Captive insurance companies are a creative way to manage the unique risks and liabilities of ultra-wealthy individuals.
With
a growing number of risks, the affluent are increasingly using captive
insurance companies to help preserve their fortunes. From mitigating
business risks tax-efficiently to mitigating personal risks
tax-efficiently, captive insurance companies- when properly implemented
and managed-can be wonderful tools for the affluent and the firms they
run and own.
For more than 50 years, captive insurance
companies have been available as an alternative to traditional
insurance companies. A captive insurance company is a closely held
insurance company whose insurance business is primarily supplied by a
select clientele who are taking the risk. One popular variation is
where a captive insurance company rents its capital, surplus and legal
capacity to organizations. The sponsor controls the captive insurance
company and generally designs a program where the insured party obtains
benefits that are equivalent to those provided by the standard forms of
a captive insurance company with- out participating in the ownership or
management-or cost-of managing the captive insurance company or its
capital-adequacy requirements. The sponsor usually provides
administrative services, reinsurance and/or an admitted fronting
company, if necessary.
A relatively recent innovation is the
cell captive. It is a single legal entity composed of individual
protected cells. The assets of one cell are not subject to claims
of/against other cells. Therefore, an affluent individual potentially
can rent a cell, thereby segregating out its own risk.
Captive
insurance companies can be formed and licensed within the United States
or in an offshore jurisdiction. A captive insurance company can be used
to provide predictability in insurance coverage and premiums, insure
risks that would otherwise need to be self-insured or to provide
supplemental insurance. Additionally, deductibles, exclusions and
coverage that are difficult to obtain at a reasonable price are all
examples of the types of risks that can be shifted to a captive
insurance company.
Benefits of a Captive Insurance Company
There are numerous benefits to using a captive insurance company. They include:
•Cost savings.
A captive insurance company is almost always cheaper to operate than a
conventional insurer. Thus, a captive insurance company can either
provide lower premiums or build reserves for future premium reductions
or the eventual return of capital to its users.
•Access to the reinsurance market.
Because captive insurance companies are not in the public commercial
market looking for individual customers, reinsurance companies work on
lower expense ratios than direct insurers.
•Coverage availability.
Cyclical changes in the insurance markets, poor underwriting results
and a reluctance to insure certain risks may cause some lines of
insurance to be unavailable, available at a prohibitive cost or
available on extremely restrictive terms. Acaptive insurance company
may be the only realistic way to insure such risks.
•Sharing in investment income.
Premiums and reserves may be invested for the benefit of the captive
insurance company. In conventional insurance the investment income is
profit for the insurer. With a captive insurance company, the affluent
can share in the investment income.
•Cash-flow management. The payment of premiums can be tailored to the requirement of the affluent client.
•Tax advantages.
Premiums paid to the captive may be tax deductible, the receipt of the
premiums by the captive insurance company may be tax-advantaged due to
the deductibility of a captive insurance company's discounted reserves,
and the reserves build up free of income taxes. Tax planning in
relation to a captive insurance facility is complex but can be very
rewarding.
Disadvantages of Captive Insurance Companies
There
are two principle disadvantages to captive insurance companies. One
disadvantage is the cost and time involved in setting them up and
operating them. Formation costs and operating costs can be prohibitive
for a stand-alone, wholly owned captive insurance company. It typically
takes six to nine months to form a captive insurance company. Formation
includes feasibility studies, a business plan and licensing in the
domicile of choice. The cost of formation is approximately $60,000 to
$85,000 or more-sometimes much more. In addition to the costs of
formation, capital, which is usually around $250,000 or more, also is
required. Annual operating costs are $50,000 and up, and this does not
include ancillary legal and audit fees.
Renting a captive
insurance company can substantially reduce the time and cost of
obtaining the benefits of a captive insurance company. The costs of
renting usually are a percentage of the premium to be charged
(generally 7% to 10%) and the time involved could be as a little as two
weeks. Annual operating costs also are typically a percentage of the
premiums and reserves built up (anywhere between 2% and 5%).
Another
disadvantage of captive insurance companies is their complexity. A
captive is a complex corporate structure to form and maintain and
involves significant tax and corporate governance issues. Maintenance
of a captive facility requires extensive expertise. This is where many
users of captive insurance companies have run aground. If the captive
is not set up just right and managed just right, there are going to be
problems-potentially severe, business-ravaging problems.
Domestic or Offshore Domicile
Numerous
states and offshore jurisdictions have developed captive insurance
legislation and are actively promoting their jurisdictions. A domestic
captive insurance company requires adherence to its state's insurance
regulatory regime and is subject to state premium taxes.
An
offshore captive insurance company is subject to the offshore
jurisdiction's insurance regulatory regime and is not subject to tax.
To level the playing field between domestic and offshore captive
insurance companies, premiums paid to an offshore captive are subject
to a 4% excise tax (1% if the premium is for reinsurance). Ownership of
an off- shore captive insurance company is subject to complex United
States tax rules, which seek to subject to United States taxation in-
come accumulated in the offshore jurisdiction by United States owners.
An offshore captive insurance company can make an election to be
treated as a United States insurance company, a section 953(d)
election. The benefit of the election exempts the captive insurance
company from the federal excise tax and withholding taxes, allows the
captive to hold meetings in the United States and to otherwise conduct
business in the United States, and allows the captive insurance company
to invest more freely in United States assets.
