captive insurance: a game changer for business clients

there are eight key advantages to captive insurance. just don’t get fooled by the hype.

by ken huffman, cpa
president, captive nation in fort worth, texas. 

while there are several common objections skeptics throw out against captive insurance, including its perception as a hidden tax shelter, there are also multiple advantages.

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here we’ll look closer at the many advantages of a captive for your business owner clients, including flexibility, speed, financing source, wealth building and creditor protection.

opportunity #1: create a giant war chest for the business
like any insurance company, captives can accumulate sizeable assets in reserves and surplus. while these assets back the policies issued by the insurance company, a portion of those assets may be available to the business owner in a worst-case scenario in which the business owner needs the funds to cover a larger catastrophe.

when the time comes, you can take out some of the money, if not all. this is faster and more economical than obtaining a business loan from your bank – with better terms. further, when you take money out of the captive, you’re always paying the lower capital gains tax rates. as i’ll discuss in more detail, money withdrawn from the captive is considered a qualified dividend, so it’s taxed at the lower capital gains rates (15% to 20%).

what’s more, you’re saving money that cannot be touched and that money is credit-protected. if something unfortunate happens to your business – say you get sued or it just goes bankrupt — creditors cannot touch the captive insurance company because it’s a totally separate legal entity. a captive is similar to a trust in that regard.

opportunity #2: cover risks otherwise exposed
businesses often find themselves self-insuring risks (whether they realize it or not) because the risk is so unusual that covering the risk is exorbitantly expensive – if it can be covered at all. these specialized risks are ideally suited for captive insurance.

this is where it’s hard for people to get their heads around a captive. that’s because some of these policies are custom. a commercial insurance carrier is interested in two things: 1) profitability and 2) predictability. for instance, they know there are going to be 1.2 fires per 1,000 houses based on mountains of actuarial data over the years. but there are some policies that a commercial insurance company would never write because they cannot predict if something bad is going to happen and they have no idea how much profit they can make on the policy. however, your captive insurance company can write the policy to cover those risks.

let’s say it’s a $1 million policy to protect you in the event you lose a key client. most commercial insurance companies would never write such a policy because it’s too hard to predict the likelihood of a business losing a key client. but even if you do find an insurer willing to write the policy, it will charge an outrageous premium, say $100,000. but, if the $100,000 in premiums are going into your captive instead, you get a very nice business deduction — and you get to keep that $100,000. that’s a win-win. when you pay the $100,000 insurance premium into your captive, you can deduct that insurance premium from your business as a bona fide insurance expense.

opportunity #3: administer claims on your own terms and timeframe
with a captive, the business owners can administer their own claims on their own terms, and they settle claims quickly before they spiral into something much larger. that’s a unique advantage of a captive. the captive manager will process all the claims for the business owner (i.e., for their captive), not the business owner themselves. that being said, you’ll get your money really fast. the claim process is very simple. you fill out the forms. you make sure it’s a legitimate claim and the money is paid. with regular insurance, as you know, the insurance company takes as long as possible to pay for legitimate claims so it can take the float on the money.

opportunity #4: save money on insurance
with your captive in place, you can draft your own policies, choose your own attorneys, administer your own claims, and save plenty of money while doing so. by incorporating a captive into your insurance strategy, you can save up to 50% on your traditional insurance premiums. you won’t always get those kinds of savings, but i’ve found that business owners typically save 10% to 50% by incorporating a captive. again, a captive is designed to work in conjunction with traditional insurance; it doesn’t replace it. you’re getting the same level of coverage with a captive that you would with traditional insurance, but it’s often much less expensive since you have access to a custom insurance company – yours! having your own captive allows you to participate in wholesale rates of the reinsurance market because you have your own insurance company.

opportunity #5: forces the business to focus on risk management
when claims are being paid from the captive – i.e., from the business owner’s pocket – it’s only natural that the business becomes more focused on enterprise risk management. you want to keep your cash cow producing. why not cover it as well as you possibly can, especially when you can retain all the premiums? this keeps the business healthy and growing. even better, it keeps the value of the business very high.

opportunity #6: create a new business/exit planning
with a captive, you’re creating an entirely new business whose assets you can tap. you tap it, through dividends, whenever you want cash for your regular business, or to purchase a house or to help pay for an acquisition. if you’re thinking about exiting your business in the next two or three years, i urge you to form a captive insurance company soon. that way, you won’t lose market value if a torpedo hits your business out of nowhere. with a captive, you’re transforming a major cost center for your business (insurance premiums) and turning them into an asset. even better, as mentioned earlier, no one can touch the assets including creditors or unscrupulous litigators.

finally, if you end up selling your primary operating business, guess what doesn’t go to the new owners? the captive insurance company. you get to keep all the money that’s accumulated in the captive over the years. it’s investable, and you can do with it whatever you wish. a captive is one of the best retirement vehicles a business owner can have. with regular retirement accounts, you pay tax at ordinary income rates (up to 37%) when you start drawing down your money. but with a captive, when you start drawing your money, you’re only taxed at your capital gains rate (15% to 20%). additionally, there’s no required minimum distribution or early withdrawal penalties and your heirs will get a stepped-up basis.

opportunity #7: create a new revenue source: warranties
remember when you purchased a tv at a major retailer? what’s the last thing they asked at the cash register: “do you want the extended warranty?” that’s a captive. if you have a captive, you can offer the same extra protection for the products or services you offer. warranties, extended warranties, service insurance, and rental insurance can all be offered through your own captive and they’re backed up by reinsurance. so, if there’s a claim, your reinsurance can pay it.

warranties create a whole new revenue stream and they’re a natural add-on to what you offer. clients want this extra layer of protection, and it benefits the business by adding to the bottom line. if fact, many captive owners use this strategy to increase regular sales by not even charging for the extended warranty. this sets them apart from their competition.

opportunity #8: all captive policies are reinsured
all captive policies are reinsured at wholesale rates. captive owners can rest easy knowing they are covered should an event occur. the reinsurance also accomplishes the risk distribution requirement.

conclusion
while the advantages of captive insurance are many, the rules can be complex. to see if captive insurance makes sense for you or a client’s business, please don’t hesitate to reach out. we’re happy to help.

key takeaways

• a captive allows your business-owner clients to insure risks that would be too expensive to cover with conventional insurance. and claims are handled quickly — on the owner’s terms.
• but the benefits of captives go beyond insurance and expense deductions.
• a captive can be an excellent source of financing for your clients’ businesses.
• when structured correctly, captives can be superior to conventional retirement accounts.
• captives can create a new revenue source – warranties.

posted on october 25, 2022