Captive Insurance Companies

NOTICE: As a result of proposed new IRS regulations, IRC 831(b) CICs are currently impractical, less useful than in the past, and IRS audit targets. If and when the U.S. Congress brings the arguably lawless and abusive IRS under control through the legislative process, 831(b) CICs might once again become a viable tool for US taxpayers, consistent with the obvious legislative intent of Congress.

With a captive insurance company (CIC), a business owner can improve insurance protection, lower costs, reduce taxes, and build and protect wealth. A captive insurance company is similar in many ways to any other insurance company. It is referred to as “captive” because it provides insurance to one or more operating businesses in the same “economic family”.

Typically, 30 to 50 percent of premium amounts paid for conventional commercially-available insurance policies are used for the insurer’s overhead and profits. A CIC reduces overhead and keeps profits “in the family”.

Insurance for some business risks is often not available from conventional insurers or is simply too expensive. Pass-through businesses (sole proprietors, LLCs and S-Corps) can build a “rainy-day” reserve fund for uninsured risk only with after-tax dollars. In contrast, a CIC can provide affordable insurance for otherwise uninsured risks, as well as build reserve funds using pretax dollars.

Two key tax benefits enable a structure containing a captive insurance company to provide insurance efficiently: (1) insurance premium payments from a business to the captive insurance company are tax deductible; and (2) under IRC section 831(b), a CIC can receive up to $2.65 million of premium payments annually income-tax-free (adjusted for inflation yearly). In other words, so long as insurance purchased from the captive is reasonable and genuine, a business owner can shift up to $2.65 million of business revenues in the form of deductible insurance premiums out of an operating business into the low-tax captive insurance company.

An 831(b) captive insurance company pays taxes only on income from its investments. The CIC can use the Dividends Received Deduction for dividends paid to it from investments in corporation stock. An owner of a CIC typically accesses wealth accumulated in the CIC either through a dividend from the CIC, which is taxed as a qualified dividend at long-term capital gains rates, or as a capital gain upon liquidation of the CIC.

As a side benefit, when insurance premium payments by a business to a CIC result in lowering the owner’s income tax bracket beneath threshold levels, the owner also pays less tax on income and capital gains.

Principal advantages of a captive insurance company include increased control and increased flexibility, which improve insurance protection and lower costs, in addition to tax benefits. As a practical matter, a captive insurance company makes economic sense when the economic family has annual business revenues of $2.5 million or more. A captive’s direct access to reinsurance increases efficiency. A captive insurance company typically participates in a reinsurance pool to diversify risk. A group of businesses or professionals having similar or homogeneous risks can form a multiple-parent captive (or group captive) insurance company and/or join a risk retention group (RRG) to pool resources and risks.

“Turnkey” solutions are available for conducting an initial evaluation, actuarial studies, licensing, and ongoing management of a captive insurance company. The annual cost for such turnkey services is typically about $40,000 to $150,000, which is high but readily offset through lower insurance costs and the potential tax savings and investment growth enabled by a captive insurance company.

For more details, contact this office for a free consultation, tel. 303-440-7800 (see CONTACT page).

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Captive Insurance Company (CIC) Benefits

FACT SHEET — Captive Insurance Company (CIC)

Captive Insurance Company — Reduce Taxes and Build Wealth

Captive Insurance — Details

CIC — Business Evaluation Criteria

Captive Insurance Company (CIC) Benefits

Business Owner: Increase your personal Wealth by starting your own insurance company to insure your business(es).

Save extra $40K to $2 million every year in a CIC, compared to no CIC.

Eliminate wasteful payments to conventional retail insurance companies. With regular retail insurance, 35-50% of your premium pays for the insurer’s profit, overhead and administration.

Get better insurance coverage.

Reduce federal and state income taxes.

CIC replacement for “self-insurance”: A CIC can build an emergency (“rainy day”) fund using no-tax dollars. Example: Without a CIC, to put $100K in an emergency reserve, a business needs about $165K before federal and state taxes. With a CIC, the equivalent substitute costs about $115K.

CIC builds a “nest egg” for its owners. CIC profits accumulate over years, insulated from liabilities of the operating business(es).

At least 29 states and D.C. have passed captive insurance statutes (e.g., Colorado, Delaware, Vermont, New York). Forming a CIC offshore, however, is easier and cheaper, and also avoids state taxes on CIC investment income.

CICs enjoy federal tax benefits under IRC 831(b).

Qualifying Criterion for forming a CIC: Annual gross revenues of at least about $2.5 million in one or more businesses in the same “economic family”.

CIC pays for itself, including “Turnkey” management service: initial evaluation, CIC formation, licensing, ongoing management, actuarial analysis, policy underwriting, reinsurance, claims management, auditing, accounting and tax compliance.

