Benefits of Owning a Captive Insurance Company

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1 Benefits of Owning a Captive Insurance Company A Game Changing Tool for Business Owners Sean G. King, JD, CPA, MAcc Principal, CIC Services, LLC Captive Insurance Companies are a unique financial structure that offers an array of benefits for owners of businesses. A captive is a unique insurance company. It includes its own corporation, insurance license, reserves, policies, policyholders, and claims. It is a formal way for business owners to self- insure risk, and captives are generally formed to insure primarily though not exclusively the risks of one or more businesses owned by the same or related parties. It is important to keep in mind, that while there are many significant benefits of forming a captive, one CANNOT choose to do so primarily for the ancillary reasons explained in this paper. The captive must be formed for the primary reason of enhanced risk management. An experienced attorney and captive management firm in the captive insurance company space will ensure this happens. CIC Services, LLC is a full service captive insurance administration firm headquartered in Knoxville, Tennessee. CIC is a Fautores Family Offices Strategic Alliance Partner.

2 Game Changing Financial Tool For Owners of Businesses or Professional Practices Ancillary Benefit Of Owning A CIC Efficiently Funding A Buy Out Agreement Between Business Owners One of the benefits of owning a captive insurance company is that it provides a remarkably efficient vehicle to fund a buy- out agreement among business owners. Before discussing this unique benefit, let s review the primary reasons that businesses form their own insurance company specifically a captive insurance company. 1. To manage business risk by formally self- insuring certain risks with pre- tax dollars 2. To protect assets from creditors of the operating business and its owners or other risks 3. To realize profits and accumulate wealth inside of a separate business entity All of the above are well known as the primary reasons that legitimate captive insurance companies are formed. What is less well known is that a captive insurance company can also be an incredibly efficient means of transferring assets or wealth from one party to another e.g., from one generation to another or from one business owner to another. In this article we ll discuss the second of these options transferring a business from one owner to another. A Common Challenge Buy- Out Agreements Between Business Owners Can Be Cumbersome And Take An Inordinate Amount Of Time A challenge common to many businesses, including often professional practices like CPA firms, physician practices, law firms, etc. is transferring ownership of the business from its current owners to the up- and- coming crop of new owners. Such transfers present a host of practical and tax complications, many of which can be resolved via use of a captive insurance company. The Solution When a business forms a captive insurance company and uses it to formally insure risks that it previously informally self- insured, two relevant things happen. First, its profits decrease since premiums paid to the captive insurance company represent business expenses. This in turn means that the insured business is worth less (since its value is usually some multiple of net income or EBITDA). Second, the business gets a tax deduction for the premiums paid. For example, assume that a given business is valued at a five times multiple of EBITDA and begins paying $1 million in premiums to a captive insurance company owned by the current (selling) owners of the business. This transaction reduces the value of that business by $5 million, which makes it far easier for the up- and- coming owners (the buyers) to afford the buy- in. Does this mean that the selling partners are short- changed? Hardly, since they reap the 1 P age

3 profits of the captive that, if it is selective about the types of insurance sold, will be substantial. These benefits alone are often enough to make what was previously an undoable deal doable. But there are additional benefits as well. Remember that small captive insurance companies pay a zero percent tax on their underwriting profits under the Internal Revenue Code. Thus, the $1,000,000 in premiums received by the captive (owned by the sellers of the operating business) in the example above is received tax- free even though the premiums were tax deductible to the business that paid it (i.e., to the buyers). Thus, the reduced tax friction of the captive arrangement also contributes to making previously undoable deals doable. But, what about claims? Won t the captive have to pay claims on policies sold to the operating business? Of course. But, with a properly structured and managed captive, one that writes a wide variety of select types of coverage that includes proper deductibles and policy limits, claims can be managed and will almost never amount to more than the tax savings that result from the transaction in any given year. Often they will be substantially less. Thus, the existence of claims is no impediment to the deal. What Is A Captive Insurance Company? A captive is a unique insurance company. It includes its own corporation, insurance license, reserves, policies, policyholders, and claims. It is a formal way for business owners to self- insure risk, and captives are generally formed to insure primarily though not exclusively the risks of one or more businesses owned by the same or related parties. A captive is a unique but REAL casualty insurance company. It can be used to replace insurance that your client is currently purchasing from third parties. But most businesses find that the real benefit of a captive is to insure risk that CAN T be insured by third parties at any reasonable price. Most every business has insurable risks that it can t afford to insure elsewhere. In fact, businesses often face major risks that are often not insured at all. It s worth noting that most businesses informally self- insure such risks with after tax dollars, meaning that its rainy day fund is usually comprised of retained earnings that have already been taxed. With a captive in place, businesses can formally insure these risks with pre- tax dollars. Premiums paid from the parent company to the captive insurance company to buy legitimate business- related insurance coverage are deductible just as if such premiums were paid to a third party insurer. Further, small casualty insurance companies (as defined in Section 831(b) of the Internal Revenue Code) pay tax in a ZERO percent tax bracket on their underwriting profits. Such profits accumulate as reserves within the captive, and these reserves can be invested into a wide variety of assets or investments (some domiciles have restrictions). Also, for a properly structured captive, the reserves that accumulate in the captive are protected from creditors of the operating business and its owners. 2 P age

