Risky Business

June 7, 2007

Risky Business - By Gary L. Rathbun , Richard L. Sobek - 06/1/2007

With a growing number of risks, the affluent are increasingly using captive insurance companies to help preserve their fortunes. From mitigating business risks tax-efficiently to mitigating personal risks tax-efficiently, captive insurance companies- when properly implemented and managed-can be wonderful tools for the affluent and the firms they run and own.

For more than 50 years, captive insurance companies have been available as an alternative to traditional insurance companies. A captive insurance company is a closely held insurance company whose insurance business is primarily supplied by a select clientele who are taking the risk. One popular variation is where a captive insurance company rents its capital, surplus and legal capacity to organizations. The sponsor controls the captive insurance company and generally designs a program where the insured party obtains benefits that are equivalent to those provided by the standard forms of a captive insurance company with- out participating in the ownership or management-or cost-of managing the captive insurance company or its capital-adequacy requirements. The sponsor usually provides administrative services, reinsurance and/or an admitted fronting company, if necessary.

A relatively recent innovation is the cell captive. It is a single legal entity composed of individual protected cells. The assets of one cell are not subject to claims of/against other cells. Therefore, an affluent individual potentially can rent a cell, thereby segregating out its own risk.

Captive insurance companies can be formed and licensed within the United States or in an offshore jurisdiction. A captive insurance company can be used to provide predictability in insurance coverage and premiums, insure risks that would otherwise need to be self-insured or to provide supplemental insurance. Additionally, deductibles, exclusions and coverage that are difficult to obtain at a reasonable price are all examples of the types of risks that can be shifted to a captive insurance company.

Benefits of a Captive Insurance Company

There are numerous benefits to using a captive insurance company. They include:

Cost savings. A captive insurance company is almost always cheaper to operate than a conventional insurer. Thus, a captive insurance company can either provide lower premiums or build reserves for future premium reductions or the eventual return of capital to its users.

Access to the reinsurance market. Because captive insurance companies are not in the public commercial market looking for individual customers, reinsurance companies work on lower expense ratios than direct insurers.

Coverage availability. Cyclical changes in the insurance markets, poor underwriting results and a reluctance to insure certain risks may cause some lines of insurance to be unavailable, available at a prohibitive cost or available on extremely restrictive terms. Acaptive insurance company may be the only realistic way to insure such risks.

Sharing in investment income. Premiums and reserves may be invested for the benefit of the captive insurance company. In conventional insurance the investment income is profit for the insurer. With a captive insurance company, the affluent can share in the investment income.

Cash-flow management. The payment of premiums can be tailored to the requirement of the affluent client.

Tax advantages. Premiums paid to the captive may be tax deductible, the receipt of the premiums by the captive insurance company may be tax-advantaged due to the deductibility of a captive insurance company's discounted reserves, and the reserves build up free of income taxes. Tax planning in relation to a captive insurance facility is complex but can be very rewarding.

Disadvantages of Captive Insurance Companies

There are two principle disadvantages to captive insurance companies. One disadvantage is the cost and time involved in setting them up and operating them. Formation costs and operating costs can be prohibitive for a stand-alone, wholly owned captive insurance company. It typically takes six to nine months to form a captive insurance company. Formation includes feasibility studies, a business plan and licensing in the domicile of choice. The cost of formation is approximately $60,000 to $85,000 or more-sometimes much more. In addition to the costs of formation, capital, which is usually around $250,000 or more, also is required. Annual operating costs are $50,000 and up, and this does not include ancillary legal and audit fees.

Renting a captive insurance company can substantially reduce the time and cost of obtaining the benefits of a captive insurance company. The costs of renting usually are a percentage of the premium to be charged (generally 7% to 10%) and the time involved could be as a little as two weeks. Annual operating costs also are typically a percentage of the premiums and reserves built up (anywhere between 2% and 5%).

Another disadvantage of captive insurance companies is their complexity. A captive is a complex corporate structure to form and maintain and involves significant tax and corporate governance issues. Maintenance of a captive facility requires extensive expertise. This is where many users of captive insurance companies have run aground. If the captive is not set up just right and managed just right, there are going to be problems-potentially severe, business-ravaging problems.

Domestic or Offshore Domicile

Numerous states and offshore jurisdictions have developed captive insurance legislation and are actively promoting their jurisdictions. A domestic captive insurance company requires adherence to its state's insurance regulatory regime and is subject to state premium taxes.

An offshore captive insurance company is subject to the offshore jurisdiction's insurance regulatory regime and is not subject to tax. To level the playing field between domestic and offshore captive insurance companies, premiums paid to an offshore captive are subject to a 4% excise tax (1% if the premium is for reinsurance). Ownership of an off- shore captive insurance company is subject to complex United States tax rules, which seek to subject to United States taxation in- come accumulated in the offshore jurisdiction by United States owners. An offshore captive insurance company can make an election to be treated as a United States insurance company, a section 953(d) election. The benefit of the election exempts the captive insurance company from the federal excise tax and withholding taxes, allows the captive to hold meetings in the United States and to otherwise conduct business in the United States, and allows the captive insurance company to invest more freely in United States assets.

