Captive Insurance Companies

Transcription

1 Monthly White Paper Series November, 2012 Captive Insurance Companies This month focuses on a well established, but often underutilized tool for business owners in managing risks and providing added tax benefits: owning your own captive insurance company. By: Michael J. Parise, J.D. Advanced Planning 401 Route 73 N. Bldg. 10, Ste. 206 Marlton, NJ P: (856) F: (856) Securities offered through American Portfolios Financial Services, Inc. Member FINRA/SIPC. Investment advisory services offered through American Portfolios Advisors, Inc., an SEC Registered Investment Advisor, an affiliated entity of American Portfolios Financial Services, Inc. Copper Beech Financial Group, LLC is not affiliated with American Portfolios Financial Services, Inc. or American Portfolios Advisors, Inc.

2 Introduction Last month, we touched on some of the major tax law changes scheduled to go into effect beginning January of next year. The purpose of that paper was to hopefully get you thinking about how your family may be able to take advantage of existing/future laws to maximize your wealth planning before the changes go into effect. This month we will focus on a more specific strategy to assist families in maximizing wealth through generations: the captive insurance company. A business faces numerous risks in its day-to-day operations, and managing this risk is paramount to a thriving and successful company. A captive insurance company, in its simplest form, is a way for a business to operate its own insurance company to assist in managing these risks. Though the concept may seem foreign to some, a business (or the owners of that business) can form a separate, duly licensed property/casualty insurance company whose primary purpose is to insure the risks of the related business entity. Though many business owners may be unaware of them, over half the states in the U.S. now allow captive insurance companies to form in their domicile. If administered properly and for the long term, a captive insurance company can be a very attractive risk management tool for a business owner. In addition, they can assist a family in managing their income or estate tax burden and provide for creative ways to recruit and retain key employees of a business. Captive insurance companies are highly complex and highly regulated corporations that cannot be fully explained in the brief time we have in this white paper series. Still, this will hopefully provide an overview to some of the benefits and costs of creating one for your business and family. The Captive Insurance Structure The insurance relationship between a business and its captive is just like any other. Your company will apply for a particular policy from your captive. The captive will then underwrite that particular risk and issue a policy for it, charging the operating company a premium. Because captives are almost always formed as property casualty insurance companies, policies are typically recurring annual policies just like a homeowners policy would be. After a year, if there are no claims made against the policy, the captive will keep the premium dollars and issue a new policy. It is very important to recognize that your captive is a true insurance company in every sense of the word. It must determine which lines of insurance to write, it must properly underwrite the risks of a business purchasing insurance from it, and it must pay claims on losses falling within its policies. Though the concept of owning your own insurance company may seem foreign to some, the idea is by no means a new one. Numerous Fortune 500 companies have used their own insurance companies for decades to manage and customize the risks of their particular business. 1 Currently, there are an estimated 5,000 captives in operation, compared to 1,000 in 1980, showing that the industry has been growing leaps and bounds over recent decades. 2 The term captive actually originated in the 1950s when an advisor named Frederic M. Reiss brought the self insurance concept to his client, the Youngstown Sheet & Tube Company in Ohio. This company wished to insure the operations of its captive mines, and the term has been used ever since to represent an insurance company insuring the risks of a related business. 3 Lower Insurance Cost Captive Insurance Benefits As stated above, a business has numerous risks. These risks may be inherent for a particular industry or may be specific to a particular company. What if you have a very special risk associated with your business you would like to insure against, but commercial carriers don t have policies to address it? And if they do have them, what if they are prohibitively expensive? In these situations a company likely keeps a side fund on its balance sheet just in case there is a loss. This same business can instead form their own captive insurance company to insure these risks. Because the captive is controlled by the business or its owners, it can be custom tailored to insure very specific and uncommon risks, perhaps giving your business an affordable insurance outlet. 2

3 Commercial insurers also tend to have larger overhead than captives which can drive premiums higher. Though your captive will have administrative costs of its own, the overall overhead tends to be lower than larger insurance companies. Greater Control Because the captive is owned within the same economic family as the operating business, so long as the necessary requirements are met, there is full control over how premium dollars are invested. You also retain control over what risks are insured and how claims are paid. This flexibility can be very beneficial to certain businesses. Improved Cash Flow When you pay insurance premiums to a commercial insurer and you don t submit a claim, what happens to your premium? Well, it s kept by the insurance company for their own uses, of course. If you purchase insurance from your own captive and there s no claim, you keep the premium within the same economic family. So long as the policies are issued properly, you get to participate in the underwriting profit of your captive. Additionally, though a captive is formed principally for the purpose of insuring risks of a related business, it can also issue policies to third parties, increasing profits even further, if desired. Tax Benefits As a disclaimer, it is imperative to understand that captive insurance companies cannot be formed for the sole purpose of achieving tax benefits. There must be a legitimate insurance need, and any transactions between your business and captive must be at arms-length. In other words, it must mimic a transaction between unrelated businesses. So, even though the entities are related, their dealings should be conducted fairly, as if they were independent of each other. If the insurance arrangement is deemed to be a sham and for the sole reason of obtaining tax benefits, there could be significant penalties from the I.R.S. A business can deduct property/casualty (not life insurance!) premiums as an ordinary and necessary business expense under Section 162 of the Internal Revenue Code (I.R.C). By purchasing insurance policies from your own captive for uncommon but legitimate business risks you otherwise wouldn t insure, you may be able to lower the business s taxable income for that particular year. For higher income earners who own LLC or S-corporation pass-through entities, this can be especially attractive as a way to lower their income tax burden. Furthermore, it is also possible to elect to treat your captive as a small insurance company under Section 831(b) of the I.R.C. The result of this election is that the captive will not be taxed on insurance premiums it receives so long as they are under $1.2 million annually. The captive will only be taxed on investment income earned on these premiums. Utilizing a captive in this fashion can be a great way to supplement the benefits of an employer sponsored retirement plan or IRA without the strict limitations on contributions. Though many states are now offering captives to be formed as LLCs, most are typically organized as C-Corporations. This means they have their own separate corporate income tax rate, and any distributions to shareholders come in the form of a dividend or capital gain. Currently, both dividends and capital gains are taxed at 15%, lower than individual income tax rates. These rates are scheduled to rise under current law beginning January 1 st. While the potential income tax benefits can be an attractive supplemental benefit, high net worth business owners can also utilize captives to achieve estate planning benefits. It is common for a business owner to own his/her captive directly. However, there can be estate planning benefits in having a captive owned by the business owner s children, either directly or in a trust for their benefit. A small business that purchases insurance from a captive is engaging in a business transaction that would not be classified as a gift for estate/gift tax purposes. This means that a high net worth business owner can transfer excess income/assets to a captive owned by a trust for his/her children without any gift tax consequences 3

