Use of Captive Insurance in Estate and Business Planning

• Publication year: 2008
• Author: By Gordon A. Schaller, Esq. and Scott A. Harshman, Esq.

USE OF CAPTIVE INSURANCE IN ESTATE AND BUSINESS PLANNING

By Gordon A. Schaller, Esq.^* and Scott A. Harshman, Esq.^**

I. INTRODUCTION

Many businesses face rising insurance costs and increasing self-insured risk. In response, an increasing number of businesses are implementing captive insurance programs.

A captive insurance company is a subsidiary or affiliate of a business entity (or entities) formed to insure or reinsure the risks of those entities. The affiliated insured companies may deduct reasonable insurance premiums paid to a properly structured captive. In addition, the captive insurance company is provided with special tax incentives, so that premium income may be nontaxable. This creates an exceptional opportunity for the owners of mid-market companies to transfer substantial wealth without gift, estate or generation-skipping tax consequences to the extent the captive insurance company is capitalized and owned by or in trust for younger generations. Captive ownership can also be structured to provide incentives for key management and business succession. These results are available by statute and IRS "safe harbor" rulings to carefully planned and implemented captives.

This article will describe the Internal Revenue Code,¹ case law and ruling requirements for a valid captive insurance company and focus on the estate and business planning opportunities that result.

II. OVERVIEW

A. What is a Captive Insurance Company?

A captive insurance company is a corporation formed either in a U.S. or foreign jurisdiction for the purpose of writing property and casualty insurance to a small, usually related group of insureds. The captive must be formed as a C corporation and is subject to Chapter L and Chapter C of the Code. There are many types of captive insurance companies, including pure captives, group captives, risk retention groups, and producer-owned reinsurance companies. This article focuses on pure captives, which insure risks of business entities related by ownership to the captive.

B. History of Captive Insurance

Modern captives began in Bermuda in the early 1960's, and captive insurance was formalized in the late 1970's, with a medical malpractice captive for Harvard University. In recent years, the growth of captive insurance and related risk transfer mechanisms has boomed, driven by businesses seeking to better manage insurance needs, including cost, coverage, service and capacity. When segregated cells, risk retention groups and rent-a-captives are included, the number of captive and alternative risk arrangements today is in the tens of thousands, and is rapidly growing. The market for alternative risks far exceeds $100 billion of annual insurance premiums.²

In the early years, captives were commonly used by Fortune 500 companies to reduce insurance costs and commissions. These large organizations insured general liability, workers' compensation, auto and property insurance through their captives, which became a profit center for the entire organization. Between 2001-2008, the IRS issued guidelines that provided clarification and "safe harbors" for captive insurance companies. These new rulings have opened the door to mid-market, privately owned captives, and the resulting estate planning and business succession opportunities.

C. Reasons to Form a Captive Insurance Company

The focus of the pure captive is to economically assume risk that is currently self-insured. A company "self-insures" many ways, including through increasing deductibles on existing policies, assuming all or some of the risk of traditional insurance, or merely taking on the risks of existing deductibles and exclusions. Often companies are forced to self-insure because certain types of coverage are unavailable or difficult to obtain, often due to historic loss experience for a sector or industry, such as medical malpractice, or conditions such as environmental, construction defect, earthquake, or wind and weather.

Financially, captive insurance is superior to conventional insurance in that conventional insurance is typically provided on a guaranteed cost basis; there is little incentive to improve risk management, since there is no participation in the profitability of the insurance program. With a captive insurance company, the parent or related companies will benefit from good claims experience, and surplus in the insurance company inures to its shareholders.

Since the client controls the captive insurance company, policies can be custom designed. This flexibility allows the captive owner to craft the policy to meet its specific needs from time to time in terms of deductibles, scope of coverage, levels of risk and premiums.

Control of the captive also allows for control of the claims process - this is important as there is often litigation with third party insurance companies regarding coverage issues. Control of the captive also means that the client controls asset investment, a major benefit not available for premiums and surplus paid to a conventional property and casualty company.

Finally, significant income tax benefits are available for captive insurance companies that are formed and administered in compliance with the Internal Revenue Code and Treasury Regulations. These benefits are explained in detail below, together with the numerous estate planning and business planning opportunities.

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III. PRACTICAL ISSUES WITH FORMATION OF A CAPTIVE

A. Risks to Insure

The first step in evaluating if a captive is appropriate is to review the client's existing insurance coverage, which typically includes workers' compensation, errors and omissions, employee practices and general liability. Often these coverages are inadequate. Many captives are utilized to take on a large deductible for such policies. The captive seldom replaces traditional policies, but rather augments and provides excess coverage and coverage for many exclusions and differences in condition. Common uninsured risks, in addition to deductibles and exclusions, are business interruption, loss of key customers, credit default, extended warranty, directors and officers, errors and omissions, litigation defense, construction defect, mold, earthquake, environmental, and wind and weather.

B. Choice of Jurisdiction

Early in the process, the client must make an important decision: domicile for the captive. The client should consider the economic and political stability of the jurisdiction, tax and regulatory environment, local employment issues and the quality and quantity of service providers such as insurance managers, auditors and legal counsel. Cost, administrative flexibility and geographic proximity are also relevant. A domicile must have the regulatory and business infrastructure to support the effective operation of an insurance company.

The captive insurance marketplace is worldwide. Several states have modern captive insurance statutes, including Utah, Nevada, Montana, Kentucky, Arizona, Vermont, Delaware, District of Columbia, and Hawaii. The number of states enabling captive insurance continues to grow in response to recent IRS "safe harbor" rulings. However, there are regulatory and financial requirements for domestic captives that do not exist in certain foreign domiciles. For example, a licensed captive may be subject to compliance with rules and regulations of the National Association of Insurance Commissioners ("NAIC"). The NAIC has complex regulations with respect to the amount of minimum capital ("risk-based capital"), and the basis for calculating reserves for future liabilities ("statutory accounting").

Captive incorporations offshore have also continued to grow for both public and private companies in places such as Bermuda, the British Virgin Islands and the Cayman Islands, where initial capitalization requirements and incorporation expenses are often lower and the insurance regulators support creative structuring of captives.

C. Capitalization of Insurance Company

Most domestic and foreign jurisdictions require a minimum capitalization. For example, Utah requires a minimum of $250,000 in capital. Some industry professionals will suggest a minimum ratio of premium to capital such as three-to-one or four-to-one. For example, if the first year premium paid to the captive is $1 million then the capital required under a four-to-one ratio would be $250,000. However, the safest approach is to have an actuary analyze the amount of capital that should be contributed as part of the captive's business plan. This analysis will project the necessary capital, based upon the type of coverage provided, the amount of coverage, and the loss history of the insureds.

D. Costs of Formation

Most captives are formed by outside consultants on a "turn key" basis. Costs include attorneys and actuarial fees, and costs associated with the regulatory licensing process, underwriting and issuing policies. In addition, the client typically engages personal tax and legal advisors to advise on ownership of the captive, business entity structures and tax planning. Total formation costs can range from $60,000 to $100,000 for most mid-market companies.

E. Costs of Administration

Likewise, most captives are also administered by outside consultants, often on a "turn key" basis. The services provided include claims administration, accounting, actuarial reserve analysis, yearly audit, tax returns and other state compliance requirements. Annual administration costs can range from $50,000 to $75,000 for most captives formed by mid market companies.

IV. WHAT CONSTITUTES "INSURANCE" FOR TAX PURPOSES

Insurance companies that are not life insurance companies are subject to special federal income tax provisions under Subchapter L of the Code.³ These provisions define an "insurance company" as "any company more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies."⁴ Regulations caution that:

though its

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