Captive or closely held insurance companies have been around a long time, at least fifty or more years. For most of their existence, captive insurance companies lived in relative anonymity and were mostly in the domain of public companies. Businesses or industries with significant warranty programs also heavily used captive insurance arrangements. The last five-seven years has seen an explosion in captive insurance activity. My explanation of “why now” goes something like this.
First, the tax law has become more certain regarding the tax treatment of life insurance companies beginning in around 2002. Second, a whole host of jurisdictions both onshore and offshore have jumped into the game making insurance jurisdiction and regulatory requirements very competitive and affordable. Third, promoters who know how to sell and market have entered into the marketplace. As a result, the sales and marketing efforts have resulted in an explosion of activity and exposure with closely held businesses.
The sales and marketing activity in itself is not always such a positive factor. A number of promoters without the requisite experience and expertise have formed small captives that are unlikely to withstand the scrutiny of the IRS under the light of day. It has been rumored that small captive arrangements are the next likely audit target now that the IRS has nearly completed its “search and destroy” mission of 419A(f)(6) plans.
As a practical matter and historically, captive insurance activity has been largely managed and controlled by company risk managers and large property and casualty insurance brokers such as Aon, and Marsh. From the perspective of the closely held business owner, the limiting factor in the historical approach has been the discussion of the requisite “What’s in it for me” consideration that drives most decision-making in the Real World. Personal wealth planners and tax and estate planning counsel traditionally have lacked the property and casualty and risk management experience to focus on that side of the equation.
The net result is that the captive insurance planning team requires an equal balance of both talents – risk management and personal tax and estate planning. When it comes to captive insurance, you can’t have one without the other in order to have a successful captive insurance program particularly when it becomes the subject of scrutiny.
At the end of the day, the net result is extremely powerful for the business owner when the risk management and tax benefits are balanced. In fact, for the high income and high net worth business owner, I would submit that no other planning technique has the ability to reduce and defer income from a tax perspective while simultaneously delivering substantial wealth transfer benefits.
Captive Insurance 101
A captive insurance company is an actual insurance company with reserves for claims, surplus, policies, policyholders and claims. The captive insurer is licensed in the domicile where it is formed- domestic or offshore. The main purpose of a captive is to insure the risks of other companies that are owned by the captive’s owner, the Parent company.
Traditional reasons for the creation of a captive insurer include the following reasons:
Stabilize Insurance Budgets
Reduce Insurance Administrative Costs
Utilize Own Experience
Increased Claims Control
Recapture Underwriting Profits
Accept Greater Deductibles
Access to Reinsurance Markets
Traditional captive insurers have been primarily viewed as an insurance solution to reduce insurance costs or provide coverage not available in the commercial marketplace. However, the captive insurance company from the perspective a Business owner can serve as a valuable deferred compensation vehicle. Furthermore, the captive can serve as a wealth transfer, wealth preservation vehicle for the business owner's family.
Captives as a Wealth Transfer and Accumulation Vehicle
A captive is much more than a loss control vehicle. A captive should be seen as a vehicle for transferring wealth out of the operating companies so that wealth is not trapped within the operating companies subject to higher taxation and the claims of the business’ and personal creditors. Premiums paid to the captive by the operating company are able to accrue reserves tax-free and enjoy the other tax advantages of captive insurers at lower tax brackets than the business owner.
The captive can serve as an inter-generational wealth transfer tool. At the time of the captive’s formation, the shares of the captive can be transferred to an irrevocable family trust that removes the assets from the business owner’s estate for federal estate tax purposes.
The captive arrangement can also provide strong asset protection benefits to the business owner. The transfer of wealth from the operating business to the captive through premium payments provides a form of asset protection for the business owner. Ownership of the captive within a family trust (irrevocable) or an offshore asset protection trust (APT) provides another layer of asset protection for the business owner.
As a wealth accumulation vehicle, the captive arrangement is very powerful. The captive arrangement allows the PC to take an income tax deduction for its premium payment. The captive is able to take a current deduction of the premium payment as a contribution to its reserves. The ability to accrue reserves provides the captive with a unique ability to create deductions, defer taxes and time taxation for years when the captive is less profitable. These deductions can offset the captive’s investment gains.
From a wealth accumulation standpoint, the closely held captive can operate as a family bank and deferred compensation vehicle. The captive as a deferred compensation vehicle is more powerful than a qualified retirement plan, which has contribution limits as well as the amount of compensation that might be considered. Qualified plans have investment restrictions and non-discrimination requirements. The captive is not encumbered by any of these restrictions.
