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

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

This decision arose out of unscrupulous practices set forth by rogue captive managers who led their clients astray by handling the clerical and administrative duties of captive formation, but doing little in the way of verifying whether businesses had bona fide risks.

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

A well-designed captive which adheres to regulatory standards will provide coverages that may be too expensive or unavailable in the conventional insurance market.

The truth about captives

Demystifying captives is at the forefront for qualified captive insurance management companies. Catching wind that captives might not be in the IRS’s good graces has left business owners confused as to the legality of forming captives. More so, they are limited in how they should handle their risk and planning initiatives.

The truth is that captives are a legal, proven risk-financing strategy which can provide a positive return on investment during favorable loss conditions. Perhaps even more poignantly, compliance with the IRS and other regulatory bodies is what’s going to allow business owners to take full advantage of their benefits. Captives have many moving parts that should be handled by insurance, tax, and legal professionals with a proven background in designing captive arrangements.

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

Right now, Property & Casualty insurance programs are set to renew in six months, and most business owners are undertaking year-end planning to maximize coverage and premium savings. The immediate reaction is to “put coverage out to bid” and let the competitive market serve up the best transaction. In today’s soft market, it is likely that policies may be priced well, with relatively broad coverage terms.

The competitive review or bid process involves significant analytical work if done properly, and, unless gaping holes exist in traditional coverage, the savings may be marginal or not at all. A much more effective strategy is to perform a top-to-bottom review of all risks a company faces, not just those for which insurance has been purchased to cover. There are many risks that are not insured commercially, and for very good reasons — risk is minimal, coverage is too restrictive, etc. Additionally, insureds are responsible for funding deductibles or retentions associated with traditional 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’t magically 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 be insured in a captive include loss of key customer/distributor, loss of a key employee, business interruption, environmental liability, regulatory changes, trade secrets/intellectual property and cyber risk.

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

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

Some questions to explore:

Are deductibles or retentions realistic?
Is the insured getting the maximum premium reduction for assuming this risk?
Have insurers declined claims that should be covered?
Are insured risks priced unrealistically?

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

A captive will enable better use of traditional insurance and will remain the cornerstone of the business’s risk management strategy.

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

William “Bill” Blankinship, CIC, CRM, is director of business development for Houston-based Capstone Associated Services Ltd., which provides captive insurance planning management services for middle market businesses.

Special Reports /

Before you renew your insurance, do a captive review

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