New tax rules boost captive insurance for smaller firms.

• Author: Landis, James P.
• Position: PrivateCOMPANIES

Risk management has just gotten easier for privately held, middle-market companies. In light of difficulties in certain insurance markets, such as Florida and the Gulf Coast, this may appear hard to believe.

But by combining an in-depth "risk optimization program" with the creation of a captive insurance company, financial executives can now better manage and finance their self-insured risks. Fairly new tax rulings have now made captive insurance companies a very efficient risk management tool, as well as a vehicle for long-term wealth planning for owners of closely held businesses.

Risk optimization is the process of evaluating a company's risk tolerance, based upon financial performance, historical insured and uninsured exposures/losses and other risk management procedures. More often than not, mid-sized companies are either over-insured or grossly underinsured. The goal of risk optimization is to find a balance between risk retention and risk transfer.

Companies that may be over-insured can usually afford to retain more risk and thereby release cash for more productive uses than buying insurance. Under-insured companies, however, run the risk of loss and damage to their capital base.

Once a company identifies its acceptable level of retained risks, it faces the issue of how to finance those risks and how to prepare financially for a possible loss. Typically, companies simply keep enough cash on their balance sheets or establish lines of credit to be used in an insurance emergency. These methods are not, of course, very efficient.

Virtually all of the largest corporations in the U.S. have long addressed this problem by forming their own captive insurance company. These captives typically have few, if any, tax benefits, but find efficiencies through better control over the risk management of retained risks and through access to the (sometimes) less expensive reinsurance market. Smaller companies, however, always found that forming a captive insurance company was difficult to justify on the basis of the economics of the transaction.

New Changes in the Tax Law

But, things have changed. Captive insurance companies are no longer just for the large corporations with armies of accountants and lawyers. Recent tax law changes now favor the formation of fairly small captive insurance companies, creating a useful risk-transfer mechanism in a tax-efficient environment for mid-sized companies.

Few financial executives or their advisors are aware that...