4 whatsoever. If done for a number of years, the benefits of this strategy can result large tax savings to a family. Asset Protection A captive is a separate, legally distinct entity and sheltered from the creditors of the operating business. Should a business be able to purchase insurance from a captive, any underwriting profits of the captive are not subject to the claims of creditors of the operating business. If a captive is owned inside a dynasty trust for future generations, or a domestic asset protection trust, the asset protection features are compounded even further. Recruiting and Retention of Employees In highly competitive industries, such medical practices, using a captive as a way to recruit and retain top talent is another added benefit addressed by captives. By giving key employees or shareholders ownership rights in a captive insurance company, you can use distributions from a captive as a supplemental benefit, either during working years or at retirement. Employing such a strategy can help attract the most skilled professionals to your business. What Can You Insure? A very common question clients ask us regarding captives is what type of risk they can insure against. The full answer requires an in-depth analysis of a business, conducted by qualified captive experts, that analyzes the business and its insurance history to determine what acceptable risks are available. The key word here is acceptable. One of the most common abusive practices with captives is to insure a business risk with an extremely low probability of occurring. Think of a business in Nebraska purchasing hurricane insurance. Would this same company purchase this policy from a third party insurance company? Probably not. The risk of a hurricane in Nebraska is so low that it makes no business sense to purchase this type of policy from a third party insurance company. Regulators would likely view this transaction solely as a way deduct the premium payments while still retaining the full use of the premiums inside the captive or, in other words, moving money from one pocket to another while getting a tax deduction. It cannot be emphasized enough: the transaction between an operating company and its captive must be similar to a relationship between unrelated businesses and make business sense. There are, however, numerous acceptable risks that are commonly insured through captives including: Cyber Risk Loss of Key Customer Loss of Key Supplier Errors and Omissions Medical Malpractice Tax Audit and Legal Defense Directors and Officers Regulatory Changes Business Interruption and Work Stoppage Can a company really purchase a cyber risk policy to protect against computer hackers? Absolutely. Considering that Lloyd s of London has, at one point, issued insurance policies on Troy Polamalu s hair, Bruce Springteen s vocal cords, and Tina Turner s legs, a policy for cyber risk isn t as far-fetched as you might believe. If there is a special risk associated with a particular business, it may be possible to insure it, but only a thorough analysis by actuarial experts can determine what risks may be insured. 4

5 Other Captive Requirements This paper has mentioned numerous times that any transactions between your operating business and captive must be conducted at arms-length and make business sense. There is another requirement that must be met in order for your captive relationship to be valid: the relationship must actually be insurance. Courts have determined that an insurance relationship exists when there is risk shifting and risk distribution. 4 Without getting too deep in legal mumbo jumbo, this means that a portion of the risk your captive is insuring must be from unrelated business entities. If the only business your captive insures comes solely from your company s risks, there will not be sufficient risk shifting and distribution, and any tax deductions taken for payment of insurance will be disallowed. The I.R.S. has passed guidelines on how to properly structure your captive to comply with these requirements. The most common way to meet them is to utilize a third party insurance company that then reinsures a portion of its risk (including both your business and unrelated businesses) with your captive. If done by qualified captive specialists, this relationship complies with I.R.S. guidelines. In the end, this means a small percentage of the premiums your business pays are at risk from another company submitting a claim. If this happens, a portion of your premiums may be used to make due on that claim. Any excess at the end of the policy year remains in your captive as a surplus asset. Conclusion Captive insurance companies are not for every business. Your insurance company requires initial set up fees in the form of registration costs and startup capital. Additionally, captives require ongoing administrative expenses in order to comply with the regulations of the jurisdiction it is domiciled in. Despite these costs, a majority of U.S. states now allow captive insurance business, and the industry is growing. This lends support to the belief that the benefits discussed above may outweigh these costs for certain companies. Captives can still be implemented for 2012 through the end of the year to help manage risk and provide added tax relief to qualified businesses. If you are interested in learning more about captive insurance companies and how they may help a business you own, please get in contact with your advisor team to learn more. To embark on long-term wealth preservation is an act of extraordinary courage for a family, like the planting of a copper beech tree, since the family members who initiate the process will never know whether they were ultimately successful. If you are courageous and you want to be a wealth creator in the most profound sense, get started. There is no time to waste. James Hughes, Family Wealth: Keeping it in the Family Helvering v. Le Gierse, 312 U.S. 531 (1941). 5