Towards the end of the year, CPA firms are generally looking for opportunities to maximize the tax deductions available to their business owner clientele. For a business owner client whose operation has the right characteristics, there is a substantial opportunity for tax deduction (up to $1.2 Million annually) that has gone unutilized until relatively recently (around 2002). This opportunity is provided by IRS tax code under IRC 831(b), and is known as the domestic captive insurance company.
831(b) Captive insurance companies (there are other types) are insurance companies formed by business owners to insure the risks of their operating business. Captives may also insure the risks of subsidiaries, brother/sister organizations, or reinsure the parent company’s own risks, and may even take on unrelated party risk.
The Captive’s owner (your client) will actually dictate the underwriting and investment policies of the insurance entity to fit the individual risk of his/her operating business and other operating businesses that he/she chooses to insure. Often this is done to insure risks for which marketplace insurance policies are unavailable, to obtain better pricing on insured risk than that available through the marketplace, or to gain favorable access to reinsurance.
Some examples of the types of risk that a parent company could insure through a Captive are professional liability, product liability, high hazard, business interruption, workers compensation, or even items such as credit risk, environmental risk, catastrophic risk, and warranty risk. The type of liability to be self-insured is entirely customizable to the client and dependent on the operations of the owning business.
Generally speaking, captives are taxed as an ordinary insurance company.
The primary tax advantage for an underlying business in forming an 831(b) Captive is that premium contributions to the entity are deductible up to $1.2 Million annually. If total premiums retained are less than $1.2 M, the insurer can elect to be taxed only on its investment income, where distributions from an 831(b) Captive are eligible for the reduced dividend/capital gains tax treatment. In a simplified sense, the owner is ultimately able to convert money that would be taxable as ordinary income at corporate rates to money that will be taxable on a capital gains basis. Generally speaking, captives are taxed as an ordinary insurance company. However, there are potential pitfalls to claiming deductibility. Specifically, in order to meet the definition of an insurance company, rules have been established associated with Risk shifting (the transfer of risk to another party) and Risk distribution (the spreading of risk amongst a number of insured parties), which must be adhered to.
Captive insurance companies are not appropriate for all businesses. They are most appropriate for businesses with strong cash flow, who have a strategic imperative to insure their business-specific risks, and who would reap economic benefits as a result of the captive creation (as determined by decreases in the cost of insurance, tax deductions, potential ancillary income, etc.).
Although there are many indirect advantages for the individual parent business owner and his/her family, let’s first look at some of the direct monetary and risk management advantages for the parent business itself:
○ Tax advantages provided by small captive tax election
○ Use of investment portfolio by the owning business
○ Retain underwriting profit and investment earnings
○ Establish partially tax deferred loss reserves
○ Turn what was formerly an expense into a profit center
Business Risk Management Advantages
○ Reduce dependence on commercial insurers
○ Create coverage for previously uninsurable risks
○ Optimize cost of risk (premiums) for the specific business
○ Smooth out insurance market cost volatility
○ Control coverage and claims
○ Obtain direct access to reinsurance markets
○ Utilize flexibility of long term investments surplus
○ Provide Non-Qualified Deferred Compensation for key employees
Some of the indirect advantages of owning a Captive insurance company for the individual owner and his family are associated with estate planning and building/accessing wealth:
○ Asset Protection
○ Wealth Transfer
○ Gift and estate tax savings
○ Wealth accumulation
○ Access to accumulated wealth
Of course, there are also potential disadvantages and risks associated with a Captive insurance company, including but not limited to:
○ Complex and labor intensive administration
○ Substantial startup and ongoing expenses
○ Regulatory and audit risks
The complexities and labor intensiveness, both administrative and legal, associated with properly constructing and running an insurance company according to IRS and domicile regulatory rules mean that gaining the benefits of a small captive is not necessarily a simple process. But with the necessary help of the right qualified team of professionals, an 831(b) Small Captive can easily be launched within a span of three months, and in some cases can be set up for operation in the span of 1-2 weeks. With that in mind, it still may be possible for accounting practice clientele to gain a tax deduction for this year. The primary professionals involved will be the following: Captive Insurance Company Manager,Insurance Broker, Actuary, CPA, Attorney, TPA/Claims professional, Investment Advisor.
The average costs associated with forming a small captive will include approximately $50,000 for formation, a necessary capitalization of the entity of $250,000-$1,200,000, and an annual operating budget which will vary depending on the entity.
4Thought Financial Group has assembled a team of Captive insurance company professionals in order to provide a turnkey program for those clientele for whom a Captive may be appropriate. To determine the appropriateness of such a solution for one of your clients or to learn more about Captives, contact your 4Thought Financial Group advisor or visit www.4TFG.com.
SOURCE: Presentation materials of the Kentucky Captive Insurance Association Conference (Louisville, Kentucky Oct. 30, 2008)
Captive Insurance Company Asset Management
One of the most important components of operating a large insurance company is the proper management of the investment assets that the company holds. This is also true of Captive insurance companies. After all, these assets are ultimately responsible for backing up the risks that the insurance company accepts.