The captive is an excellent wealth preservation vehicle. The captive may be subsidiary of the operating business. The liabilities of the captive are limited to the exposure of the policies that it underwrites. Structuring the ownership of the captive through a family trust or APT protects the captive’s assets from claims against the captive’s parent company.
Types of Captive Insurance Companies
A business owner should consider forming his own captive cell within an incorporated protected cell captive insurance company. The cell captive is treated as a valid insurance company for federal tax purposes. The minimum threshold of premiums paid to the captive should at least $300,000. In the event the business owner does not have sufficient premiums to justify the creation of its own captive, the business owner may consider a Group (Association) Captive.
A Group or association captive is a third alternative for captive. The association captive may offer an array of coverage for a business owner. The group captive may also provide an experienced rated dividend to association members based upon the claims experience for the group.
IRC Sec 831(b) Election
The Internal Revenue Code provides special tax treatment for small property and casualty insurers by providing for a tax election under IRC Sec 831(b). This tax election treats the first $1.2 million of annual underwriting income (premium) to receive tax-exempt treatment. The small insurer does not need to maintain reserves and is only taxed on its investment income under the regular tax rates for regular corporations.
From a tax planning perspective of the captive owner, i.e. the business owner, the tax attributes are significant. First, the tax exempt treatment for annual premium income up to $1.2 million far exceeds any qualified retirement plan limit. Secondly, the captive owner's active management control provides for much control than the prohibited transaction rules allow in the qualified retirement plan area. Dividend payments by the captive receive preferential tax treatment and qualify as qualified dividends. Ultimately, the captive owner receives long-term capital gain treatment upon the sale or liquidation of the captive versus the ordinary income treatment on pension plan distributions. Nevertheless, the primary purpose of the captive is to operate as an insurance company.
Types of Coverage within the Captive
A hallmark feature of captives is the ability to customize coverage for the needs of the medical practice. Furthermore, the policy terms can be constructed to the specifications of the insured.
An example of customized coverage for a business owner includes the following risks:
(1) Deductible Reimbursement
(2) Errors and Omissions
(3) Commercial General Liability
(4) Employment Practices Liability Insurance
(5) Property (Difference in conditions)
(6) Wind and Weather
(7) Operating Risk
(8) Legal Defense
(9) Environmental Value
(11) Loss of Key Customer
(12) Loss of Key Lender
(14) Business Interruption
(15) Construction Defect
(16) Computer System Failure caused by Detrimental Code
(17) Tax audit defense or controversies.
(18) Technology Equipment
Joe Smith, age 50, is a business owner that is a co-owner of a business. He is married with two children and earns $750,000 per year. Joe's family has a lifestyle that requires $300,000 per year.
The Smith family creates a new captive insurance company, Good Insurance Inc. (Good Insurance), that is licensed in Nevada. The captive is a series or captive cell captive. The company is capitalized with $150,000. The shares will be owned by the Smith Trust, which is an asset protection trust, domiciled in Nevis. The company makes an IRC Sec 831(b) election. Under this election, the first $1.2 million of premium per year will not be taxed to the captive. Only the captive’s investment income will be taxed.
Joe hires Active Captive Management (AM) to perform a feasibility study for the captive and identify a portfolio of new coverage for the captive. AM develops the policy forms as well as performs an actuarial review to determine the appropriate pricing. Coverage will also be sold to the parent development company as well. The projected premiums per year are $1.2 million per year.
Over the next five years, $6.0 million of income will be paid to the captive on a tax-deductible basis before the payment of claims. The premium income will not be taxed. The investment income of the captive will be taxed. The transfer of $2.5 million is not subject to gift taxes.
First things first! The business purpose of a captive insurance arrangement is risk management. Every business has property and casualty risks that are either uninsured or under-insured. Commercial coverage frequently has important exclusions in policy coverage that may be necessary to insure through a captive insurance arrangement. The cost of coverage may also be prohibitive. Claims management is another important consideration. The last thing a business owner wants and needs is for coverage to effectively be underwritten at the time of claim. Why not control the outcome?
The business owner captive insurance company is a powerful risk management tool. The captive provides an integrated tax solution for the business owner of a closely held corporation for both income and estate tax planning purposes. The special tax provisions available to small captive insurers provide the business owner with the ability to achieve significant deferral and timing of taxes along with lower marginal brackets.
The coverage underwritten by the captive is arms-length coverage under commercial terms. However, the goal is to underwrite coverage that is either currently self-insured or under-insured with a reasonable likelihood of low claims experience. As a result, the captive provides a mechanism for shifting wealth from the business owner, which are subject to the liabilities of the corporation, and business owner into the captive, which is structured for asset protection and tax benefits.