in the underwriting profit and investment income on the extended service contracts and other insurance products they sell, reinsurance is paying off for both dealers and providers in these unprecedented times. But there was a time when the mere mention of reinsurance struck fear in participating dealers and providers.
The PORC Conspiracy
Steve Barrett, senior vice president of Reinsurance at Resource Automotive, remembered the time well. The year was 2002 and the Internal Revenue Service (IRS) had just put reinsurance providers and users on notice.
“Even after things were resolved, there was a period of time where everybody in that part of the business took a step back to reexamine things,” he said.
The IRS’s review centered on what are known as producer-owned reinsurance companies (PORC), which are typically offshore entities that reinsure risks of customers of a related service provider, lender or retailer.
The IRS charged that PORCs were wrongly being used as tax shelters, as it claimed entities believed they were exempt from federal income taxes.
There were several court cases that prompted the IRS’s review of reinsurance, including ones against Compaq, UPS, and a partnership between Colgate-Palmolive Co. and Merrill Lynch & Co.
The IRS charged the companies with attempting to avoid taxes by entering into offshore entities that artificially created losses. It further charged that the companies allocated those losses to offset any capital gains.
Despite a series of court victories, the IRS saw many of those decisions reversed in appellate courts. Much of that litigation centered on whether the business dealings had any economic substance, or if they were structured solely for tax purposes.
“The Internal Revenue Service historically suspects that dealer-owned reinsurance companies, particularly those domiciled off-shore, are used as a means to avoid or evade tax payments,” said Bill Burfeind, executive vice president of the Consumer Credit Industry Association (CCIA), an organization that played a key role in defending reinsurance companies.
Answering the Bell
The IRS and the Treasury Department took several steps to identify and deter tax-sheltered investment activities, including the release of a disclosure initiative on Dec. 24, 2001. It allowed taxpayers to avoid accuracy-related penalties if the taxpayer came forward and disclosed tax-sheltered investments, as well as any other controversial investments, on their tax returns.
The impact of the IRS’s review really hit the automotive industry on Nov. 4, 2002, when the agency published Notice 2002-70. It made PORCs a listed “transaction” for IRS reporting purposes.
“That raised the level of scrutiny on the industry, and for two years it was difficult for reinsurance,” said Jim Smith, CEO of SouthwestRe.
Smith found out about the agency’s actions a month before he was to give a speech in front of 200 certified public accountants about the health of the reinsurance industry. Even worse, his speech preceded a presentation by the IRS’s Terri Harris, who discussed the pending release of Notice 2002-70.
“What a life altering experience that was,” Smith said. “I had submitted my presentation two months before and four weeks later I found out about the pending release of Notice 2002-70 by the IRS. So there’s Terri Harris talking about what the IRS was doing and why it had concerns about PORCs, and I have to speak immediately after her about the increased regulatory acceptance of captive insurance companies, including PORCs, which I still strongly believed in.”
Smith joined the CCIA and others in making the case to the IRS that dealer-owned reinsurance companies had a legitimate business purpose, assumed real risk and did pay out claims.
“The point is that what the industry was doing was proper and had extensive legal precedence,” he explained. “Reinsurance programs allow dealers to legitimately make the same profits that would typically go to big insurance companies, with much less capital expenditure.”
Even Resource Automotive felt the effects despite the fact that the majority of its reinsurance business was with entities and programs which weren’t on the IRS’s radar. The company features insurance programs involving Bermuda-domiciled Non-Controlled Foreign Corporations (NCFC), which have several characteristics that differentiate them from traditional PORCs. For instance, for tax purposes, no one individual can own 10 percent of the NCFC’s voting control, thus requiring a wide base of ownership and dealer participation. Offsetting this lack of individual control, however, are clear-cut bylaw provisions which lay out the dealer’s right to liquidate his shares and repatriate his profits.
“The IRS audited a good handful of companies, but they did not find the misuse and fraud they thought they would find,” said Barrett. “The IRS scrutiny, even for those not directly subjected to it, probably caused a general reassessment of business practices in this area. What it did for Resource, since NCFCs were not subject to Notice 2002-70, was to confirm our longstanding belief and practice of erring on the side of conservatism.”
In October 2004, the IRS rescinded Notice 2002-70, as the agency ruled dealers no longer had to identify PORCs as tax shelters. “Based on disclosures by taxpayers and examination of tax returns, we have determined problems associated with these transactions are not as prevalent as initially believed. Accordingly, we are no longer classifying them as listed transactions,” read a statement from then IRS Commissioner Mark Everson.
