Is Using a Captive the Right Move for Your Company?

Adoption of captive insurance arrangements is on the rise — but the IRS’s focus on 831(b) structures has kept some business owners at bay.

The adoption of captive insurance arrangements is on the rise, with middle-market business owners realizing both their risk management and planning benefits. But ambiguity and controversy has kept some business owners and their advisers at bay.

For the past three years, the Internal Revenue Service (IRS) has placed the Section 831(b) small captive structure on its “dirty dozen” list of abusive tax schemes.

This stems from unscrupulous practices set forth by unprofessional captive managers who have led their clients astray by handling the clerical and administrative duties of captive formation, but doing little in the way of verifying whether businesses had bona fide risks that could be funded in a captive insurance affiliate.

Consequently, there's been noise. Those unfamiliar with captives and how they should operate or who should manage them are perpetuating the idea that business owners should shy away from this so-called “unknown” and “volatile” strategy.


The truth about captives

Demystifying captives is at the forefront for qualified captive insurance management companies. Catching wind that captives might not be in the IRS's good graces has left business owners confused as to the legality of forming captives. More so, they are limited in how they should handle their risk and planning initiatives.

The truth is that captives are a legal, proven risk-financing strategy that can provide a positive return on investment during favorable loss conditions. Perhaps even more poignantly, compliance with the IRS and other regulatory bodies is what's going to allow business owners to take full advantage of their benefits. Captives have many moving parts that should be handled by insurance, tax and legal professionals with a proven background and strong track record of designing robust captive arrangements.

Owners, shareholders and CEOs or CFOs of profitable private companies with revenue of $25 million to $250 million are the best candidates for 831(b) captives.

Many property and casualty insurance programs are coming up for renewal on July 1, and business owners are looking to maximize coverage and premium savings. The immediate reaction is to “put coverage out to bid” and let the competitive market serve up the best transaction. In today's soft market, it is likely that commercial policies will be well-priced, with relatively broad coverage terms. But captives covers risk that are not commonly covered in the commercial marketplace. Thus, the timing of captive formation is independent of the market cycle.

The competitive review or bid process involves significant analytical work if done properly, and, unless gaping holes exist in traditional coverage, the savings may be marginal. A much more effective strategy is to perform a top-to-bottom review of all risks a company faces, not just those for which insurance has been purchased to cover. There are many risks that are not insured commercially, for good reason: Risk is infrequent, and coverage is too restrictive. Additionally, insureds are responsible for funding deductibles or retentions associated with traditional insurance programs.

What should be covered?

The fact that you didn't “buy” commercial insurance didn't magically take the risk away. It just means that you’ve knowingly, or unknowingly, elected to “self-assume” that risk. Think of all the risks that publicly traded companies must disclose in their 10-K filings.

Examples of risks that are frequently not insured but can be insured in a captive include loss of a key customer or distributor, loss of a key employee, contingent business interruption, environmental liability, regulatory changes, trade secrets, intellectual property and cyber risk.

Unlike nondeductible reserves that are allocated or set aside, reasonable premiums paid into the 831(b) captive insurance company are tax-deductible. With genuine risk and a properly structured captive, the IRS allows your company to prefund expected losses, deduct the premium paid to your captive and pay claims from those premiums. Under the alternative taxation of the 831(b), only the captive's investment income is taxable.

For a profitable private company with revenues of $25 million to $250 million preparing for an insurance renewal in 2017, a captive review could be an integral part of the strategy and planning. It will help identify the company's real risks, both insured and uninsured, and it will increase awareness of the true cost of risk.

Here are some questions to explore:

  • Are deductibles or retentions realistic?
  • Is the insured getting the maximum premium reduction for assuming more risk?
  • Have insurers declined claims that should be covered?
  • Are insured risks priced unrealistically?

Before repeating the usual competitive bid process for the next insurance renewal, mid-market business owners should carefully evaluate the cost and potential savings of that approach with the long-term benefits of forming and owning an 831(b) captive.

A captive will enable better use of traditional insurance and will remain the cornerstone of the business' risk management strategy.

Those on the fence should filter out the noise and read up on why the IRS wants you to go about captive ownership the right way.

Steven Lonergan, CPCU, is director of business development for Houston-based Capstone Associated Services Ltd., which provides captive insurance planning management services for middle market businesses. Contact him at info@capstoneassociated.com.

 

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Originally published on PropertyCasualty360. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.

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