4 How Does a Captive Insurance Company Work? A captive primarily insures its parent company or related companies. Hence, the parent company is able to purchase insurance from its captive, and it can insure risks that third party insurers will not insure or risks where third party insurance cost is unaffordable. Premiums are paid from the parent company to the captive with pre- tax dollars. The captive can invest its assets mostly as its owners choose (some domiciles have restrictions). The primary purpose of any captive insurance company must be to provide more effective risk management and casualty insurance protection to operating businesses or related entities. Among other things, a properly- structured captive insurance company will usually reduce business insurance costs, provide access to types of insurance not offered by third- party carriers, allow customizable insurance coverage to match exact business needs, and give access to the discounted re- insurance market. The economic impact of these benefits over time can be extraordinary in most cases. What Are Other Ancillary Benefits Of Owning A Captive Insurance Company? Assuming a captive insurance company is created for the above primary purposes, there are many other ancillary benefits that often flow from owning and operating a captive insurance company. These may include but are not limited to: Improving After- Tax Cash Flow Reducing State and Federal Income Taxes Improving Asset Protection Accelerating Wealth Accumulation (via ownership of a highly profitable insurance company) Facilitating Estate Transfer to Future Generations Providing Alternatives to Non- Qualified Retirement, Deferred Compensation Plan or Phantom Stock plans Creating Golden Handcuffs or Golden Parachutes for Key Employees Facilitating Buy- Sell, Buy- In, or Buy- Out Arrangements Why Should Financial Professionals Introduce Captive Insurance Companies to Their Clients? Part one of the answer is simple. For many business owner clients, operating a captive insurance company is far and away the best financial move their business can make. Few other moves will create as great a financial impact for so little cost. Part two is simple as well: A well- run captive insurance company (just like a well- run commercial insurance company) will amass significant reserves over time. Managing these assets often requires the expertise of a financial professional. 3 P age

5 More Thorough Explanation of Some Benefits of Captive Ownership to Clients Here s a more detailed explanation of some of the benefits of owning your own insurance company: 1) Reduce Insurance Costs a. Conventional third party insurance policies insure a bundle of risks; some of which may not be particularly relevant to your client s business, and yet they pay for them nonetheless. They are baked in the cake. This forces many businesses to pay for coverage that they don t need while going naked on coverage that they do need. b. Third party insurance premiums also include markups for things like marketing and distribution expenses (think advertising and commissions, just to name two) and large underwriting departments, not to mention profit margins, which may not benefit clients at all. These additional costs are reduced or eliminated with captive insurance. c. Currently, any risks businesses self- insure are insured with after tax dollars. So, it takes almost $1 million in earnings, with $500,000 or so first paid in taxes, to save $500,000 in a sinking fund to pay for $500,000 of losses incurred. d. Because a captive insurance company is a licensed insurance company, it has access to the reinsurance (or wholesale insurance) market. Utilizing reinsurance can lower third- party insurance costs for many businesses. 2) Improve Risk Management and Insurance Protection - a. Because businesses are willing to insure real risks that up until now have been considered too remote to insure or too expensive to insure through third party insurance companies, they will experience better risk management and insurance protection. b. As a result, the business is better positioned to survive the uncertainties of today s business world. 3) Improve Cash Flow and Manage Earnings a. Businesses can experience improvement in overall after- tax cash flow by obtaining cheaper and more relevant insurance coverage and reducing taxes. b. Business owners and CFO s can effectively manage earnings by varying the amount of insurance purchased from their captive from year to year. 4) Experience Tax Savings a. Income Tax Every year clients can take a tax deductible business expense of up to $1.2 million. 1 This tax savings can be as much as 40% to 50% when considering the combined federal, state and Obamacare tax brackets. This could 1 Businesses should limit their total expense for casualty insurance to no more than 20% of gross revenue. 4 P age

