Is it Time to Form Your Own Insurance Company?

Regardless of the business you run, there is risk. And the universe of risks applicable to your circumstance will differ (often wildly) from other businesses. Even businesses in the same industry can present very different risk profiles.

The universe of risk applicable to your business breaks down into two general subsets: 1) those risks for which you have purchased insurance from some third party carrier, and 2) those risks for which you have not. Business owners purchase insurance from third parties when they view certain risks as sufficiently likely, premiums are priced reasonably, and/or insurance is required for some regulatory purpose. When risks are more remote, and coverage is not required, many opt instead to “self-insure” those remaining risks in their risk universe.

The good news as it relates to purchasing insurance from a third party carrier is that the premiums are tax-deductible. The bad news is that if there are no claims, the money is gone – and with no benefit. You have basically moved your profits from your company over to the insurance company. The transfer is for good reason, but most insurance premiums become lost dollars. After all, insurance companies are in business to make money. The upside with self-insurance is that you save the money by not paying the premiums, and therefore keep the profits. The downside is that although you are effectively insuring a wide variety of risks, you are not enjoying any tax deduction in the process.

Establishing a Captive Insurance Company (“CIC”) for your currently uninsured risks may provide you with the best of both worlds – retention of insurance profits and tax deductibility of premiums. And with recent laws, there has never been a better time for the private business to create its own insurance company.

The CIC is referred to as “captive” because it is an insurance company that is formed to provide insurance to its parent company or to multiple companies owned by the same individual or group of owners. This “captive” feature allows for greater customization and control of the overall risk management and insurance solution for the private business. Unlike the typical third party insurance carrier, which necessarily caters to the masses and offers mainstream coverages, the CIC model is unique to its owner and the owner’s business(es).

To be sure, the CIC proposition is very real and very substantive. If you are to form a CIC the right way, you are truly forming an insurance company and operating it with full discipline. A CIC requires:

1) Real Risks. An assessment of real risks relevant to your business. Please do not buy international kidnap and ransom insurance if you are a local dentist who does not even have a passport…
2) Real Insurance. To identify a risk and provide insurance, it should be for a coverage that actually exists in the marketplace and can be understood by whichever regulatory body may be subjecting it to review. The CIC strategy is not the ideal time for you to become a creative insurance pioneer.

3) Real Actuarial Support. The insurance industry, and its success, is premised upon proper actuarial support and design of policies. The CIC is no different. The CIC coverages and rates must be based on legitimate, independent actuarial opinion.

4) Real Market Rate Premiums. Not only must the coverages exist in the marketplace, but the insurance premiums that you pay to your own CIC must also be within market range. Please resist the urge to pay too much for any particular coverage or to pay too much in general of your overall profits. Your payments must always be “reasonable” to satisfy IRS inquiry. It would be unreasonable for you to pay 10x the worker’s compensation insurance rate you could get from a major carrier, just as it would be unreasonable for you to wipe out all your profits at year-end to pay for a massive basket of insurance coverages.

Done correctly, the CIC provides a whole host of benefits:

• Improved risk management;
• Greater profitability through positive underwriting experience;
• Asset protection;
• Income tax minimization;
• Estate tax minimization; and
• Key employee planning.

Done incorrectly, the CIC is a waste of time. It will be viewed as abusive and will cost you dearly in penalties, interest, legal and accounting fees, and distraction from your business.

There was a time when I would not have recommended that the private business client even consider the CIC option. The notion of establishing an affiliated insurance company within the same economic family was objectionable to the IRS, and therefore hotly contested. The battleground for what is current CIC law played out with major public companies over 20+ years. The stakes were high and so were the fees involved to defend the structure. While this may be a worthwhile calculable economic risk for the likes of United Parcel Service (“UPS”), which ultimately won its case through rounds of appeals and set favorable precedent for us all, this risk proposition was simply not appealing to the author or any if his clients.

Even after the UPS case broke through the “same economic family” objection of the IRS, and allowed the deductions to be upheld for premiums paid to one’s own captive, the risk proposition was still not in the favor of the private client. The IRS was still intent on attacking the adequacy of the “risk shifting” and “risk distribution” elements of CICs. So, although the deduction could be allowed, one could expect a fight on whether the risks of the operating company were sufficiently shifted to the CIC, and whether the risks were thereafter sufficiently spread out to satisfy the law of large numbers prevalent in the insurance industry. For the private client, this was still too great an uncertainty to justify the CIC application.