Deciding on whether to use a domestic or offshore captive insurance company can be a complicated matter. It will depend, very much, on the particular situation.

Additional Uses Of Captive Insurance Companies

Captive insurance companies are proving very worthwhile for many affluent individuals and families. They prove to be exceptionally versatile and can be employed to deal with many unconventional risks and related concerns.

Some of the ways captive insurance companies have been used include:

Insuring the liabilities associated with owning your own plane, such as fuselage damage and passenger liability.

Insuring that the acquisition of small businesses close.

As a way to obtain more liability insurance when traditional sources have been tapped out.

Providing legal cost coverage for tax transactions.

As a substitute for a prenuptial agreement after years of marriage.

To ensure the continuity of a business if key employees leave or die.

As an overlay to traditional insurance for valuables such as fine art.

Protecting the future value of numismatic collections.

Overall, the versatility of captive insurance companies is making them very attractive to the exceptionally affluent. The ability to recapture underwriting profit and investment income, flexibility in program design, broader coverage, access to reinsurance, low program costs and potential cash refunds of premiums in the event of a positive loss history.

Case Study No. 1: The Real Estate Developer

A real estate developer who was winding out of a real estate limited partnership had $2 million of negative capital that will be recaptured and recognized as taxable ordinary income. This person had a significant risk he wanted to address. He needed excess disability insurance but was been unable to obtain additional coverage through conventional insurance companies. A captive proved to be an effective way to deal with these two issues.

First, he established a new partnership and transferred in the real estate interest from the previous partnership, with a $2 million negative capital account. The partnership then purchased a disability income policy in the amount of $2 million per occurrence and $6 million aggregate.

The premium for the policy was $2 million. The $2 million was financed and spread over several years. The partnership then took a 754 election, which exchanged the basis in the disability policy for the negative capital ac- count in the real estate partnership. The partnership then sold the real estate interest to a family trust. The family trust then sold the negative capital account for $2 million, resulting in no immediate recognizable gains. The family trust pays 20% down to the partnership for this interest and issues a 20-year note for the other 80%. This will then spread the recognizable gain from the negative capital account over the next 20 years. This transaction resulted in deferring the recognition of the negative capital account for several years and taking care of a disability insurance issue that otherwise would be very difficult to cover.

Case Study No. 2: Intergenerational Asset Protection

Anyone who owns their own business is potentially exposed to multiple sources of liability, to the business proper as well as its owners. If the business has profits that are left in the name of the company, this creates a source of funds that would be appealing to any potential creditors. Additionally, as the profits are passed on to the owners, they will likewise be available to the creditors of the owners.

By having the business use a captive insurance company to insure the various risks that the business has, the business essentially exchanges cash for an asset (a policy) that is impossible for a creditor to gain any value from. The profits of the company are moved out of the reach of a creditor and into the reserves of the insurance company.

The premiums paid need to be deemed reasonable and be backed by a third-party actuarial determination of the risk. As with most insurance premiums paid, they will have a current income tax deduction for the company. Premiums are generally paid every year, so the business owner has the opportunity to continue to transfer wealth out of the company to the captive, very quietly and out of the reach of creditors. This movement of funds can continue as long as the business needs the risk coverage and has profits to pay for the premiums.

A captive arrangement can allow a company to cover all kinds of risks that would normally be difficult to mitigate, such as:

Higher deductibles on commercial coverages.

Exposure to claims that exceed current coverage limitations.

Workplace issues such as workplace violence, sexual harassment, discrimination and violations of various Department of Labor regulations.

Directors and officers liability, along with compliance with Sarbanes Oxley regulations.

Acts of terrorism or fluctuations in the economy due to terrorism.

Litigation expense policies.

Any other risk associated with a particular business and its owners that are normally uninsured.

Although many captive insurance companies are owned by the business owners, an excellent wealth transfer strategy is to have the captive owned by the heirs and/or beneficiaries. When this is built into an overall intergenerational wealth accumulation and transfer plan, the business owner's children and grandchildren will get the benefit of the net underwriting income. So long as the insurance policies and the premiums cover legitimate risks and the transactions are "arms-length" there is no risk of fraudulent transfer.

The ownership structure of the captive insurance company is structured similarly to a family limited partnership, in that it is owned by a limited liability company with 1% of the ownership of the LLC representing the managing member and the remaining 99% held in the heirs' trust. The income of the captive is divided proportionately, and any growth in the captive assets completely bypasses the estate of the business owner.

The bottom line is that this strategy allows the business owner to transfer wealth to succeeding generations in a very cost-efficient basis. Once the captive is established and the ownership determined, the only limit on transferring wealth is the amount of legitimate risks that can be transferred to the captive insurance company and the premiums paid.

Gary L. Rathbun is president and CEO of Private Wealth Consultants LTD. Richard L. Sobek is the risk management practice leader for Oswald Companies.