Keeping the Guard Up
Despite the victory, the CCIA’s Burfeind said there is legislation across the country aimed at policing reinsurance companies.
“The agency’s investigation revealed fewer abusive transactions than anticipated,” said Burfeind. “However, for the last couple of years there has been a lot of state legislation updating reinsurance law in response to current business needs and practices.”
It’s one reason why dealers must continue to do their due diligence when evaluating reinsurance programs. And while choosing providers with a history of success is a good place to start, Burfeind defines success as “a reinsurance company that generates a profit and is compliant with Internal Revenue Service tax law and regulation.”
He added: “If it sounds too good to be true, it probably is. Expectations need to be realistic and reasonable.”
Experts also recommended that dealers check for blemishes on a provider’s record, including whether the provider was involved in a company that went under.
Kayser Auto Group’s Baxter said dealers can take it one step further. “Ask the provider to put you in touch with their dealers so you can find out firsthand how the company worked out for them,” he said.
Car World Kia’s Cockerham also suggested that dealers look at the provider’s infrastructure. “Make sure there’s infrastructure behind it,” he said. “And make sure the reinsurance company can provide training for F&I people, as well as statistical reporting.”
Along with a provider’s infrastructure, Resource’s Barrett said dealers should look at the company’s underwriting experience and capability. A provider’s financial depth, and the capabilities of its front-writing insurer and administrator are other important considerations. “In discussing fees, dealers should always know not only what they are paying for, but also what they are getting for their money,” he said. “While the up-front cost is important, more so is the total return at the end of the day.”
Kelly Price, president of National Automotive Experts, said a provider’s commitment to technology should be another consideration, as features such as e-contracting and e-remittance can go a long way in saving the dealer money. “Pay attention to every single fee that could be taken out of your reserve,” she said.
Becoming a Reinsurance Candidate
Price said with vehicle sales down and dealerships facing financial problems, reinsurance is definitely becoming more attractive. “As it becomes harder to make profits on the front-end, dealers are looking into every aspect of the sale and finding where they can recoup lost profits due to the economy and competitiveness,” she said. “We’ve been able to help dealers look at how to tie the front- and back-end together, and how to offset the loss of front-end profits.”
But dealers and experts warned against viewing reinsurance as a quick fix for a dealership’s financial problems, as these types of programs should be considered long-term investments.
“It’s like starting a savings account,” said Marv Eleazer, financial services specialist for Langdale Ford Company in Valdosta, Ga.
Resource’s Barrett agreed. “What we’re seeing now is a payoff from years of commitment,” he said.
Experts, however, said reinsurance isn’t for everyone, as some dealers don’t have the volume or penetration rates to make the program worthwhile. And even when it’s the right time, dealers will need to look for the right program.
For instance, PORC-backed programs are better suited for small- to mid-size dealers moving about 50 to 70 products a month. Programs backed by a NCFC are typically more conducive for multi-franchised
dealers, said Barrett.
“Anyone doing less than 30 percent penetration would be a tough sell for reinsurance,” he added.
Price said her company’s “magic number” for reinsurance qualification is around 150 ancillary products a month. “That goes down if dealers are remitting service contracts as well,” she said.
Depending on the type of contracts the dealer is writing, Price added that dealers will need to move about 25 to 30 contracts a month if they are only reinsuring service contracts.
SouthwestRe has its own benchmark. “A dealer should be doing 20 vehicle service contracts a month or more to consider reinsurance,” Smith said. And if a dealer is barely meeting the minimum, he should consider reinsuring other products as well, added Smith.
Preparing for Reinsurance
When Langdale Ford went through its selection process for a provider, Eleazer said the key for him was the type of training it could provide. “I look forward to my rep’s monthly visit because of the vast knowledge he brings,” he said. “This person is also important to fixed ops because they’re actually administering VSCs daily.”
Eleazer also suggested that dealers considering reinsurance should also look for a consultant to manage the program. “It’s important to hire an experienced consultant or expert for the dealership, because dealers aren’t experts on everything,” he said.
Being a victim of failed providers, Eleazer said this person is not only important for keeping things compliant, but also for making sure the provider remains financially solvent. He added that dealers should look for someone who has experience tracking the progress of a program, as well as determining which products and which plans work best.
While dealer support is key, SouthwestRe’s Smith said a key measurement for reinsurance readiness is F&I production. “Dealers need to look at every opportunity to make money,” he said. “They are trying to maximize income, and reinsurance allows for the most income in F&I profits.”
That’s something Car World Kia’s Cockerham has come to realize. “In most parts of the country, sales are horrible,” he said. “Reinsurance has been the one glimmer of hope for our dealership.”
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