Captives the devil's in the details.

• Author: Landis, James P.
• Position: PRIVATE COMPANIES

Many financial executives are already familiar with the concept of forming and operating a small captive insurance company for risk management and wealth-building benefits--and those can be considerable.

In a nutshell, profitable closely held businesses can form a separate, domestic-licensed insurance company to insure business risks. If done properly, the operating company can pay up to $1.2 million a year in premiums to the new insurance company. That amount will be fully tax-deductible to the operating company, and yet the new captive will pay no taxes on those funds, pursuant to section 831 (b) in the Internal Revenue Code--a potential net benefit of roughly $480,000.

The result is: a) the creation of a pre-tax reserve against potential future losses; b) a reduction in third-party insurance expenses; c) a reduction in current tax-able income; d) a deferral of tax events; e) a conversion of ordinary income to capital gains; and f) a potential efficient transfer of wealth to the next generation. And all of this is possible because of clear, black-letter law and specific "safe harbor" Revenue Rulings issued by the IRS in 2002.

So, what is the problem? There are none--as long as your captive provider is very careful with critical details and issues. Otherwise, these details can derail the expected benefits of a captive or worse, increase your costs and create potential economic losses beyond your comfort level. What follows is designed to give readers a roadmap of the key issues involved in forming and operating a section 831(b) captive insurance company so each CFO can better advise company owners.

* Underwriting: The most common shortcoming with most captives is that those who create them do not understand how to underwrite the risks to be transferred to the captive. Too often, captive providers put the risk analysis last rather than first, which is its proper place. Since the tax rules are a very important part of the economics of these captives, providers are typically accountants and lawyers with little or no risk underwriting experience,

As a result, their captives tend to carry too few risks, or the wrong types or wrong amounts of risk. This means that the new insurance company may not create the desired underwriting profit that is an important motive for forming and operating a captive insurance company.

Properly designed captives should hold a carefully diversified portfolio of risks, much like an investment portfolio. Selecting...