The adoption of captive insurance arrangements is on the rise,with middle market business owners realizing both their riskmanagement and planning benefits — but ambiguity and controversyhas kept some business owners and their advisers at bay.

In early 2015, the Internal Revenue Service placed captives onits “dirty dozen” list of abusive tax schemes.

This decision arose out of unscrupulous practices set forth byrogue captive managers who led their clients astray by handling theclerical and administrative duties of captive formation, but doinglittle in the way of verifying whether businesses had bona fiderisks.

Consequently, there’s been noise. Those unfamiliar withcaptives, how they should operate, who should manage them, etc.,are perpetuating this idea that business owners should shy awayfrom the so-called unknown and “volatile” strategy.

A well-designed captive which adheres to regulatory standardswill provide coverages that may be too expensive or unavailable inthe conventional insurance market.

The truth about captives

Demystifying captives is at the forefront for qualified captiveinsurance management companies. Catching wind that captives mightnot be in the IRS’s good graces has left business owners confusedas to the legality of forming captives. More so, they are limitedin how they should handle their risk and planning initiatives.

The truth is that captives are a legal, proven risk-financingstrategy which can provide a positive return on investment duringfavorable loss conditions. Perhaps even more poignantly, compliancewith the IRS and other regulatory bodies is what’s going to allowbusiness owners to take full advantage of their benefits. Captiveshave many moving parts that should be handled by insurance, tax,and legal professionals with a proven background in designingcaptive arrangements.

Owners, shareholders and CEOs or CFOs of profitable privatecompanies with revenue of $25 million to $250 million are the bestcandidates for 831(b) captives.

Right now, Property & Casualty insurance programs are set torenew in six months, and most business owners are undertakingyear-end planning to maximize coverage and premium savings. Theimmediate reaction is to “put coverage out to bid” and let thecompetitive market serve up the best transaction. In today’s softmarket, it is likely that policies may be priced well, withrelatively broad coverage terms.

The competitive review or bid process involves significantanalytical work if done properly, and, unless gaping holes exist intraditional coverage, the savings may be marginal or not at all. Amuch more effective strategy is to perform a top-to-bottom reviewof all risks a company faces, not just those for which insurancehas been purchased to cover. There are many risks that are notinsured commercially, and for very good reasons — risk is minimal,coverage is too restrictive, etc. Additionally, insureds areresponsible for funding deductibles or retentions associated withtraditional insurance programs.

There are a lot things that can be covered under a captive,such as the loss of a key employee or an interruption of business.(Photo: Thinkstock)

What should be covered?

The fact that you didn’t “buy” commercial insurance didn’tmagically take the risk away. It just means that you’ve knowingly,or unknowingly, elected to “self-assume” that risk.

Examples of risks that frequently are not insured but can beinsured in a captive include loss of key customer/distributor, lossof a key employee, business interruption, environmental liability,regulatory changes, trade secrets/intellectual property and cyberrisk.

Unlike nondeductible reserves that are allocated or set aside,premiums paid into the 831(b) captive insurance company are taxdeductible. With genuine risk and a properly structured captive,the IRS allows your company to pre-fund expected losses, deduct thepremium paid to your captive and pay claims from those premiums.Under the alternative tax in 831(b), only the captive’s investmentincome is taxable.

For a profitable private company with revenue of $25 million to$250 million preparing for an insurance renewal in 2016, a captivereview could be an integral part of the strategy and planning. Itwill help identify the company’s real risks, both insuredand uninsured, and it will increase awareness of the true cost ofrisk.

Some questions to explore:

• Are deductibles or retentions realistic?
• Is the insured getting the maximum premium reduction forassuming this risk?
• Have insurers declined claims that should becovered?
• Are insured risks priced unrealistically?

Before repeating the usual competitive bid process for the nextinsurance renewal, business owners should carefully evaluate thecost and potential savings of that approach with the long-termbenefits of forming and owning an 831(b) captive.

A captive will enable better use of traditional insurance andwill remain the cornerstone of the business’s risk managementstrategy.

Those on the fence should filter out the noise and read up onwhy the IRS wants you go to about captive ownership theright way.

William “Bill” Blankinship, CIC, CRM, is director ofbusiness development for Houston-based CapstoneAssociated Services Ltd., which provides captive insuranceplanning management services for middle market businesses.

Related: Substantialgrowth in nontraditional captive coverage