Then, in 2002, the IRS provided some much needed guidance in clarifying exactly what constitutes adequate risk shifting and risk distribution. Moreover, in doing so, the IRS set forth specific “safe harbors” that one can follow. With the advent of safe harbor CIC planning, the CIC proposition opened up instantly to the private client. Following the safe harbor approach would ensure allowance of the deduction for the premiums paid without the risk of a challenge to the client’s risk shifting and risk distribution structure. With the uncertainties removed, CIC planning for the private client has mushroomed in the last ten years.

The two safe harbors are known as: 1) the 12-entity safe harbor, and 2) the 50% pool safe harbor. In the first, the IRS stated that if you have at least 12 entities that contribute premium in substantially equal amounts to the CIC, then that will provide adequate risk shifting and distribution on its face without a need to combine risks with others. In the second, where one does not have a sufficiently large number of companies, greater than 50% of the risks must be pooled with unrelated third parties in order to achieve adequate distribution. Both work well – the client’s fact pattern dictates which is most suitable.

Once the proper CIC, coverages, and premiums are in place, the flow of dollars in the CIC is generally as follows:

1) Payment of Premium. The operating company(ies) pay(s) premiums to the CIC. The premiums may be paid annually, quarterly, or monthly. The premiums are deductible to the company against its ordinary income provided they are reasonable.

2) Receipt of Premium. The CIC receives the premium, which is tax-exempt if the CIC is what is known as an 831(b) captive. The 831(b) captive rules allow the first $1.2M of premium income each year to be tax-exempt. This allows for a mismatch which can be very beneficial for tax purposes. While the operating company gets a deduction for the premium as an expense, the CIC does not have to recognize a corresponding amount as taxable premium income. Therefore, no taxes are due at either company for the premium amount.

3) Distribution of Risk. If the client can use the 12-entity safe harbor, then the CIC can simply place the premium amount into its own bank account in full as “insurance reserves.” If the client has less than 12 companies, then the CIC will transfer just over 50% of the premium to a risk pool, and retain the rest in reserves. With some pools, the pooled amount remains in a separate pooled account for the duration of the coverage; with other pools, the pooled amount may be released to the CIC and simply obligated by agreement. While the money is setting as reserves, it must remain liquid – to satisfy potential claims.

4) Release of Reserves. The contracts for insurance are generally one-year contracts. Once the year has expired, the contract terminates automatically, and the monies can move from reserves to “surplus.” Once in surplus, there is no contingency of a payout, and the monies can be invested with less liquidity and more liberally for long term wealth planning purposes.

5) Payment of Claims. If claims are made, the CIC pays the coverage out of reserves. And yes, to be clear, if there are claims, the CIC should pay them. It is good to have positive experience with your underwriting, but never paying out a claim can be suspect with the IRS for obvious reasons.

6) Distribution of Profits. If the client desires to take profits out of the captive, this is generally done through declaring dividends. Under current law, the taxation of CIC dividends in the right structure receives “qualified dividend treatment.” Qualified dividend treatment results in the lower capital gains rate being assessed instead of ordinary income. Therefore, there can be a significant tax arbitrage when the dollars come out the other end of the CIC structure.

The flow of dollars in the CIC structure can be depicted as follows:CIC-structure

To achieve even greater tax efficiency, you can even consider having the CIC owned by a trust for the next generation or beyond. By doing so, you can not only save income taxes with the CIC, but you can also eliminate estate taxes. The value of the CIC and any declared dividends go to the trust for tax and wealth transfer purposes. This allows the senior generation to avoid income taxes while passing wealth to the next generation on a tax-free basis.

Lastly, the CIC, and its ownership structure, serve to insulate the family wealth from creditors far better than if the money remained in the company as retained earnings or in the client’s individual accounts. The CIC removes assets from the riskier enterprise (the operating business) and puts them into a structure that is generally owned by limited liability companies or trusts with asset protection features. Moreover, since the payment of premiums for coverages is a fair market value exchange, the client can send premiums to the CIC (onshore or offshore) even during a lawsuit as this is not a fraudulent conveyance. Consequently, the CIC structure provides the optimal combination of income and estate tax minimization while maximizing asset protection for long term wealth planning.

Given the complexity, and the risk of incorrect implementation, it is critical that you implement a CIC only through experienced counsel.

By: Jim Duggan, JD, MBA


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