ELITE ADVISOR BEST PRACTICES
Captive Insurance: A Detailed Look - Part Three
Key steps, considerations and caveats (third in a series)
By Randy Fox
- Well-planned, professionally managed captive insurance companies can provide significant benefits for owners of closely held businesses and their families.
- A CIC is not a panacea, nor does it apply to every business owner looking to reduce taxes or seeking an “easy” method of transferring wealth.
- The CIC must have the legitimate purpose of providing insurance and requires legal, accounting, actuarial and risk management expertise.
Previous articles about captive insurance companies (CIC) discussed the basic elements and some possible uses for the CIC. To provide some context for better understanding, a case study that utilized a CIC as part of a family business plan illustrated some of the potential economic opportunities that can be gained when a CIC is implemented. Of course, the decision to implement a CIC is a complex one, and there are many details to consider. As is the case with many planning strategies, the CIC is a continuing commitment, and knowledge of the nature of the ongoing obligations associated with establishing and maintaining a CIC is important.
When a CIC makes sense
First, it is important to recognize that the CIC is not a panacea, nor does it apply to every business owner looking to reduce taxes or seeking an “easy” method of transferring wealth. The CIC must have the legitimate purpose of providing insurance and must conduct its business to that end. To do so requires professional expertise. Legal, accounting, actuarial and risk management skills are all necessary to establish and operate a compliant CIC.
For a business to consider forming its own CIC, it will probably need at least $25 million in annual sales. While there are no absolute prohibitions, it is considered good practice to keep premiums below 25 to 28 percent of total annual revenue. Owners must be aware of the cash flow requirements of the business as well as the CIC and have some confidence that the CIC will be sustainable for a period of time. For a CIC to be cost-effective, the annual premium should be at least $300,000.
Capital requirements and next steps
In addition to the annual cash flow and costs associated with the CIC, capital will be required at formation. After all, an insurance company needs funds above and beyond its first year of premiums collected. Depending on the domicile selected and the funding level, the amount could be anywhere between $65,000 and $500,000. Capitalization is not an “expense” and is therefore not tax-deductible. Since the capital contribution must be made in cash or cash equivalents, ample time to gather the necessary funds should be planned for. Attempting to establish a CIC at year-end to take advantage of the tax planning opportunity may seem like a good idea, but waiting too long to find the necessary cash reserves can be unnecessarily stressful. The most successful CICs are those that are well-thought-out and properly planned.
Many steps are involved in the consideration, formation and operation of a successful CIC. The first steps include:
- A complete analysis of the company, including all of the existing coverage and costs
- A feasibility study
- Domicile discussion (There are currently 30 states and more than 30 foreign countries with CIC legislation.)
- Actuarial review
- Cost/benefit analysis
This process alone can take four to six weeks. Once this data has been developed, the owner must then decide whether to move forward. This entails a complete understanding of all of the implications of the feasibility research findings. One overriding question is determining which risks the CIC will insure. While all businesses face risk, the types of risk that each business will insure will vary. Some of the common risks include excess liability, fiduciary liability, professional liability, terrorism, environmental, surety, worker’s compensation, property damage, and auto and vehicle liability. These examples are not all-inclusive, and a great deal of the preliminary work must be focused on assessing the various risk and insurance opportunities. Once the owner is committed to the CIC, additional steps include:
- Final domicile selection
- Entity formation
- Formation of the CIC
- Application filing to domicile
- Meeting the domicile requirements
- Payment of initial premium
Once the CIC is operational, a number of administrative details must be attended to:
- Collect and verify all premium amounts, confirm with underwriters and actuaries, maintain all policy forms, calculate premiums, and determine rules and loss costs.
- Comply with domicile rules regarding policy issuance, renewal, cancellation and pricing.
- Invoice for and collect and deposit all premiums.
- Investigate, substantiate and pay all claims on behalf of the CIC.
- Examine and execute all contracts.
- Pay all expenses for operation of the CIC.
- Negotiate for third-party reinsurance, if necessary.
- Maintain books and records.
- Perform tax filings and other compliance duties. Pay all domicile-related fees, file regulatory documents, and perform necessary analysis of reserve ratios, solvency and capitalization.
- Supervise audits.
The CIC needs to be well-managed and regularly supervised in order to remain in compliance and to provide the many benefits available. Consider engaging a professional captive management company to perform most of the above-mentioned tasks. Fees commonly range from $50,000 up to $150,000, depending on the scope and complexity of the situation.
There are some professionals who believe that the CIC concept, especially the small captives formed under §831(b), are nothing more than a tax dodge and a sham. However, a well-planned, professionally managed CIC can provide significant benefits to owners of closely held businesses and their families.