6 save about $480,000 to $600,000 in income taxes per year per $1.2 million of captive insurance premiums. b. Death Tax A properly- structured captive is often owned by a trust for the benefit of the business owner s children for asset protection and other reasons. With sufficient planning and forethought, this trust can be made irrevocable, thus removing the captive s reserves from the business owner s taxable estate. Each year premiums are paid to the captive, assets are thus transferred from senior generation to junior generation with no gift or estate taxes. 5) Bolster Asset Protection a. By having the stock of the captive insurance company owned by a family trust, the stock cannot be subject to personal creditors of the business owners or their businesses. b. Captive insurance company assets are often protected by statutory law of the jurisdictions in which they are domiciled. The assets of an insurance company are generally preserved for the benefit of policyholder claimants. In other words, the captive s assets can only be accessed to pay claims of an insured, and not by general creditors of the operating business or its owners. c. If your client s CIC is incorporated in certain international jurisdictions, the laws of the international jurisdiction may place procedural hurdles in front of a potential plaintiff that make it extremely difficult, if not practically impossible, for any non- policyholder future creditor, especially one in the US, to get to the assets of the company. d. Captive insurance company assets can be invested in such a way that, even if a creditor were successful in obtaining a judgment against the company, the creditor would be thwarted from obtaining much value by doing so. This is accomplished by investing the assets in a special asset protected LLC, where a creditor is limited to a Charging Order. 6) Function as an Alternative to a Non- Qualified Retirement, Deferred Compensation Plan, or Phantom Stock Plan a. Stock ownership in a captive insurance company is a great alternative to supplemental non- qualified retirement plans and deferred compensation plans. 7) Function as Golden Handcuffs or Golden Parachutes Arrangement a. Stock ownership in a captive insurance company can tie key employees to your client s business. b. Stock ownership in a captive insurance company can reward key employees for past performance. 8) Accelerate Wealth Accumulation a. The wealth which you can accumulate from the profits of your captive insurance company is available for many life cycle needs or wants: 5 P age

7 i. Retirement ii. Long Term Care iii. Education iv. Dreams 9) Facilitate Estate Transfer to Future Generations a. 4b above not only saves on the cost of death taxes, but it transfers assets from your client s estate to future generations in the most effective method of which we are aware. 10) Facilitate Buy Sell, Buy In, or Buy Out Arrangements a. A captive can be very effective in facilitating the purchase of a business, or the buying into a business, or buying out someone from a business. It is important to keep in mind, that while all the above ancillary benefits have significant value, when forming a captive, one CANNOT choose to do so primarily for the ancillary reasons above. The captive must be formed for the primary reason of enhanced risk management. An experienced attorney and captive management firm in the captive insurance company space will ensure this happens. How Should Captive Assets Be Managed? In a word conservatively. The optimal strategy will maintain liquidity, capture upside of market and minimize adverse impact of downturns, minimize taxes, be compliant, and provide reasonable returns under most any set of assumptions. In other areas where the above considerations are paramount, specially- designed life insurance contracts are often used as a portion of the investment portfolio. For instance, other regulated entities like banks often invest a significant portion of their Tier 1 capital in such policies, and nearly 70% of Fortune 1000 companies fund their nonqualified deferred comp plans (for most of their senior executives) with life insurance. 2 Why is that? Among other things, consider that:» High cash value life insurance provides liquidity» Equity Indexed Universal Life Insurance (EIUL) eliminates downside risk» EIUL ROR captures upside gains» Life insurance is highly tax efficient (important for C Corps)» Life insurance serves as a guaranteed source of collateral for loans 2 American Society of Actuaries Study 6 P age