Owner(s) can retain control of CIC accounts and assets.

Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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FACT SHEET – Captive Insurance Company (CIC)

Reduce taxes, build wealth and improve insurance protection

1. A captive insurance company (CIC) provides insurance to one or more operating businesses in the CIC-owner’s “economic family”.

2. Two key tax benefits enable a structure containing a CIC to build wealth efficiently:

2.1 Insurance premium payments from operating business to CIC are tax deductible; and

2.2 Under IRC 831(b), a CIC can receive up to $2.65 million of premium payments annually income-tax-free.

In other words, so long as insurance issued by the CIC is reasonable and genuine, up to $2.65 million of business revenues in the form of deductible insurance premiums can be shifted out of operating businesses into the low-tax CIC. An 831(b) CIC pays taxes only on investment income and gains (no state taxes if formed offshore).

3. Other principal benefits of a CIC include:

– increased control and increased flexibility regarding insurance policies,

premium payments, risk management, claims processing, etc.

– insurance of risks for which retail insurance either does not exist or is

too expensive

– tax-efficient substitute for self-insurance, i.e., a “rainy day fund” of no-tax dollars

– asset protection, wealth accumulation, wealth transfer

4. Formation Criteria:

4.1 Annual gross business revenues of $2.5 million or more

4.2 Annual total business profits + insurance costs of $250K or more

5. Formation, Management, Costs.

5.1 “Turnkey” service includes: initial evaluation, CIC formation, licensing, ongoing management, actuarial analysis, policy underwriting, reinsurance, claims management, auditing, accounting and tax compliance.

5.2 CIC owner(s) can retain control of CIC accounts and assets.

5.3 Typical cost of comprehensive turnkey solution, including cost of reinsurance and claim payments: 12–18% of annual premiums, depending on total premium amount (16–26% in first year). Thus, assuming a typical CIC claims profile, annual CIC profits can be 80—90 % of annual premiums (plus investment income and gains).

5.4 Initial CIC capitalization requirement: 20% of 1st year’s premium amount.

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DETAILED INFORMATION AVAILABLE UPON REQUEST

Thomas Swenson 303.440.7800 tswenson@swenlaw.com

Captive Insurance Company

Reduce Taxes and Build Wealth

Summary: For a business owner paying taxes in the United States, a captive insurance company saves taxes, builds wealth and improves insurance protection. A captive insurance company utilizes two key tax benefits: insurance premium payments from a business to the captive insurance company are tax deductible; and the captive insurance company receives premium payments up to $2.2 million annually income-tax-free.

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Captive Insurance – Details

A captive insurance company (CIC) is an insurance company that insures the risks of operating business entities within the same “economic family”.

1. A CIC benefits its owner(s) generally through a combination of factors.

1.1 As with any conventional insurance premium, premiums paid from a business to the CIC are tax deductible expenses under IRC § 162(a).

1.2 A CIC that elects treatment under IRC § 831(b) is exempt from income taxation of premiums received up to $2.65 million annually (adjusted for inflation). There is a public policy rationale for this favorable tax treatment. By including this provision in the tax code in 1986, the US Congress intended to increase competition among insurers and increase the range of choice for insurance consumers.

1.3 An 831(b) CIC is taxed only on its investment income. The “dividends received deduction” under IRC § 243 provides additional tax efficiency for dividends received from its corporate stock investments.

1.4 Policy premiums paid to the CIC stay in the economic family. Roughly 35–50% of premiums paid for conventional “retail” insurance go to overhead, administration and profit. A CIC reduces those costs. Further, since a CIC invests its reserves and surplus in its own investment accounts, investment gains benefit the CIC’s owner(s) (not an outside insurer).

1.5 A CIC customizes insurance policies directly to the needs and preferences of a business to improve insurance coverage and/or decrease premium costs.

1.6 A CIC customizes policies to insure risks that are otherwise uninsurable or too expensive to insure using conventional insurance. Thus, a CIC is a tax-efficient substitute for “self-insurance” (i.e., no insurance). Instead of using post-tax dollars to make a “rainy-day” fund, up to $2.65 million no-tax dollars (adjusted for inflation) can be shifted as insurance premiums to the 831(b) CIC annually.

1.7 A CIC is particularly well-suited for insuring “business loss” risks; for example, loss of business revenue resulting from loss of key employee or customer, change in government regulations, loss of operating license, etc. (see Section 6 below).

1.8 A CIC has access to reinsurers. For a high-premium policy (e.g., $1 million), a CIC can negotiate directly with a reinsurer for favorable “wholesale” insurance rates.

