The Definitive Guide to Captive Insurance Companies: What Every Small Business Owner Needs To Know About Creating and Implementing a Captive America's top corporate estate, tax and asset protection attorney provides readers with true insight on multiple key sophisticated planning techniques for small business owners implementing captive insurance companies. The Definitive Guide to Captive Insurance Companies will provide readers with the ability to: - Reduce income taxation, - Increase cashflow, - Self-insure, - Protect personal and business assets, and - Enhance estate planning.
The Definitive Guide to Captive Insurance Companies
What Every Small Business Owner Needs to Know About Creating and Implementing a CaptiveBy Peter J. StraussAuthorHouse
Copyright © 2011 Peter J. Strauss, J.D., LL.M.
All right reserved.ISBN: 978-1-4670-3866-9 Contents
MEET THE AUTHOR.......................................................................................................................viiACKNOWLEDGEMENTS......................................................................................................................ixPREFACE...............................................................................................................................xi1 FUNDAMENTAL PRINCIPLES: WHAT YOU NEED TO KNOW ABOUT CAPTIVE INSURANCE...............................................................12 HOW TO MINIMIZE YOUR ESTATE AND INCOME TAXES WITH CAPTIVE INSURANCE.................................................................233 PUTTING THE CAPTIVE INSURANCE COMPANY TO WORK FOR YOU: HOW TO SET UP A CAPTIVE AND START INSURING YOUR BUSINESS.....................444 WHAT YOU NEED TO KNOW ABOUT MANAGING YOUR CAPTIVE INSURANCE COMPANY: TAX AND REGULATORY REQUIREMENTS................................675 PROTECTING YOUR ASSETS FROM LAWSUITS WITH A CAPTIVE INSURANCE COMPANY...............................................................77APPENDIX: CAPTIVE INSURANCE CASES AND RULINGS.........................................................................................90
Chapter One
FUNDAMENTAL PRINCIPLES: WHAT YOU NEED TO KNOW ABOUT CAPTIVE INSURANCE
Life is filled with risks. Every day, you take risks in your business. Some of these risks are calculated on your part; after all, you must take on these risks in order to make a profit in your business. Other risks may not be so well known to you, or they may not be at the forefront of your mind on a regular basis. As much as you may carry insurance on the truck used to make deliveries in your business, you may not carry similar insurance on the computer used to track your deliveries. There may even be some risks which you know about but which are simply too expensive for you to insure.
Unfortunately, unless you pay an insurance coverage a premium to insure your business against all of these risks, there is no tax benefit to self-insurance. According to the American Institute of Certified Public Accountants (AICPA), most businesses unknowingly self-insure a great part of their risks from daily business activities. This same AICPA report says:
Self-insurance, whether funded out of company reserves or personal after-tax savings is not tax-deductible. To compound the problem, smaller deductibles are expensive and not tax-beneficial.
The solution, according to this AICPA report, is a captive insurance company. Properly structured, "self-insurance through a captive structure can create substantial tax deductions, resulting in tremendous tax savings."
Captive insurance produces material tax savings that help you to save real dollars in your business. Furthermore, captive insurance helps businesses to combat inadequate insurance and excessively high premiums. Yet, most business owners have no idea what captive insurance is, much less how to use it to their advantage.
Captive insurance is a strategy whereby your business purchases insurance coverage from an insurance company that you own and control, i.e., a "captive" insurance company. The premiums paid by your business are tax deductible. Meanwhile, the premiums that your captive collects are tax-free. You read that correctly: The premiums collected by your captive insurance company are tax-free.
Suppose your business pays $1 million in premiums to your captive insurance company every year. Assume further that your combined federal and state income tax rate is 50%. Your business would deduct $1 million from its taxable income, saving you $500,000 each year. Furthermore, that $1 million would be received free of income tax each year inside your captive insurance company. You would pay less in taxes and have more money in the bank.
In this first chapter, I will start you out with a brief history of captive insurance. I will share with you how captive insurance came to evolve into an insurance strategy with tremendous tax savings potential. I will then provide you with an overview of the fundamental legal and tax principles governing captive insurance planning. Finally, I will walk you through an overview of the captive insurance industry so that you have a better understanding of how captive insurance works and how captive insurance companies operate to save their owners money. By the end of this chapter, you should have a basic understanding of what captive insurance is and how it works. More importantly, you should gain some insight into the tremendous tax savings involved by utilizing captive insurance in your business.
A Brief History of Captive Insurance
To better understand how captive insurance works, I would first like to walk you through the origin of captive insurance. It all began with a company in Youngstown, Ohio, called Youngstown Sheet and Tube Company, and their insurance agent, a man by the name of Fred Reiss.
The City of Youngstown and the Steel Industry
Youngstown, Ohio is a rough-and-tumble Rust Belt city sitting on the Mahoning River, almost in a straight line halfway between Cleveland to the northwest and Pittsburgh to the southeast. The city first earned its reputation for holding large coal deposits. With the discovery of iron ore nearby, Youngstown also became a center for steel production.
