deconstructing misconceptions about forming your own insurance company to optimize cash, mitigate taxes and build enterprise value
by ken huffman, cpa
president
captive nation
with continued economic uncertainty, companies of all sizes are looking toward captives as a way to manage high-severity risks and gain enhanced flexibility and greater control over their total cost of risk. and you don’t have to be a global behemoth to form a captive.
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captive insurance can be one of the most effective ways for businesses to protect themselves, optimize cash, mitigate taxes and build enterprise value. however, captives often arouse suspicion among those who are not well-informed. that’s because there have been widely publicized cases of companies using captives as illegal tax shelters, among other abuses.
to separate fact from fiction, i will walk you through some of the most frequently heard objections to captives and explain why those objections are often short-sighted.
objection #1: bogus risk pools
as many of you know, some businesses cannot meet the test for risk distribution without being in a risk pool. a risk pool is an insurance arrangement involving multiple, usually unrelated captive owners who share certain risks through their individual captives. there’s a misconception among some advisors that if a client is still in a risk pool after a few years just because they need the risk distribution, which has been a serious failure in business planning by someone. that’s not necessarily true.
maybe you’ve heard the expression among cynics: “pools are for fools.” that’s simply not true, either. when it comes to risk pools, businesses get into trouble when the risk distribution pool is not actively valid or it isn’t run correctly. i know there are bogus pools out there. so, you have to go with what is called the “safe harbor” rule, in which 51% of your premiums must go temporarily to this risk distribution pool so you distribute your risk properly. it’s important to know what makes a risk pool valid. the safe harbor rule is critically important.
many business owners, attorneys, cpas and even insurance providers may not understand the intricacies of a captive. you have to have risk shifting and risk distribution, which is required for all insurance companies. your business pays premiums to your captive. if you’re not distributing your risk among other people, you don’t have a valid captive, and so you have to distribute your risk.
the most common way to distribute risk is by participating in a risk distribution pool. the other option is via the 12-entity rule. that means if you have 12 or more entities or locations, you don’t have to participate in a risk distribution pool, because you are distributing your risk sufficiently among your 12-plus entities. there can’t be bogus shell entities to make up the 12-entity count. each entity or location must account for 5% to 15% of the overall revenue.
objection #2: incomplete feasibility study prior to the formation
before forming a captive, you should conduct a feasibility study that looks at all aspects of the captive, and that validates its viability, including the economic pros and cons as well as whether the captive will satisfy tests for risk-shifting and risk-distribution. that’s true. i strongly recommend using a third-party independent actuary who is not in-house. that way, there’s little chance of collusion. more on that in a minute.
objection #3: single-line myopia
too often, captives are formed to underwrite one single risk of the organization without looking at the myriad other risks of the enterprise. this often happens when the captive is promoted by an insurance broker who only focuses on helping the client with one line of business. you want to look at all the risks of the business. this way, you have all your coverage options and then ensure all of those risks for however much you can afford. it can be cost-prohibitive to have a captive if you’re just insuring a single line of business. the more insurance you write, the more economical and efficient the captive becomes.
objection #4: poorly drafted policies
conventional wisdom is that policies underwritten by a captive should not be substantially different from policies underwritten by any other insurance company. it’s further believed that a good captive manager will use modified standard industry forms to draft policies.
just remember that traditional commercial policies come with deductibles, exclusions and gaps. there are so many things for which you may or may not get paid. traditional commercial policies are significantly more narrow than captive insurance policies. captive policies are written very widely to pay you if at all possible. so, there are not many exclusions and there’s no deductible. you can customize a policy to cover exactly what you’re looking for.
remember, a captive is your own insurance company. you want it to pay you promptly when you have a claim. with a regular commercial policy, by contrast, you’re dealing with an insurance company whose primary goal is to make money. they don’t want to pay you every time you have a claim, and when they do, it’s not in their best interest to do so promptly. that’s why they have so many gaps and exclusions. essentially, a captive is your own insurance company, but you don’t have to pay for marketing, executive salaries or building expenses that conventional insurance companies require.
objection #5: bogus insurance contracts
according to the u.s. supreme court, “insurance” must include an “insurance contract.” if there is no valid, binding contract, which is fully honored between the captive and the operating subsidiaries, then there is no insurance. it’s fraud. the whole point of a captive is to use it for insurance purposes. so, when you have claims, you file. now, the risk distribution pool will naturally produce some claims, and everybody shares a percentage of those claims. actually, that shows the captive is healthy. do you know of any insurance companies that never have claimed? i don’t, either. yes, there should be claims in your captive. it shows that the captive is operating properly.
objection #6: questionable risks
naysayers will tell you that captives are disguised tax shelters that underwrite extreme longshot risks such as an asteroid hitting the earth or a hurricane swamping lincoln, nebraska. that’s why you need to have someone with credibility as your captive manager. that’s what makes the cpa different. we’re held to higher standards. we have board oversight that will challenge questionable or extremely unlikely risks. that’s why you need to use an objective third-party actuary unrelated to you. their reputation is on the line too.
objection #7: premiums not based on reality
you’ve probably heard stories of a client’s tax attorney, insurance pro and other advisors asking the client: “how much do you want to save in taxes?” and then, they make up some bogus premium amounts just to get the client to their desired savings target. obviously, that’s wrong. the premiums of a captive must be set the same way a traditional insurance company does it – via an arm’s length transaction. the premiums must take into account the risks of the operating subsidiaries, their needs for a particular insurance, and the minimum and maximum coverage required.
again, that’s why it’s important to have an independent actuary, so there’s no collusion.
objection #8: captive sold as a tax shelter
there have been many stories of promoters of tax shelters selling captives as a way to save taxes, with a scant mention of risk management. that’s wrong. a captive is, first and foremost, designed for insurance purposes — it just happens to come with a tax advantage.
i know some business owners and cpas create captives for tax advantage. but as a captive manager, the primary objective is to protect the business and its owners.