1.9 A CIC established in an offshore jurisdiction incurs no state income tax liabilities.

1.10 Although a non-831(b) CIC must recognize premiums as income, deductions under IRC § 832(b)(5) for IBNR (incurred but not reported) loss reserves provide arbitrage opportunities to the CIC. The “dividends received deduction” under IRC § 243 also applies.

1.11 A CIC offers flexible financing of annual premiums (and capitalization requirements), accommodating a business’s cash flow problems. For example, a significant portion of annual premiums may be paid at the end of the premium year.

1.12 CIC reserves and surplus are not exposed to general creditors of the operating business. Insurance reserves are available for paying insurance claims only. At the end of a policy term, corresponding insurance reserves become surplus. CIC surplus is not subject to claims and can be invested to maximize return.

1.13 When owned by one or more asset protection trusts, a CIC is a valuable part of an integrated asset protection, wealth accumulation and generational wealth transfer structure.

2. A well-designed CIC managed by a “turnkey” service provider can be operated and properly reinsured for about 12-16% of annual premium payments. For example, if premiums of $1.2 million were paid to the turnkey CIC, total management costs including the cost of reinsurance could be less than $150K, potentially resulting in a profit of $900+K at the end of the year if there were minimal non-reinsured claims.

Generally, a CIC makes good economic sense when the CIC receives about $250K or more in premium payments annually. The insurance licensing agency in the jurisdiction of formation requires initial capitalization of a CIC, typically about 20 percent of the first year’s premiums.

Generally, formation of a CIC is less expensive in one of the traditional foreign jurisdictions than in one of the states in the US. In any case, an 831(b) CIC usually elects to be taxed as a domestic company under IRC § 953(d), its operating account is located in the US, and its investment account (holding the bulk of its assets) can also be located in the US and controlled by its owner(s).

Unrelated owners of businesses (i.e., owners from different “economic families”) can form a multi-owner CIC, a so-called “group captive”. For example, four unrelated owners of businesses having similar types of risk could form a group captive that insures some or all of their operating business entities.

3. CIC assets can be accessed in several ways.

3.1 Dividends. Qualifed dividends are taxed at 15% for taxpayers in lower tax brackets, at 23.8% in highest tax brackets.

3.2 Direct investments. The CIC can invest directly in new business ventures.

3.3 Shareholder loans. Loans should be transacted only with strict formalities at arms length to avoid problems with the IRS and licensing agency.

3.4 Liquidation of the CIC will be treated as a long term capital gain.

4. To qualify as insurance, an insurance policy must shift a genuine risk from the insured to the insurer. A rule of thumb used by actuaries is that there should generally be a 10% chance of a 10% loss of the policy limit. In any case, a good CIC manager employs underwriting and actuarial skills to provide sound insurance coverage, satisfy statutory and IRS requirements, and maximize profits for a given set of circumstances.

To avoid scrutiny by the IRS concerning the appropriateness of deducting insurance premiums under § 162, total annual premiums paid by a business entity to an 831(b) CIC should not exceed 10% of the business’s gross revenue. For example, if a business has annual gross revenues of $3 million, insurance premium payments should not exceed $300,000.

For discussion purposes, risks can generally be characterized as follows.

4.1 Low-frequency/low severity risks. A CIC can issue a policy that is efficiently priced and avoid paying overhead costs of retail insurers.

4.2 High-frequency/low severity risks. Conventional insurance for such risk can be expensive because of high administration costs. The operating business can purchase a low-cost high-deductible (stop-loss) conventional policy and pay the numerous small claims up to the deductible amount. The CIC can then issue an indemnification policy to the business that covers the high deductible.

4.3 Low frequency/high severity risks. A CIC is well suited to insure this type of risk. Operating businesses often pay high insurance premiums for high severity events that rarely if ever occur. Other businesses are completely exposed to such high severity events because they do not insure against them, simply because they occur so rarely. Such risks are efficiently covered when the operating business purchases a conventional low-cost stop-loss (catastrophic) policy and the CIC writes an indemnification policy to cover rare, high-severity events.

4.4 Premiums approach policy limits of insured risk. There is little benefit from conventional insurance if premiums paid are close to policy limits. A CIC can underwrite risks more efficiently by reducing overhead costs and investing the premiums in its own accounts.

4.5 Risks that the business manages better than the industry average. A CIC enables the operating business to customize its insurance to meet its own risk profile, rather than indirectly subsidizing other companies having high claims histories.

5 Business Liability Policies. Liability policies cover claims made against the operating business by third-party claimants.

Direct policies directly pay claimants and pay legal fees and expenses. They could create an asset for plaintiffs to pursue and, therefore, are not preferred for a CIC.

Indemnification policies indemnify, or reimburse, the business for third-party claims that the business pays. The business decides whether it will pay third-party claims. In other words, an indemnification policy could cover the risk for the business without offering an asset for plaintiffs to pursue.