At the turn of the 20th century, as large national steel companies were making their way into Youngstown, a group of local businessmen founded the Youngstown Sheet and Tube Company. At the same time, labor unions were beginning to make inroads into the Youngstown steel factories.
Youngstown Sheet and Tube gradually earned a reputation for not being easy to intimidate. In 1916, workers at the company went on strike, setting fire to a portion of the city. Afterward, East Youngstown was renamed the City of Campbell in honor of the company's president, who had stood up against the strikers. In 1937, unions banded together and staged what became known as the Little Steel Strike. Youngstown Sheet and Tube joined a group of steel mills that resisted signing an agreement with the strikers.
The Steel Seizure Case
Later, in the early 1950s, labor unions again confronted Youngstown Sheet and Tube, pressing for wage increases amidst the Korean War. As steel mills were under government-imposed price controls, the management at Youngstown Sheet and Tube refused to give into the strikers' demands. When the unions sought help from a labor-friendly White House, President Truman in 1952 issued an executive order seizing Youngstown Sheet and Tube's steel mills. The company's lawyers immediately went to court to fight the presidential decree as unlawful.
The resulting U.S. Supreme Court decision in Youngstown Sheet & Tube Co. v. Sawyer, became known as the "Steel Seizure Case" and was a rebuke of the U.S. President's authority. The Supreme Court ruled that the President could not seize private property without specific authorization in the Constitution or under an act of Congress.
Fred Reiss, the Inventor of Captive Insurance
Around the time that Youngstown Sheet & Tube was fighting President Truman over the right to control its own destiny, Frederic Mylett Reiss entered the picture. Reiss had served in the Navy and gone through college on the GI Bill. After college, he went to work for the Ohio Inspection Bureau, assessing insurance risks for large plants and steel mills.
Working next as an underwriter in Cleveland, Reiss became familiar with the techniques for calculating premiums and drafting reinsurance agreements. Finally, he accepted a position with an insurance agency in Youngstown, where he sought to put his talents to good use.
Reiss began working with Youngstown Sheet and Tube, helping them to procure insurance for their steel mills. At that time, most of the policies for large factories and steel mills were underwritten among a handful of large insurance companies. There was a limited supply of available insurers, and premiums were skyrocketing. When Youngstown Sheet and Tube, one of Reiss' largest clients, saw its financial stability threatened by rising insurance prices, Reiss decided to call on his colleagues in London and take action.
The Captive Insurance Solution
Fred Reiss developed a creative solution for his client, Youngstown Sheet and Tube, with the help of Lloyds insurance underwriters in London. Instead of paying hefty premiums to buy insurance from a large insurance company, Reiss'client would form a new insurance company in Ohio, Steel Insurance Company of America. Steel Insurance would issue insurance to its parent company, Youngstown Sheet and Tube.
Lloyds of London helped out by providing reinsurance to Steel Insurance. If a large claim hit the newfound insurance company, Lloyds would be able to pay on the claim, protecting Youngstown Sheet and Tube financially from a catastrophic claim. At the same time, Steel Insurance would be responsible for processing its own claims and paying on smaller claims.
It's All in the Name
Youngstown Sheet and Tube owned a number of coke and iron mines that supplied its steel mills, guaranteeing a supply of raw materials free from external market forces. These mines were known among the company's executives as "captive mines." When Fred Reiss set out to form Steel Insurance for Youngstown Sheet and Tube in 1955, he labeled the insurance subsidiary a "captive" insurance carrier.
Captive Insurance Moves Offshore
As if creating the first captive insurance company was not enough, Fred Reiss also created the first "captive management company," International Risk Management Limited, in Bermuda in 1962. Bermuda has since become world renowned for its captive insurance industry, although many other countries also host vibrant captive insurance markets. Many U.S. states have also jumped into the game, enacting business-friendly captive insurance laws that permit you to do everything from here in the U.S.
Captive Insurance In a Nutshell
What is "Captive Insurance"?
From the preceding discussion, you may have gathered that, when Youngstown Sheet and Tube set up its own insurance company, Steel Insurance, and bought a policy from Steel Insurance, Youngstown Sheet and Tube was basically insuring itself. In fact, captive insurance is a form of self-insurance. It is not entirely self-insurance; Steel Insurance ended up reinsuring most of its risks with Lloyds of London.
Smart businessmen engage in self-insurance almost every day in their businesses. You may have declined one or another form of coverage offered to you by your insurance agent in the past. When you do so, you are making a conscious choice: You would prefer to live with the risk (and suffer the consequences of not being insured) than to pay money for insurance.
Consider for a moment how many people drive without basic auto insurance. This is an example of self-insurance brought about by choice, but what if you have no choice? What if insurance is simply not available? Many doctors find themselves in this position, unable to obtain certain forms of medical malpractice coverage, particularly if they have been sued in the past.
If captive insurance is not unlike self-insurance, then why would you need a captive insurance company? I will explain the benefits of captive insurance in a moment to you. However, bear in mind this one point: Captive insurance is a way of quantifying the amount by which you self-insure.
