- The captive insurance company enables the business to protect itself and the partners against uninsured and underinsured risks.
- Businesses can use CICs to reduce the costs of third-party insurance, improve insurance coverage, gain access to the re-insurance market, and accumulate assets outside of the central business
- The insured business pays annual premiums to the CIC in exchange for normal and usual insurance of underinsured and uninsured risks. The premiums are typically tax deductible as business operating expenses, and the not taxable to the CIC.
You may have never heard of a captive insurance company. However, many physicians and physician-owned practices could benefit significantly by implementing this creative financial solution.
A captive insurance company (CIC) is a fully functional insurance company that is formed by the investor or by the practice in order to underwrite, distribute, and shift risk.
A CIC can make it much easier to write re-insurance, and to write insurance policies on your business and business partners.
Importantly: Medical practices and partners can use CICs to reduce the costs of third-party insurance, improve insurance coverage, gain access to the re-insurance market, and accumulate assets outside of the central business of medicine.
The insured business pays annual premiums to the CIC in exchange for normal and usual insurance of various risks. The premiums are typically tax deductible as business operating expenses, and the not taxable to the CIC.
The CIC offers 5 major advantages:
- Risk shifting. The CIC can shift risk away from the practice and practice partners onto the CIC. This is a service for which the practice would otherwise either have to pay a third party or simply self-insure. The CIC enables the business to protect itself and the partners against uninsured and underinsured risks.
- Income-tax reduction. The implementation of a CIC can significantly reduce the partner’s and the businesses’ income tax burden.
- Estate-tax protection. All the assets contained within the CIC at its formation, and for the lifetime of the company, can be removed from the estates of the owners with proper planning. For physicians or families with large estates, this can be an enormous advantage.
- Asset protection and creditor protection. All assets contained within the CIC carry the maximum rating of protection against creditors.
- Wealth accumulation. Assets held within a CIC are pledged as reserves and surplus, and so can be invested.
831(b) Captive Insurance Companies
Generally, CICs are taxed on all income, as are C corporations and other types of corporations. However, the Internal Revenue Code (IRC; 831[b]]) permits property and casualty insurance companies to take certain deductions against taxable income, including premium income and investment income.
These deductions are often not available to other corporations. As a result, a carefully administered property and casualty CIC may have little or no taxable income from premiums received. The CIC is able to accumulate surplus revenue from underwriting profits. Assuming the CIC carefully chooses its risks, it can accumulate significant assets in a fairly short period of time if claims are few.
Section 831(b) of the IRC states that small insurance companies (with less than $1.2 million of annual premiums) are exempt from income tax on insurance underwriting profit. In the case of a business with substantial risk exposure, such as a medical practice, the owners or partners could insure a variety of currently underinsured or uninsured risks by establishing a small insurance company.
The parent company would receive a tax deduction for the premiums, and the CIC would not have to pay taxes on profits resulting from a favorable loss experience. Further, these tax-efficient funds would be protected from creditors as they remain in the reserves of the CIC in case they are needed to pay claims.
Founding a CIC is complex financial undertaking. Most of our readers should not attempt this maneuver on their own. We strongly suggest that anyone interested in founding a CIC first meet with a group of professionals who are expert in establishing these types of companies. On the other hand, the appropriate practice or investor can realize enormous savings and profits from a CIC.
Use our “Ask Mike” feature to learn more about CICs and similar sophisticated financial tools.
The fees to create a formal insurance mechanism are not insignificant. Professional legal, tax, actuarial, and insurance advice will be required. Importantly, these experts must take the time to integrate the captive into both the existing business structure and into the owners’ personal financial goals. The cost may be $50,000-$100,000 to create the CIC and $40,000-$80,000 annually to maintain it.
What is a CIC Again?
The bottom line is that CICs are fully licensed insurance companies domiciled either in one of the United States or in a foreign jurisdiction that has special legislation for small insurance companies. These types of companies receive favorable tax treatment as a way to promote the accumulation of reserves and the expansion of insurance coverage.
Costs of a Captive
The fees to create a formal insurance mechanism are not insignificant. Professional legal, tax, actuarial, and insurance advice will be required. Importantly, these experts must take the time to integrate the captive into both the existing business structure and into the owners’ personal financial goals. The cost may be $50,000-$100,000 to create the CIC and $40,000-$80,000 annually to maintain it.
To offset the sizable (though tax-deductible) fees, it is important that partners in a practice each contribute in order to reach the $500,000 of annual premiums necessary to run the company. Considering that as much as $1,200,000 of tax-deductible premiums could be paid annually to a CIC (provided the business has enough risk and revenue to warrant such premiums), the fixed costs become less significant as the total amount of tax-deductible premiums increases.
You Can Capture the Profit
Because successful businesses often have significant underinsured and uninsured risks, captives provide a tax-favored vehicle to protect your business from business interruption or potential uninsured claims.
If the CIC owners implement risk-management programs and realize a better-than-average claims history over the life of the captive, they may also realize wealth accumulation for themselves and their families in ways other business owners do not.
The interest level in CICs increases considerably for high-profit-margin businesses. For a very successful and savvy business owner or one who works in the high-liability space, it would be prudent to review the viability of adding a captive.
Captives offer Risk-Management Benefits
The captive must always be established for a legitimate business purpose and must be operated with attention to the details that qualify a company as an insurance company. By following the formalities required for transferring risk, you can achieve levels of financial flexibility that are hard to accomplish without this type of planning.
First, clients can use the captive to supplement existing insurance policies. Deductibles, co-insurance clauses, policy exclusions, and losses above traditional coverage limits could be managed tax-efficiently through the use of a CIC. We often refer to these as holes in traditional insurance policies. Such excess protection gives the client the security of knowing that the company and its owners will have immediate access to cash in the event of a claim not falling under existing coverages.
Second, captives are commonly used to insure against business risks. From the loss of a key employee to losing a contract with a hospital to being subject to a recovery audit contractor (RAC) audit, there are many events that could cripple a medical practice. The captive could have hundreds of thousands or millions of dollars available to the practice or hospital to help bridge the financial gap until the situation is resolved.
Third, there is an entire category of litigation protection policies. Captives are used to add coverage for liabilities excluded by traditional general liability policies, such as wrongful termination, harassment, or even Americans with Disabilities (ADA) violations. Given that these awards can be in excess of $1 million, this could be a valuable coverage.
Fourth, in a market in which insurance is very expensive or difficult to acquire, some businesses will use a CIC to replace traditional insurance. This is most commonly done with medical malpractice (in a risk retention group), health insurance, or Worker’s Compensation insurance.
Use the Savings to Grow Your Business
Funds in the insurance company can be invested in the usual ways that investments are made by insurance companies, through purchasing stocks, bonds, real estate, and other assets.
What Happens if You Successfully Avoid Claims
If the CIC has a favorable loss experience, the owners of the insurance company will ultimately receive a dividend from the insurance company. Currently, the Federal tax rate on dividends is 20%. For older doctors, the company can be owned by a trust for children or grandchildren to create an additional estate-planning benefit as well as asset protection and potential tax benefits.
For answers to finance questions, Ask Mike. Michael Berry, ChFC, is the lead financial advisor for MDalert.com. You can always reach him at mberry@msf-advisors.com.