4Thought has performed a great deal of due diligence in developing the expertise and relationships necessary to properly manage these small captive insurance company assets. This is extremely important for the well-being of the Captives we institute and their owners. It is equally important for us, as these portfolios become fee-based assets under management for 4Thought’s CPA partners, internal advisors, and external partnered advisors. With average annual premiums paid into Captives of roughly $1,000,000 per year per client, the cumulative asset buildup and ongoing ancillary income stream generated can be substantial.
Specialized Captive insurance company asset managers should have the expertise necessary to perform the risk-specific portfolio management associated with Captives with attention to the special regulatory and reporting requirements of the entities. It is essential that the assets are managed by specialists in insurance company asset management, and more specifically, specialists in Captive insurance company asset management. Institutional assets of this type cannot be managed in the same way that an individual’s portfolio might be managed under a typical wealth management platform. An exploration of some of the specifics associated with Captive asset management is in order:
Treasuries and Municipal bonds often make up the bulk of a Captive’s portfolio...
Captive insurance company assets will optimally be managed using a diversified institutional style, but must also be adjusted for the overall investment objectives of the captive owners, especially if the captive will be used for estate planning, gifting, or other specialized purposes. Institutional style Modern Portfolio Theory or Liability Driven Investing will generally use a diversified portfolio of high quality fixed income issues (often treasuries and municipals) to provide for liquidity and income needs associated with the risks being undertaken by the insurance company (in anticipation of paying claims). Treasuries and Municipal bonds often make up the bulk of a Captive’s portfolio, with a large portion in the home state to capitalize on tax benefits, and a significant portion in outside states for diversification purposes. Any excess available assets are then invested in some proxy for the “Market Portfolio”, composed of a fully diversified portfolio of equities, bonds, real assets, and alternatives.
For a purely institutional investment objective, this “Market portfolio” portion of the overall portfolio is invested over a theoretically infinite time horizon. However, the actual percentage split between each of the abovementioned asset classes will depend on the specific risks being insured by the entity, and ultimately, on the non-insuring investment objectives of the owner client and his operating business (ie. Estate planning, wealth building, capital preservation, etc.).
The assets of an insurance company are segregated into reserves and surplus, with attention being necessary to both of these and to the reporting requirements of the state of domicile. Reserves are those assets that are required by the Insurance Commissioner to be set aside to administer and pay potential claims arising from the policies issued by the company and currently in force. “Permitted Asset Rules” are often imposed on reserves. They outline the assets that the domicile’s Insurance Commissioner allows captive asset managers to utilize, often limiting them to conservative investments. This is the portion most often composed of cash, treasuries, municipals, and other fixed income. Some domiciles are more liberal with these rules than others. The size of the reserve requirement is most often set by an actuary and may be reviewed or set by the Insurance Commissioner, depending on domicile.
Surplus assets generally do not have any limitations on the types of investment vehicles utilized, and are most optimally invested as mentioned above, in some proxy of the “Market” portfolio or other widely diversified portfolio. The surplus is often low or nonexistent for new Captives, but will grow as premiums are paid in and as underwriting profits are retained. The following are additional important considerations for Captive insurance company asset managers:
○ Managing overall organizational performance: Investment managers cannot run a stand-alone asset portfolio, and thus performance must be viewed in the context of the risks and liabilities taken on by the Captive.
○ Matching assets and liabilities: Each captive will have different claims liabilities, and the portfolio assets will optimally be matched to these, with specific attention paid to the insured risks that the Captive is taking on.
○ Focused liability portfolios: As the insurance company assets are being used to manage the risk of the operating business, they should be invested in assets that are contrary to those of the operating business. Diversification into non-correlated businesses and assets is essential. Small pure captives will likely have an extremely specific concentrated risk in their claims liability as they are insuring against one or a few potentialities. As such, the corresponding portfolio assets must not be negatively affected at the same time that a claim occurs.
○ Portfolio diversification: The inclusion of non-correlated assets extends beyond consideration of the operating business, as the internal portfolio must be well-diversified to reduce long term volatility in keeping with an institutional methodology.
○ Tax efficiency: Captives are treated as a “C” corporation and investment income is taxed at corporate rates, so the tax efficiency of the portfolio will likely be important.
○ Evolution and growth of the captive: As Captives mature, their investment objectives generally become more long-term, necessitating reallocation of the portfolio.
As a result of the specialization necessary to properly manage the assets of small captive insurance companies, 4Thought has actively worked with outside professional renowned in this area to internally develop the competence needed to be effective in this area. This provides us with the final component necessary to build and operate Captives effectively.
Despite the relative infancy of the captive insurance industry, through proper due diligence and human resources development, 4Thought has accumulated exceptional experience in this arena and now supplies our accounting firm and advisor constituents with a robust turnkey Captive Insurance Company platform, including all necessary professionals to build and manage captive insurance companies from the ground up. Our team of experienced experts is composed of all the necessary parties, including captive managers, actuaries, CPAs, attorneys, insurance brokers, TPAs/claims professionals, and investment advisors, each with a specialization in Captives.