8 Conservative investments including high cash value Equity Indexed Universal Life Insurance meet the strict guidelines of the National Association of Insurance Commissioners (NAIC) for the reasons cited above. The NAIC guidelines are included for reference at the end of this white paper. Conclusion Captive ownership has become a REAL possibility for small, closely- held businesses because competition among domiciles (U.S. states and other countries) seeking to attract revenue from newly formed captives have driven down start- up costs and capital requirements. There are approximately 6,000 captives in existence today, and the number grows by approximately 200 every year. The captive market continues its steady growth because captive ownership affords game changing benefits to business owners. This is an excellent time for financial professionals to educate their clients and help them reap the benefits of owning their own insurance company. For Reference High Cash Value Life Insurance Conforms with the NAIC (National Association of Insurance Commissioners) Guidelines NAIC MODEL LAWS, REGULATIONS AND GUIDELINES...COMPANY ORGANIZATION, MANAGEMENT, SECURITIES...Investments of Insurers Model Act (Model 283) - - (Defined Standards Version) Model 283 s 5 Prudence Evaluation Criteria The following factors shall be evaluated by the insurer and considered along with its business in determining whether an investment portfolio or investment policy is prudent; the commissioner shall consider the following factors prior to making a determination that an insurer's investment portfolio or investment policy is not prudent: A. General economic conditions; B. The possible effect of inflation or deflation; C. The expected tax consequences of investment decisions or strategies; D. The fairness and reasonableness of the terms of an investment considering its probable risk and reward characteristics and relationship to the investment portfolio as a whole; E. The extent of the diversification of the insurer's investments among: 7 P age

9 (1) Individual investments; (2) Classes of investments; (3) Industry concentrations; (4) Dates of maturity; and (5) Geographic areas; F. The quality and liquidity of investments in affiliates; G. The investment exposure to the following risks, quantified in a manner consistent with the insurer's acceptable risk level identified in Section 6H: (1) Liquidity; (2) Credit and default; (3) Systemic (market); (4) Interest rate; (5) Call, prepayment and extension; (6) Currency; and (7) Foreign sovereign; H. The amount of the insurer's assets, capital and surplus, premium writings, insurance in force, and other appropriate characteristics; I. The amount and adequacy of the insurer's reported liabilities; J. The relationship of the expected cash flows of the insurer's assets and liabilities, and the risk of adverse changes in the insurer's assets and liabilities; K. The adequacy of the insurer's capital and surplus to secure the risks and liabilities of the insurer; CASE STUDY: Ancillary Benefit of Owning a Captive Insurance Company Efficient Removal of Retained Earnings from a C Corp. 8 P age

10 The Challenge Retained Earnings Trapped in a C Corp Another issue common to many small and mid- size businesses is the accumulation of retained earnings inside of a C Corporation. Retaining significant amounts of earnings inside of a C Corporation often only makes it a bigger target for creditors or plaintiffs. And yet distributing retained earnings via dividends often only aggravates the creditor/plaintiff issue and triggers a second layer of tax on the businesses accumulated profits (i.e., double taxation ). Captive insurance companies can assist in resolving this issue. Our client was the owner of a construction company that built large commercial buildings including hospitals and shopping malls. The business was a C Corporation in a high risk business and had numerous uninsured risks. With over $5 million in retained earnings that had already been taxed at the corporate rate of 35% (at that time), it was a target. The owner planned to phase out of the business over a several year period. And, the owner faced an additional dividend tax on the distribution of retained earnings. The Solution The client formed a captive insurance company to formally self- insure business risks that it previously only informally self- insured. This gave the business owner better overall risk management at a reduced cost. Furthermore, the business owner was able to pay tax deductible insurance premiums to the captive insurance company up to $1.2 million annually, for the needed insurance coverage. Over five years, the owner was able to transfer a significant amount of retained earnings from the C Corporation to the owner s captive insurance company in a tax- preferred manner, thereby removing it from the C Corp and protecting it from the C Corps future creditors. Importantly, electing small insurance companies such as the one described above pay tax at a zero percent rate on their underwriting profits (i.e., premium income less claims and operating expenses). About CIC Services, LLC We are professionals with over a century of experience in the insurance industry. Since 2005, we have been helping businesses and business owners create and own their own closely- held casualty insurance company. A closely- held insurance company, called a captive insurance company, is a powerful financial tool that can provide tremendous added value to businesses and their owners. We have worked with financial professionals and advisors who had clients that would benefit by owning their own insurance company. As such, we have facilitated many win- win- win transactions a win for clients, a win for their trusted financial advisors and a win for us as captive managers. 9 P age