In today's fast-moving business environment, many successful companies are increasingly choosing to supplement their existing Property and Casualty policy coverages with a Captive Insurance Company to more effectively manage their enterprises risk. A high percentage of these companies are not just Fortune 1000 companies but rather highly successful family-owned businesses searching for a need of a more effective approach to managing the risks of their growing business.

We have found that companies typically choose one of the three options listed below. We often refer to these three options as:

The "A.R.T." of Risk Management. Below is a brief description of each.

Avoid—Avoiding all risks in business is usually not possible, however there are circumstances in business which clients can effectively mitigate and/or avoid some risks with are associated with operating their business. For some businesses this may be an option; however, many businesses rarely can avoid the majority of the risks they face.

Retain or Self Insure—Many businesses retain these risks by self-insuring the economic loss, which may be incurred to the business if one of the risks were to happen. We have found that self-insuring these risks are typically not the most cost-effective way of managing a business’s risks, yet so many continue to do so to their own demise.

Transfer—This is where a captive insurance company can be an effective risk management tool because the business can shift a good amount of their risks to a captive insurance company they own by paying a normal and necessary premium to more effectively manage their business risks while taking a large corporate deduction in the process.

As you’re reading this article, I would like to challenge you to see which option (Avoid, Retain or Transfer) your business owner clients are choosing to manage their business risks. Below we have included a short list of coverages many businesses experience through their normal business cycles which have the ability to be managed through structuring their own captive insurance company.

List of Risks

Administrative Actions, Breach/Release of Data, Computer System Failure, Deductible Reimbursement, Legal Defense Cost Reimbursement, Employee Benefits Plan Administration Error, Employment Practices Liability, Excess Medical Malpractice Defense Cost Reimbursement, General Liability, Difference in Conditions, HIPAA Violations, Injunction Risk, Inventory Spoilage, Legislative and Regulatory Changes, Liquidated Damages, Loss of Franchise, Loss of Key Customer, Loss of Key Employee, Loss of Key Supplier, Loss of Licensure, Loss of Liquor License, Loss of Market, Loss of Referrals, Loss of Rental Income, Medicare Audit, Medicare/Medicaid Reimbursement, Political Risk, Product Contamination, Product Recall Expense, Reputational Risk, Subcontractor Default, Suppliers/Supply Chain Interruption, Trade Credit, Transit Risk, etc.

What Is a Captive Insurance Company?

A captive insurance company is typically a property and casualty insurance company established to provide coverage primarily for the business(es) of the owner(s) of the captive. Think of it as a mini GEICO which exists primarily for the business owner to purchase coverage to insure risks of their operating business(es).

Today, many Fortune 1000 companies, as well as many smaller ones, have decided to go the captive route. No company, however, should start one without completely understanding how they work, and how taxes fit into the plan. From a tax perspective, the key rule is IRC Section 831(b), which allows certain captive insurance companies to be taxed only on their investment income. This means that they do not pay income tax on the premiums they collect or on the earned underwriting profits, provided that net or direct premiums do not exceed $2.3 million per year.

A captive insurance company is a separate entity which will have revenue (insurance premiums, investment gains), expenses (cost to form the captive, claims paid, etc.) and surplus.

As an alternative to being taxed on underwriting profit, a captive may elect to be taxed according to Internal Revenue Code 831(b) which states the following;

• The captive does not pay income taxes on the premium it collects provided the premiums do not exceed $2.3M annually
• The captive may retain surplus from the underwriting profits free from income taxes
• The captive will pay taxes only on its investment earnings

Different Types of Captive Arrangements

Below is a list of the many different types of captive insurance company arrangements available in the market today. Each of these captive structures have many advantages and some disadvantages as well. Just like any other strategy your client will implement for their business, the devil is in the details. As an advisor to your successful business owner clients, I would also state that not all captive providers are the same and that a thorough analysis of their business model and processes is extremely important.

• Single-Owner Captives

• Small and Intermediate Captives

• Group Captives

• Association Captives

• Agency Captives

• Rent-a-Captives

• Protected Cell Companies (PCC)

• Risk Retention Groups (RRG)

What Is the PATH Act and Why Is It Important?

In 2015, Congress passed the PATH “Protecting Americans from Tax Hikes” Act, enacting substantial changes to the law governing 831(b) captive insurance companies. As of 2017, The PATH Act of 2015 directly affects 831(b) captive insurance companies in two primary ways:

• The maximum annual premium amount that qualifying captives may receive is $2,200,000; and is indexed for inflation. As of 2019, the maximum annual premium limit has been increased to $2,300,000.
• 831(b) captives must now meet one of two new “diversification tests.”  These tests were designed to target perceived abuses involving the use of captive insurance companies to leverage estate tax avoidance strategies, increasing the amount of wealth transferred to future generations while avoiding estate and gift taxes.