Deciding on
whether to use a domestic or offshore captive insurance company can be
a complicated matter. It will depend, very much, on the particular
situation.
Additional Uses Of Captive Insurance Companies Captive
insurance companies are proving very worthwhile for many affluent
individuals and families. They prove to be exceptionally versatile and
can be employed to deal with many unconventional risks and related
concerns. Some of the ways captive insurance companies have been used include: •Insuring the liabilities associated with owning your own plane, such as fuselage damage and passenger liability. •Insuring that the acquisition of small businesses close. •As a way to obtain more liability insurance when traditional sources have been tapped out. •Providing legal cost coverage for tax transactions. •As a substitute for a prenuptial agreement after years of marriage. •To ensure the continuity of a business if key employees leave or die. •As an overlay to traditional insurance for valuables such as fine art. •Protecting the future value of numismatic collections. Overall,
the versatility of captive insurance companies is making them very
attractive to the exceptionally affluent. The ability to recapture
underwriting profit and investment income, flexibility in program
design, broader coverage, access to reinsurance, low program costs and
potential cash refunds of premiums in the event of a positive loss
history. |
Case Study No. 1: The Real Estate Developer
A
real estate developer who was winding out of a real estate limited
partnership had $2 million of negative capital that will be recaptured
and recognized as taxable ordinary income. This person had a
significant risk he wanted to address. He needed excess disability
insurance but was been unable to obtain additional coverage through
conventional insurance companies. A captive proved to be an effective
way to deal with these two issues.
First, he established a new
partnership and transferred in the real estate interest from the
previous partnership, with a $2 million negative capital account. The
partnership then purchased a disability income policy in the amount of
$2 million per occurrence and $6 million aggregate.
The premium
for the policy was $2 million. The $2 million was financed and spread
over several years. The partnership then took a 754 election, which
exchanged the basis in the disability policy for the negative capital
ac- count in the real estate partnership. The partnership then sold the
real estate interest to a family trust. The family trust then sold the
negative capital account for $2 million, resulting in no immediate
recognizable gains. The family trust pays 20% down to the partnership
for this interest and issues a 20-year note for the other 80%. This
will then spread the recognizable gain from the negative capital
account over the next 20 years. This transaction resulted in deferring
the recognition of the negative capital account for several years and
taking care of a disability insurance issue that otherwise would be
very difficult to cover.
Case Study No. 2: Intergenerational Asset Protection
Anyone
who owns their own business is potentially exposed to multiple sources
of liability, to the business proper as well as its owners. If the
business has profits that are left in the name of the company, this
creates a source of funds that would be appealing to any potential
creditors. Additionally, as the profits are passed on to the owners,
they will likewise be available to the creditors of the owners.
By
having the business use a captive insurance company to insure the
various risks that the business has, the business essentially exchanges
cash for an asset (a policy) that is impossible for a creditor to gain
any value from. The profits of the company are moved out of the reach
of a creditor and into the reserves of the insurance company.
The
premiums paid need to be deemed reasonable and be backed by a
third-party actuarial determination of the risk. As with most insurance
premiums paid, they will have a current income tax deduction for the
company. Premiums are generally paid every year, so the business owner
has the opportunity to continue to transfer wealth out of the company
to the captive, very quietly and out of the reach of creditors. This
movement of funds can continue as long as the business needs the risk
coverage and has profits to pay for the premiums.
A captive arrangement can allow a company to cover all kinds of risks that would normally be difficult to mitigate, such as:
• Higher deductibles on commercial coverages.
• Exposure to claims that exceed current coverage limitations.
•
Workplace issues such as workplace violence, sexual harassment,
discrimination and violations of various Department of Labor
regulations.
• Directors and officers liability, along with compliance with Sarbanes Oxley regulations.
• Acts of terrorism or fluctuations in the economy due to terrorism.
• Litigation expense policies.
• Any other risk associated with a particular business and its owners that are normally uninsured.
Although
many captive insurance companies are owned by the business owners, an
excellent wealth transfer strategy is to have the captive owned by the
heirs and/or beneficiaries. When this is built into an overall
intergenerational wealth accumulation and transfer plan, the business
owner's children and grandchildren will get the benefit of the net
underwriting income. So long as the insurance policies and the premiums
cover legitimate risks and the transactions are "arms-length" there is
no risk of fraudulent transfer.
The ownership structure of the
captive insurance company is structured similarly to a family limited
partnership, in that it is owned by a limited liability company with 1%
of the ownership of the LLC representing the managing member and the
remaining 99% held in the heirs' trust. The income of the captive is
divided proportionately, and any growth in the captive assets
completely bypasses the estate of the business owner.
The
bottom line is that this strategy allows the business owner to transfer
wealth to succeeding generations in a very cost-efficient basis. Once
the captive is established and the ownership determined, the only limit
on transferring wealth is the amount of legitimate risks that can be
transferred to the captive insurance company and the premiums paid.
Gary L. Rathbun is president and CEO of Private Wealth Consultants LTD.
Richard L. Sobek is the risk management practice leader for Oswald
Companies.
