Captive Insurance Company
CAPTIVE INSURANACE COMPANY
A Wealth Preservation Strategy
A captive insurance company is not just for risk management!
“Captive insurance companies have been around for about 50 years but yet they are not widely used as a wealth preservation strategy by family businesses,” according to leading family business expert
“When family business owners are discussing “self-insurance” they are generally thinking in terms of risk management – not within the context of estate planning, retirement planning, creditor protection and employee benefits,” notes Schwerzler
Schwerzler has been studying and advising family business entrepreneurs for more than 40 years and is the founder of Atlanta-based
Family Business Institute.
To better understand how a Captive may benefit your family business, we are republishing an article written by our friend Douglas Stein, a partner in the prestigious law firm of Smith, Gambrell and Russell. SGR has offices in Atlanta, New York, Washington DC, Jacksonville and Frankfort Germany.
Captive Insurance Company
A Captive insurance company (“Captive”) is a domestic or foreign insurance company formed by a business owner to insure the risks of the operating business. The owner of a business or a group of businesses can form a wholly owned Captive for the purpose of insuring his/her related companies. The insured businesses pay premiums to the Captive in exchange for insurance. The insurance premium paid is a deduction to the operating businesses income and, in many cases, the premium income received by the Captive insurance company will be tax free.
A Captive can be owned by the business, the business owner, spouse, relatives, a Trust, or any other entity. The operating business pays premiums to the Captive, and the Captive insures some of the risks of the operating business. A Captive not only allows a business to control its insurance costs and ensure hassle free payment when a claim is made but also provides a highly tax efficient method to accumulate wealth. Businesses can also use Captives to reduce their cost of insurance or improve their coverage at little to no cost. Often, the use of a Captive with a risk manager can greatly reduce the cost of the coverage and identify and insure over gaps in coverage.
This article summarizes many of the non-insurance benefits a stand alone property and casualty Captive (“Pure Captive”) offers. It does not discuss the other types of Captives such as group Captives, where multiple businesses join in the formation of a single Captive and share the risk of each other’s business.
While other forms of Captives are valuable when appropriate for your unique situation, for the sake of brevity this article is limited to Pure Captives. These benefits include, but are not limited to, estate planning and wealth accumulation, retirement planning, and asset protection. This article is intended to be very broad and to merely draw your attention to this sophisticated and flexible tool.
History of Captives
Modern Captives began in Bermuda in the early 1960s, and were formalized in the late 1970s with a medical malpractice Captive for Harvard University. The growth of Captive insurance and related risk transfer mechanisms has boomed. The total number of Pure Captives in the United States today is well over 1,500. Worldwide there are well over 5,000 Pure Captives. When segregated cells, risk retention groups, and rent-a-Captives are included, the number of Captive and alternative risk arrangements today is in the tens of thousands, and is rapidly growing. Captives are not fly by night entities. Rather they are sophisticated tools that have been time tested and approved by the IRS.
Generally, Captives are taxed on all of their income just like C corporations. However, the Code permits property and casualty insurance companies certain deductions against taxable income, including premium income and investment income that are not available to regular corporations. As a result, a carefully administered property and casualty Captive may have little or no taxable income from premiums received. Code Sec. 831(b) provides a very powerful tax advantage for qualifying small Captives. If the Captive receives less than $1.2 million of premiums each year, it may elect to be taxed only on its investment income. Thus, premiums are not taxable income to the Captive. Once the Code Sec. 831(b) election is made, it may not be revoked without prior written consent from the IRS.5 Fortunately, a Code Sec. 831(b) election does not affect the deductibility of premiums paid by the operating companies. The key advantage to making a Code Sec. 831(b) is that the Captive is able to accumulate surplus from underwriting profits free from tax. Assuming the Captive carefully chooses its risks, it can accumulate significant assets in a fairly short period of time.
Imagine a Captive that receives annual premium income of $1,200,000 and goes five years without a significant claim and little appreciation the Captive can easily accumulate $6.0 Million in assets. Even if a claim of $100,000 was made during that 5 year term there should still be $6.0 Million after moderate appreciation is accounted for. If the Captive were structured to be owned by a trust or limited liability company for the benefit of your children and grandchildren then you would have effectively shifted $6.0 Million to your children and grandchildren free of income, gift, and generation skipping tax. In addition, you would have the added benefit of shifting the $6.0 Million while creating an income tax deduction for your business without income to the children and grandchildren. In sum, if properly structured a Captive can create a significant income tax deduction while moving assets out of your estate free of gift taxes.
A Captive that makes a Code Sec. 831(b) election can also provide substantial retirement benefits for their owners. The profits a Code Sec. 831(b) Captive earns on its insurance premium is taxed when they are distributed to its shareholders as qualified dividends or as long term capital gains, both of which are currently taxed at 15%. This tax deferral feature provides substantial flexibility while Congress continually changes the tax rates. Since the shareholders control the timing and amount of distributions they receive from their Captive, they can choose to receive these distributions in the manner and time which provides them with the greatest tax benefits.
Depending on the structure, a Captive can provide significant creditor protection. In addition to the protection afforded by the corporate shield, some jurisdictions prevent premiums paid to a Captive from being attacked by creditors of the insured. Anguilla, for example, has legislation which provides that the premium paid to the Captive is protected from the creditors of the insured unless the payment of such premiums was made with the intent to defraud the creditor. In addition, the legislation also protects the insurer from actions against insurance premiums paid to it, providing it maintains such premium in accounts separate from every other account.
Employee benefits is an area where risks can be insured by an employer’s Captive including group term life, accidental death and dismemberment (AD&D), business travel accident, disability, and active and retiree medical. A Captive may also insure nonqualified plans such as employer or executive life and AD&D, deferred compensation, and salary continuation. ERISA exemption may or may not be available for these coverages. Under the U.S. Department of Labor’s “expedited procedure” (EXPRO) guidelines, the DOL may approve the employer Captive underwriting these coverages even though the Captive insures no outside business and the IRS will recognize these as “unrelated risks” for the purposes above. These provide enhancements to coverages that the DOL views as favorable, including the increase of voluntary life limits, addition of new programs, lowering of employee contributions, provision of increased coverage, accelerated death benefits, increased monthly disability benefits, and increased lifetime maximum benefits payable.
Captives are very flexible but sophisticated tools which can have significant noninsurance benefits. Despite the non-insurance benefits of Captives, they are not right for everyone and no two Captives are the same. No one solution fits all. Let us help you determine if a Captive makes sense for you.
If you have a question about how a Captive Insurance Company may benefit your family business, we invite you to use our ASK THE EXPERT feature.
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