To accomplish this, Congress modified 831(b) to basically require that the ownership of closely held captive insurance companies must be nearly the same (within 2%) of the ownership of the underlying business. These regulations are applicable to ALL 831(b) insurance companies going forward, regardless of whether they were created before 2017, meaning that, anyone who is looking to establish a captive now or anyone who already established one needs to examine the ownership of that captive to ensure that it complies with the law.

Below is a short overview of the two diversification tests:

Diversification Test #1

This test is sufficed if the captive insurance company receives no more than 20% of its net written premiums (or, direct written premiums, if greater) from a single policyholder. Should a captive insurance company fail to satisfy this test, it will be required to satisfy the second test.

Diversification Test #2

A captive insurance company can also satisfy the diversification requirement through the “Relatedness Test.” This test prohibits a spouse or descendant of an owner of the policyholder from having a percentage interest in the captive that exceeds his or her interest in the policyholder by more than a de minimis amount, here defined as 2%.

To illustrate, let’s assume that the XYZ Company forms XYZ Captive Insurance Company. Let’s also assume that the father owns 70% of the XYZ Company and son owns 30% of the XYZ Company. According to this fact pattern, the son can own no more than 32% of the XYZ Captive Insurance Company. If the son owns more than 32% of the XYZ Captive Insurance Company, then it would not be eligible to make an election under section 831(b).

The 5 Myths and Misconceptions about Captives

Myth #1 – “Captives are a new concept.”

Captives have been around in the states since the 1950s. Until more recently, the cost structures were cost prohibitive to many businesses, however captive arrangements are now more affordable and user friendly and thus being implemented more regularly by small to mid-size business owners.

Myth #2 – “Captives are too expensive for smaller businesses. I heard they are only for Fortune 1000 type companies.”

Captives are no longer cost prohibitive for small to mid-size business owners. Obviously, there are costs associated to your clients setting up their captive insurance company; however, due to the evolution of the industry, companies can benefit from the utilization of a captive for as little as $200,000 to $300,000 in annual premiums.

Myth #3 – “This is a tax shelter and not real insurance.”

Captives do provide valuable risk management advantages and enjoys nice income tax benefits as well. When designed with true risk management in mind, they become a phenomenal complement to many business owners existing property and casualty policies. As with any insurance company, captives are evaluated for valid coverage, liquidity, and solvency standards, along with ensuring appropriate premium levels are being paid.

Myth #4 – “The IRS is looking into captives and is going to be coming down on them.”

The IRS has issued numerous rulings and related guidance defining the rules to follow. Unfortunately, there are many captive arrangements which push the envelope; and the IRS is conducting a campaign to identify those programs and promoters. The key is, utilizing a conservative, compliant structure and partnering with professional advisors who understand the rules and actually abide by them.

Myth #5 – “I was told that 831(b) captives can no longer be owned by third parties or trusts.”

With the passing of the PATH Act, there are new guidelines which need to be adhered to. We address this further in the section “What Is the PATH Act and Why Is It Important.”

Types of Businesses That Can Benefit from a Captive Insurance Company

• Accounting Firms
• Agriculture
• Automobile
• Banking
• Consulting
• Construction
• Distribution
• Entertainment
• Environmental
• Farming
• Family Office
• Financial Services
• Franchise
• Government Contracting
• Healthcare
• Investment Advisory
• Law Firms
• Medical Groups
• Manufacturing
• Professional Athletes & Entertainers
• Sales
• Professional Service Firms (Architects, Real Estate Brokerage, etc.)
• Real Estate Holding Companies
• Restaurants
• Technology Firms
• Transportation
• Many others not listed above

Chad L. Reyes is the President and CEO of Wealth and Legacy Group, a boutique firm specializing in advanced insurance planning. At WLG, they guide highly successful entrepreneurs, industry leaders, and generational families to efficiently create, protect, and transfer their wealth to future generations through the utilization of their L.O.V.E. Based Approach. WLG has built a national collaboration model with CPA firms, law firms, wealth management teams and family offices to more effectively serve HNW and UHNW families and the businesses they own. Mr. Reyes can be reached at 646.402.6300 Ext. 301 or at creyes@WLGPrivateClient.com.

The foregoing information is not intended to be tax, legal, investment, or property and casualty insurance advice and is provided for general educational purpose only. Neither Wealth and Legacy Group, nor its subsidiaries, agents, or employees provide tax, legal, investment, or property and casualty insurance advice. You should consult with your proper tax, legal, and financial advisor regarding your situation.