Let me explain this to you with a simple example: Assume you have a policy of commercial liability insurance for your business each year, and that policy costs $25,000. If you pay the premium for that year, you deduct $25,000 from the revenue (and taxable income) of your business. If, however, you choose not to pay the premium, there's no deduction. Even though you are choosing to self-insure yourself for coverage that is worth $25,000, there is no physical payment of $25,000 that you can claim on your business tax return.
The lesson to draw from this example is that you cannot deduct the value of risks you self-insure in your business each year. However, by using a captive insurance company, you can deduct the premiums paid even on risks that might be self-insured.
What is a Captive Insurance Company?
A captive insurance company is nothing more than an insurance company that you (or your business) owns. Fred Reiss borrowed the name "captive" from the "captive" mines that Youngstown Sheet and Tube owned and used to supply raw materials for their steel mills. A "captive" insurance company is one that is related to the business that it insures.
You should note that we are talking about a captive insurance company. I am not referring to a shell company that is formed by filing a simple set of papers with your local secretary of state's office. This is an actual insurance company that is formed and licensed for the specific purpose of providing real insurance coverage to your business. It is operated as an insurance company likewise, with real insurance policies, a service office, claims processing, and reinsurance.
The Design of the Captive Insurance Plan
As you may gather from the historical overview of captive insurance, Fred Reiss' original design was pretty simple:
1. An operating business forms its own insurance company.
2. The insurance company provides insurance to the operating business.
3. The insurance company acquires reinsurance coverage to protect against catastrophic claims.
4. The insurance company processes its own claims and pays out of its own pocket for smaller claims, using reinsurance to handle bigger claims.
That's it. That is all you need to know. Sounds simple, doesn't it? Of course, everything is in the details (and, in Chapter 3, I will dive into detail on how each of these four design points works), but I want you to understand this point: Captive insurance is a simple concept. You may not understand how to run every machine in your factory or all the software on your bookkeeper's computer, but you know how to run your business. Most likely, after reading this book, you may not be ready to start writing your own policy forms and processing your own claims. Yet, if you keep these four design points in mind, you now know how to examine a captive insurance structure and what to be looking for.
Benefits of Captive Insurance: What's In It for Me?
Freid Reiss formed Steel Insurance for his client because steel mills in the 1950s were having difficulty buying insurance in the face of skyrocketing premiums. Depending on the business you are in, particularly if you are in a high-risk occupation (such as a medical practice) or have lots of employees, you too may be facing skyrocketing premiums. Captive insurance might be a way for you to take control of ever-rising premiums. After all, if you pay a lot in premiums to an outside insurance company and don't make any claims, that money is lost for all time. If instead you pay premiums to your own captive, the profits from a low claims history are yours to keep inside your captive.
Another benefit of captive insurance is tax-related. As you may know, the U.S. tax law, called the Internal Revenue Code of 1986 ("IRC"), is riddled with loopholes and exclusions. I am not about to editorialize on U.S. tax policy, but I do want you to be aware of a phenomenal tax benefit that is there for the taking. Nobody is going to just give it to you; you have to make the effort to claim it. To best understand this, let's start with an example:
Example: James is a successful dental surgeon, having built Tidewater Dental from a single office with three employees to a multi-state practice with 40 employees and three locations. The company grosses $5 million annually.
Tidewater Dental is an S corporation, all net income flows through to James on his personal tax return. James pays a top combined federal and state income tax rate of approximately 50%.
James meets with his attorney and decides to form a captive insurance company. His new company, "Tidewater Insurance," insures commercial liability and property used in his business. In the first year of this new captive insurance arrangement, Tidewater Dental pays $300,000 in premiums to Tidewater Insurance.
Whenever you pay an insurance premium in your business for commercial liability and property coverage, it is normally an expense of the business that is deducted against income. Therefore, in the above example, James deducts $300,000 against his S corporation income for the premium paid into Tidewater Insurance. Since James is taxed at a 50% rate, deducting $300,000 from his business income saves him $150,000 in taxes.
"Wait a minute," you may say to yourself while you are reading this. "What happens to that $300,000?" The premium is paid into James' own captive insurance company. Now, insurance companies are taxed like any other company; they pay taxes on their income. However, there is a little-known provision of the U.S. tax law that exempts the first $1.2 million of premium income in a captive insurance company. When Tidewater Dental pays $300,000 into Tidewater Insurance, the insurance company receives this money free of income tax.
It gets better. The $1.2 million exclusion that Congress bestows on "small" insurance companies is an annual exclusion: You get to exempt up to $1.2 million each year from the captive's premium income. In the above example, James could keep paying $300,000 each year into his captive, continuing to rack up greater and greater tax savings.
(Continues...)
Excerpted from The Definitive Guide to Captive Insurance Companiesby Peter J. Strauss Copyright © 2011 by Peter J. Strauss, J.D., LL.M.. Excerpted by permission of AuthorHouse. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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