As a 30-year veteran of the automotive industry, I wanted to share this article to give you a better understanding of the DOWC vs. the CFC reinsurance structures. The latest buzz in the automotive industry is of this not so new and shiny apple, called the DOWC, and I am referring to the structure and not the company. I travel around the country speaking with auto dealers, associations, and groups about participation programs and have decided to write this article because I feel they may have been sold the proverbial bill of goods. This is not meant to be financial or legal advice (and you should seek proper counsel for those questions), but Insight into these formations.
Not matter what formation you select, participation is the way to go for every dealer.
A dealer-owned warranty company (DOWC) is an administrative corporation (C Corp) designed to be the obligor for non-insurance F&I products such as vehicle service contracts (VSC). The company is not regulated as an insurance company but typically qualifies as an insurance company for federal income tax purposes. The DOWC is generally owned by a dealer or a dealer group and is administered by a third-party provider, and it often purchases an excess of loss insurance provided by a third-party insurance company.
Every participation program has it place in the automotive space, including the DOWC. But when it comes to the DOWC, you must ask yourself: “Have I been properly qualified for this program?” Many dealers are enamored by the prospect of controlling the cash flow and investments, with possible higher returns, claims of increased profits that could reach 50% greater than that of the controlled foreign corporation (CFC), lower admin fees without ceding expenses, or premium taxes. As I cautioned you in my last article, “The Reinsurance Check-up,” lower admin fees usually equal lower services, and this typically equates to dissatisfied dealers. As you sit and wonder if the DOWC is the right fit for you, here are some things you need to know and a few questions you may want to ask yourself:
- Am I properly educated in insurance and risk mitigation?
- Am I confident I can run a stand-alone warranty company parallel to my dealership?
- Am I ready to increase the workload for myself and for my dealership team?
- Is my dealership properly staffed to handle the additional workload?
- This would include a separate operating statement that runs parallel to your dealerships statement, reserves account and statement, insurance company P&L statement, investment strategy (with or without an advisor), and the tracking of investments returns, just to name a few.
- Am I capable of knowing and meeting statutory requirements?
- Am I comfortable with failure to perform insurance vs. a CLIP policy?
- Although, a CLIP insurance may be available for an additional cost.
- Am I comfortable with no corporate administrator assistance such as an obligor company?
- Am I okay with limited product selections with no insured products permitted?
- This may limit your ability to work with specialty partners.
The reason I mention some of these things is that dealers I have met with over the past two years have been struggling with the DOWC formation, primarily because they were not properly qualified and do not have the support they need to succeed. Dealers have been unclear on a few things. They are required to pay an additional layer of tax as an insurance company. They need to move money to an investment account and invest it, knowing what and when to buy, and when to sell. Also, they need to understand their risk tolerance and have a risk strategy. Obviously, they need to consult with an advisor who is familiar with the statutory requirements; however, this is one more step in total ownership.
Not all DOWC providers are equal. Many tout their ability to use a customized vs. a template format, where many, if not all, of the F&I products can be customized to include deductibles, terms, coverage, and surcharges. Although everyone loves the idea of customization, that comes with a lot of work in some cases. Allowing a third party administrator (TPA) to provide a structure based on years of historical data, analytics, and loss costs may be prudent and less labor intensive, not to mention more profitable in the long run. Lastly, are you confident you would be prepared for an IRS audit of your stand-alone warranty company? Do you have your proper reserve statements, claims reports, investment statements, capital gains statements, retail accounting statement of P&L for the product sales, commissions, and tax payments, etc.? All DOWC providers will provide some level of statement activity, but the more involved they are, the more expensive the admin fees will be. Additionally, the statements they are providing in many cases is based on the information you provided. So if you did not provide accurate data, the report they provide could be off, possibly causing long-term issues.
- Domestic U.S. C-Corp formation.
- Stand-alone warranty company.
- Open an account with almost any U.S. bank.
- No 8886 – form Filing is needed. (Reportable Transaction Form)
- No 8938 – form filing is needed. (Foreign Financial Assets Form)
- No foreign domicile fees.
- No 953 (d) re-domestication election necessary.
- Possible access to unearned cash. (Loan against unearned premium reserves)
- Potential for greater investment income based on higher return investments. (Higher risk)
DOWC Tax Difference:
- Most DOWCs utilize retail-cost accounting, which recognizes the retail cost of the VSC as premium, and expenses dealer commissions and administrative fees up front, which generates a large tax loss for the first 5-7 years of the program.
- DOWC stand-alone warranty company typically does not make IRC Section 831(b) election until it is placed in runoff status, and this is assuming the new program is not part of a controlled group with runoff DOWC.
- DOWC stand-alone warranty company files both state and federal income tax returns, with no premium tax paid.
- DOWC stand-alone warranty company federal taxation is as a P&C insurance company. (TAM 9601001)
- DOWC stand-alone warranty company pays state taxation, which will vary, but most states start with federal taxable income and adjust for various items, except for California.
- DOWC is a domestic stand-alone warranty/insurance company whose revenue meets the IRS requirements for an insurance company.
- DOWCs file a 1120-PC and are only taxed on a prorated amount of earned premiums.