Litigation expense policies pay only legal defense fees and expenses. These are good policies for a CIC because they do not create any rights in favor of third-party claimants.

Business liability risks commonly exist in the following exemplary areas:

Vehicle use

Construction and design defects

Performance liability

Structural defects

Title insurance

Environmental impacts

Product liability

Professional malpractice

Advertising liability

Antitrust

Unfair trade practices (e.g., Lanham Act violations)

Director and officer liability

Errors and omissions

Sarbanes-Oxley violations

Employee relations (e.g., discrimination, sexual harassment)

Failure to investigate/control employees and agents

Libel and slander

Workers Compensation (subject to limitations)

Employee Health Insurance (subject to limitations)

6 Business Casualty Policies. A good type of policy for a CIC to issue is a business casualty (i.e., business loss) policy because only the business can assert a claim and no third-party claimant is involved. Most businesses consciously or unconsciously self-insure many potential business casualty risks.

Business casualty risks commonly exist in the following exemplary areas:

Unforeseen administrative action of a governmental body (e.g., mandatory pandemic lockdowns)

Changes in state or federal law

Judicial or administrative delays

Extortion (even if not provable legally)

Market volatility

Inability of key individual to work

Loss of professional or business license

Loss of key client or investor

Business credit (e.g., credit loss, delayed or withheld loans)

Labor cost or strike

Property damage

Unfair calling of guarantees

Litigation costs

Tax audit defense

Business interruption (e.g., due to computer, supply chain, weather, pandemic)

Lawsuit interruption (i.e., interruption by lawsuit into business operations)

Consequential damages

Contract frustration

Advertising and marketing failure

Business reputation

Commercial crimes (e.g., theft of trade secret)

Currency risks

7. Bonds. CICs are also suitable in some circumstances to underwrite surety, performance and other types of bonds.

Warning & Disclaimer: This is not legal or tax advice.

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Criteria Useful for Evaluating Suitability of a Captive Insurance Company for a U.S. Business Owner

The following criteria and considerations are useful for making a preliminary evaluation of the suitability and practicality of using a captive insurance company (CIC) to insure risks of an operating business.

1. Ownership Structure of Operating Business Influences Ownership of CIC.

Question: What is the ownership structure of the operating business?

A CIC is owned by an operating business (that the CIC insures) or by the owner(s) of the operating business.

1.1 When relatively few owners own a closely-held business, and the ownership is stable over time (i.e., owners are not coming and going frequently, e.g., as in some investment funds), then it is sensible for the owners to own the CIC. The ownership can mirror the ownership of the operating business, so that CIC growth benefits the owners proportionally to their equity in the operating business.

Since the CIC is owned by the owners, assets of the CIC are not exposed to the liabilities of the operating business. As the CIC grows, the fortune of each individual CIC owner grows proportionately.

When total annual premium payments to the CIC do not exceed $2.65 million, the CIC pays no income tax on the premiums.

1.2 When the operating business has many owners (e.g., a public company) or has an unstable ownership over time, then ownership of a CIC by the owners is impractical. In such a case, the CIC is owned by the operating business.

A CIC can benefit the business by insuring the business risks more efficiently. The CIC can reduce the cost of insurance by keeping the profit and overhead costs of conventional insurance in the “economic family” instead. A CIC makes it possible for the business to build an “emergency” or “rainy day” fund using no-tax money if the CIC qualifies for treatment under IRC 831(b) by receiving annual total premiums less than $2.65 million.

2. Gross Business Revenues Determine Maximum Allowable Amount of Insurance Premiums.

Question: What are the annual total, gross business revenues?

Total amount of insurance premiums paid by an operating business should not exceed ten percent (10%) of annual gross revenues. This rule of thumb is applied to avoid the ire of the IRS.

Therefore, since a CIC makes economic sense only if the premiums received add up to about $250K, the operating business should have annual gross business revenues of at least $2.5 million.

3. Operating Business(es) Should Be Able to Afford $250K Premium Payment to CIC.

Question: Does the business’s total amount of excess profits plus current retail insurance premiums equal at least $250K?

If the total of current insurance bills plus excess business profits equals about $250K (preferably more), then it might make sense to form a CIC. The term “excess business profits” means profits that the business owners do not need (to pay the mortgage, buy groceries, etc.) and which could be used to buy extra insurance in a CIC.

A very large business might already be paying $250K or more for insurance.

Typically, a smaller business pays less than $250K for retail insurance. By insuring previously uninsured business risks, the business (or business owner(s)) can effectively shift otherwise taxable income out of the operating business into a CIC.

Warning & Disclaimer: This is not legal or tax advice.

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