Many successful business owners with small- to mid-sized businesses have discovered the potential benefits of forming captive insurance companies, also known as “captives.” Captives may be one of the best business planning tools for business owners, as they can reduce insurance costs, save taxes, protect assets, and transfer business value and family wealth to future generations. Legal changes in the last five years may make this one of the most advantageous times to form a captive.
A captive is an insurance company (often small) that covers the insurance risks of an affiliate. For example, a group of doctors can form and own a captive to insure against medical malpractice risks, or even risks unrelated to medical malpractice, such as the loss of a key employee, wrongful termination, or the loss of electronic medical records or medical license. Captives can be formed in the U.S. or a foreign jurisdiction. A business owner in Arizona for example, can form a captive in a non-Arizona jurisdiction, and still have all of the captive benefits.
Captives Put Doctors Back in Control
In many areas of the country, medical malpractice insurance is a legitimate crisis because of high costs and the lack of control allowed the insured. However, a captive allows physician groups (typically at least
$750,000 in aggregate medical malpractice insurance premiums) to write medical malpractice insurance to shareholders or other doctors. This puts the physicians in control, allowing them to respond to claims, hire attorneys and make settlements on their terms. Better still, if the claims are low, the insurance reserves in the captive can be paid out to the physicians upon retirement (or sooner).
One little-known fact about commercial insurance is that it typically is priced at a 50 percent loss ratio, which means that only 50 cents of every dollar in premiums is expected to be paid out in claims. The insurance company uses the other 50 percent for overhead and profit. Alternatively, captives may allow business owners to retain a portion of their premiums. For example, a group of physicians can form a captive and pay $1 million in total malpractice premiums to the captive. If the group has average claims, each member can keep the extra $500,000 per year inside his or her captive, and as the physicians retire, they can cash out their stock in the captive – an impressive $5 million after just 10 years, not counting investment income. In addition, reinsurance can be obtained for catastrophic risks.
Captives Create Tax Savings
Captives are also attractive because the IRS provides favorable tax treatment for insurance companies. Exemptions are allowed for small insurance companies receiving up to $1.2 million per year, and larger insurance companies can take current deductions for estimated future losses. Both provisions make owning an insurance company an attractive investment. For example, a business owner or company paying $1 million in premiums to a captive will receive a business deduction for the insurance payment, but the captive will not pay tax on the payment. This can result in $400,000 or greater of annual income-tax savings alone.
Most business owners unknowingly self-insure a tremendous amount of risks, including malpractice deductibles, professional liability, employment practices, accounts receivable, administrative actions
[such as Medicare or Health Insurance Portability and Accountability Act (HIPAA)], disability, loss of business license or professional license and business interruption. Self-insurance without a captive is not tax deductible. However, with a properly structured captive, self-insurance can create tax deductions, resulting in tax savings of almost $500,000 per year.
Captives Protect Assets Against Litigation
Captives may be the best asset protection tool available to business owners. Assets in a captive are not reachable by creditors and attorneys, and are only available to pay valid claims—claims approved by the captive company. A captive also allows the use of customized policies that are often too pricey or unavailable through large insurers. Many physicians would like a malpractice policy that would pay legal fees and allow full choice of attorney, but could not be used to pay creditors or claimants, preventing the physician from appearing as a “deep pocket.” Most large insurers do not provide this type of policy.
Typically, when a physician invests in securities or real estate, the assets stay in his or her name, or the name of the practice, leaving assets available to lawsuit claimants, creditors, divorce settlements, or
bankruptcy trustees. Conversely, using a captive, physicians can transfer such funds into an independently operating, fully licensed insurance company. Any lawsuit, claim, divorce, tax or other action against physicians or their practices is completely separate from the captive, meaning the funds in the captive are fully protected against any litigation risks.
Captives Offer Many Benefits
If you are a business owner that has insurance premiums for current business coverage in amounts exceeding $250,000 per year, risks that are uninsured or self-insured, and business income of $1 million per year, you may want to explore how a captive may potentially help improve risk management, reduce taxes and protect assets. Even if premiums are not as large, smaller businesses or groups of individual physicians may form captives to cover the hidden risks of operating a business, possibly reducing the inherent risks caused by these litigious times, and potentially receive the benefits of owning an insurance company. Other options are available for those requiring even smaller premiums. There are a number of exit strategies for captives, such as dividends, loans, salaries or even wind-downs of the captive itself, which can be accomplished easily in a matter of months at favorable tax rates.
Captives are specialized risk and business management tools and require special management expertise. The captive structure must be properly created and maintained by specialists in the field. If it is not, the insurance, asset protection and tax benefits may be lost.
Laws and regulations, including any compensation or investor protection arrangement, may vary from state to state. The information in this article is provided as a guide and is not intended to be legal and/or taxation advice. You are strongly recommended to seek your own legal and taxation advice from suitably qualified professional advisors.
About the Authors:
Rick A. Jaye serves as Chief Financial Strategist of Advanced Equities Asset Management, an affiliate of First Allied Securities, providing management support and financial planning oversight to the company’s Advisor community. His duties also include integrating existing programs into the firm’s portfolio of solutions and developing new services and strategies for clients. Previously, Mr. Jaye spent 23 years providing financial services to high-net-worth business owners and health professionals through his affiliation with several national planning and investment advisory organizations. Mr. Jaye serves on the Board of Directors of Doctors Bank, LLC, a bank holding company in Manhattan Beach, CA. He is a registered investment advisor representative and holds a life, health, and variable insurance license. Mr. Jaye earned an economics degree from the University of California, San Diego. For more information, please visit www.aewm.advancedequities.com, call (407) 496-0205, or email email@example.com.
Karl N. Huish is the President and CEO of Tribeca Strategic Advisors, LLC. Mr. Huish has extensive experience with insurance company formation and management. He graduated cum laude from the University of Chicago Law School, where he was a member of the University of Chicago Law Review and a recipient of the John M. Olin Student Fellowship in Law & Economics. A National Merit Scholar, he graduated magna cum laude from Brigham Young University with a B.A. in Economics, and minors in Japanese and Music. Mr. Huish is an attorney licensed with the state of Arizona. For more information, please visit www.captiveadvisors.com, call (480) 248-6400, or email firstname.lastname@example.org.