- Within the DOWC structure, the F&I department’s profits/commissions are a written off as an expense, creating a long-term net operating loss (NOL) carry forward. As a result, the DOWC enjoys deferred tax liability for years.
- Potential for higher profit margins base on retail cost accounting method.
- Risk is limited to the initial capital invested. ($50,000-$500,000 FL)
- DOWC is usually tax deferred for the first 5-7 years of the program due to retail cost accounting.
- Dealer controls funds, although, backend insurance may require some funds to be invested in trust for expected claims.
- Potential for deferral of taxation to shareholders.
- DOWC stand-alone warranty company is a more dealer-involved, hands-on and labor-intensive program.
- Much higher initial capital requirement than the CFC, and this investment is at risk.
- Limited to non-insurance products – no ability to add insurance products that require reinsurance.
- Earnings are subject to additional layer of taxation.
- Regular P&C company taxation may be excessive.
- May require additional capital investment from the dealer based on losses.
- Significantly greater ongoing operating costs.
- Greater IRS scrutiny of captive programs. (IRS Notice 2016-66)
- Additional regulatory requirements.
- May have limited ownership rights of the next formation. (May be limited to 50%)
- Midyear transitions with greater than 2.3 million ceded premiums may create ownership issues for the next formation. (Retail cost accounting plays into the concern)
- Potential negative tax status once the initial tax loss is exhausted.
- Program may have hidden costs if the dealer decides to change administrators.
- No portability of the program.
- Limited life span of the program.
- Uncertain exit strategy, when leaving the program and moving to the next strategy.
In the last two years, I have meet with more than 30 dealer principals that were in DOWC formation with multiple providers. My takeaways from these discussions were that not one dealer could show me where the DOWC generated 20%, 30%, 40% or 50% more profits than the previous CFC … not one. Not only did they not capitalize on a claim of up to 50% more profitability, they did not realize higher gains in their investment portfolio either. Actually, in almost all cases, investment income was lower. In my opinion, this is based on softer oversight of the investment portfolio and lack of global connectivity of the formation, like you might see in a CFC. With this said, I believe the DOWC formation is a great program for the well-educated and experienced dealer, or the dealer group looking for a Non-Control Foreign Corporation (NCFC) option. It is certainly not a one-size-fits-all program for dealers, and they should proceed with caution as they consider the DOWC formation.
I believe the CFC is still one of the best options for most dealers producing less than $2.3 million in annual ceded premiums. It has been around since the early 1990s, it has a proven track record, it is backed by IRS TAMs, and with its plug-n-play structure, it works well for almost all dealers and does not discriminate based on their education or experience in reinsurance. The CFC is the perfect combination of control, investments, customization, and access to surplus and loans, with crucial protective measures in place for the dealer, and it typically comes with a professional support team (provided by the TPA), helping to ensure greater levels of success.
- Administrator Obligor (AO) or Dealer Obligor (DO) options.
- Virtually no initial capital requirement necessary.
- Low liability.
- Domicile of economic convenience for insurance product flexibility.
- US Tax Payor. (953(d) election status)
- Programs qualify for preferential tax treatment.
- Shareholders are not taxed until distributions are declared.
- Money remains in the country in a U.S. bank that is usually FDIC insured.
- TPA involvement – loss controls, fraud protection, professional guidance with professional cession review, investments and loans. Total global wealth management.
- First dollar loss insurance CLIP/stop loss Insurance.
- Professional Investment advisors that are vetted and capable of working in the reinsurance space and are familiar with the statutory and trust requirements.
- Dealer may self-direct investment strategy within in the trust guidelines.
- In some cases, the dealer may borrow unearned premiums in lieu of profit distributions.
- Reserve guidelines to protect the dealer from insolvency.
- Very few product restrictions.
- No restrictions to work with specialty partners.
- Program portability.
- No exit strategy issues.
In closing, the DOWC is great for the larger and more experience dealers, and CFC is an excellent choice for all others. In my experience, a dealer will have the highest level of success with the CFC, giving them just the right amount of control, flexibility, and options. The agent and TPA provider will assist the dealer with formation selection, set-up, launch, compliance assistance, fraud, and loss control, making this option not as labor intensive and tedious for the dealer. This brings me back to the beginning, when I shared with you the “have you been properly qualified” question: Has the consultant reviewed your size, production, premiums, products, secession plan, and exit strategy before making a formation recommendation? The simple question I asked was to show me 20%, 30%, 40%, 50% increased profits in an active formation, show me 10%, 12%, 15% ROI in the investment portfolio as it related to the DOWC. So far, not one person has been able to do so, costing dealers lots of time, money, and expenses that may not be necessary. Do not step over dollars to pick up pennies, picking a formation that is not a good fit, will cause exit strategy issues, and could cost you ownership of the next formation. The CPAs and attorneys I have discussed this topic with for the past two years feel as I do, that the difference between the DOWC and CFC may not be worth the aggravation unless you are educated and have the proper staff to run a stand-alone warranty company in a way that maximizes in every aspect of the business. Not matter what formation you select, participation is the way to go for every dealer. I hope this review sheds light on this difficult topic and potential choice of formation for you, and you will have one or two takeaways that will guide you into a better future.
Mike Haas, LPN, LPFS is president of Dealer Performance Center.