SIIA A2: Introduction to 831(b) Captives

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1 SIIA A2: Introduction to 831(b) Captives Park E. Eddy, MBA Active Captive Management, LLC Lawrence Prudhomme, CPA, ACI GPW and Associates, Inc Agenda What is a Captive? Why Consider a Captive? 831(b) Captives Defined Trend of Commercial Markets Insurance Company Qualifications Risk Distribution Captive Red Flags 1

2 What is a Captive? An Insurance Company formed by a business owner to insure the risks of related or affiliated businesses. (Over 50% of the Fortune 1500 have Captives) It is an Insurance Company, with a Limited License Why Consider a Captive? Improve overall risk management Provide coverage for uninsured or hard to insure risks Capture Underwriting profit Access to reinsurance market Control over claims management Potential income tax benefits Potential estate planning opportunity 2

3 What is 831(b)? A Specific Tax Election within the IRC Relates to Income Tax Treatment of Small Insurance Companies Premiums up to $1,200,000 Annually Underwriting income (premiums less claims) is not subject to tax Taxed only on Net Investment Earnings Example of 831(b) Captive Tax Difference Premiums $1,000,000 Claims $100,000 Net Investment Income $10,000 (Assumes policies with 1 year terms and no unearned premium) Non 831(b) Captive 831(b) Captive Net Income $910,000 $910,000 Taxable Income $910,000 $10,000 Federal Tax Liability $309,400 $1,500 Tax savings $307,900 3

4 Captive with 831(b)Election Designation Premiums Taxation P&C w/ 831 (b) election Up to $1,200,000 Investment Earnings P&C Insurance Co. Premiums Less Reserves Established in 1986 Why? 4

5 Commercial Markets In the 80 s Huge Crisis in Insurance Market Investment Losses/ Increased Litigation Cash Flow Underwriting / Reinsurance Crisis Shrinkage of Surplus Worldwide Prices Up / Availability Down Trend In Commercial Markets Reduction in Coverage Affecting Liability Policies (Wind, EQ, GL) 831(b) Critical Risk Management Tool Greatest Growth in the past 5 years Service Captives largest segment 5

6 Insurance Company Status Elements of a valid insurance company Non tax business purpose Insures insurance risks, not speculative, business or investment risks Risk transfer Risk distribution Walks, talks and acts like an insurance company Respected as a separate and distinct entity and is not a sham So What If You re Captive Doesn t Qualify As An Insurance Company? Insurance Insurance premium payments are deductible Captive has income Captive takes deduction for ultimate loss reserves on a discounted basis If domiciled offshore, the parent can elect to be taxed as an United States taxpayer Not Insurance Payments are not deductible since they do not qualify as insurance premiums Captive does not have income Claims are deductible when paid with no deduction for loss reserves Considered a risk financing vehicle by the IRS 6

7 Risk Distribution Risk distribution means a pooling of premiums for sufficient risks to allow the law of averages (law of large numbers) to operate. The IRS believes that there must be a number of entities in order to be insurance and that a single insured (no matter how large) cannot have insurance if it is the insurance company s only insured. Risk Distribution Risk distribution may take the form of: Outside business (unrelated third party risks) or Brother sister insurance (enough related entities being insured to constitute sufficient distribution of risk) 7

8 Risk Distribution Pooling of risk the foundation of insurance Risk Pool A contractual arrangement or legal entity via which unrelated companies come together to share risk and a means by which to provide a level of risk transfer for self insured risks Typical coverages for an 831(b) captive are low frequency/high severity risks and risks that are either uninsurable or overpriced in the commercial market Risk Distribution Pools allow you to diversify your risk and spread risk around other pool members If you have a loss, you ve effectively bought insurance from the others and the loss is spread across multiple parties If other pool members have losses, you ve effectively sold insurance and you will absorb your share of their losses Pools attempt to achieve the law of large numbers 8

9 A Pure Captive with Pooling Shareholder (s) Client (s) Entities Premiums paid to Captive Insurance Policies issued to Operating Business and Related Entities Captive Insurance Company (the Captive ) Pool Policies issued Premiums paid for Pool Policies Insurance Pool Insurer Premiums paid for Pool Policies Pool Policies issued Numerous other Companies Insurance Coverages Building Ordinance Contractual Liability Construction Defect Cyber Liability Directors and Officers Distribution Liability Deductible Reimbursement Earthquake Environmental Liability Employee Practices Liability Errors & Omissions Independent Distributors Liability Intellectual Property Infringement Product Recall Prof. License Defense Property- Inventory Punitive Damages Rental Income Loss Rental Discrimination Strike Insurance Tax Audit Expense Unfair Competition Liability Union Audit Insurance Warranty Workmanship Liability HIPAA/Billing Audit Liability 9

10 Case Study: Nursing Home Scenario: Louisiana Client has 2000 beds, commercial quote of $4,000 for Professional Liability. Solution: Instead of self insuring, Client formed a Captive to cover these risks with custom policy drafting and controlled claims management. Property Insurance Flood & Wind Workers Compensation Deductible Reimbursement Results: Cost per bed was reduced to $1,400. With a tax advantage position, Client increased investment savings and saw a decrease in the number of claims. Case Study: Emergency Room Doctors Scenario: $1.8mm quote for Professional Liability coverage. Claims run approximately $500,000 per year. Solution: Obtain new quote with $250,000 deductible. Captive formed and owned by trust for Children to cover the $250,000 deductible, with premiums of $900,000 per year. Result: $900,000 Premium to Captive, underwriting profit of $400,000 in Captive with tax advantage, and wealth transfer to next generation. 10

11 Case Study: Seafood Distributor Scenario: Family Owned, Importer and wholesaler of Seafood and operates Specialty Markets, $500mm in Gross Revenue. Solution: Instead of self insuring, Client formed a Captive to cover these risks. Contractual Liability, Supply Chain Interruption Product Recall, Wage & Hour, Earthquake, Trademark Infringement Results: Improved risk management, with a tax advantage position, Client increased investment savings and saw a decrease in the number of claims. Captive Red Flags Inflated or Unsupported Premiums Captive must rely on a competent actuary to establish reasonable and supportable insurance rates and not charge what the insured wants to pay in a given year Inadequate Risk Distribution There must be legitimate unrelated third party risk in the captive in a percentage sufficient to satisfy IRS scrutiny Bootstrapped Capital and Premium Payments Payments and loan backs to the insured before funds become surplus will indicate a sham designed for tax evasion purposes 11

12 Questions 12

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