With the continued expansion of 831(b) captive insurance company utilization Assurance Partners was recently asked to participate in the 2015 Tennessee
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Report published by Captive Review. As a result of our domicile-neutral approach and expertise in the formation of 831(b) captive insurance companies, Assurance Partners is uniquely qualified to provide an outside perspective on working with the State of Tennessee as well as help to answer some of the questions that swirl around the expanded use of the 831(b) election in captive insurance company formation.
Joined by a strategic captive insurance partner (Sean King of CIC Services) we address questions related to the advantages provided by the Internal Revenue Service Code Section 831(b), to what extent the 831(b) election is responsible for industry growth, and the main considerations a company should assess when deciding to establish an 831(b) captive insurance company.
A web version of the article is as follows:
Clearing Up The Confusion
Sean King and Nate Reznicek, of CIC Services and Assurance Partners LLC. respectively, help shed some light on the growth of micro captives and confusion surrounding them.
Captive insurance companies. A tool once reserved for only the largest of companies has continued to see significant growth in utilization across all industry in the U.S.. Competition from states continues to drive down the cost of entry into the market and the exponential sophistication of small and middle-market businesses aligns with the significant competitive advantages available through the ownership of a captive insurance company.
The continued growth of small and closely-held companies has led to a steady trend of formations of new “micro captives”. This influx of new captive insurance companies has led to some confusion, half-truths, and misinformation around the purpose of these captive insurance companies and the legitimacy of the arrangements. We turn to Sean King of CIC Services, and Nate Reznicek of Assurance Partners to help shed some light on the growth of this segment of the captive insurance market:
Q: What is a "micro captive"?
Sean: Micro captives are simply small captive insurance companies generally utilized by middle-market, privately held businesses. Small businesses face unique survival challenges as compared to Fortune 1000 companies--their revenue streams are not nearly as diversified, they have smaller and often more highly leveraged balance sheets, and they can't readily access capital and credit markets to smooth cash flows when the unforeseen happens. Events that might simply knock a few dollars of the earnings per share of a Fortune 1000 company can easily bankrupt small or mid-market business.
Nate: Micro captives look, feel, and operate very similarly to “traditional” captive companies. However ownership of these captives is typically held by owners of small or mid-sized closely held companies instead of the Fortune 1000 organizations in which we are most familiar. These micro captives are more often used to insure first-party exposures, deductible reimbursements, business interruption or loss of income events, and other low frequency/high-severity events that larger companies, with their more robust business models, may choose to just informally “self-insure.”
Q: What are the advantages of the 831(b) tax election for captive insurance companies?
Sean: "Small" insurance companies--those that take in less than $1.2 million per year of premium income and meet a few other criteria--can elect under Internal Revenue Code Section 831(b) to pay no tax on their underwriting profits. This tax benefit is designed, in part, to incentivize small businesses to form captives to better manage their well-known risks. It's also intended to make operating these smaller insurance companies economically viable: Without the tax subsidy, the operating costs (legal, accounting, actuarial, administrative, managerial, jurisdictional, etc.) would in many cases exceed the potential benefits.
Micro captives, being small and otherwise meeting the criteria, frequently take advantage of this tax benefit and are therefore often referred to as "831(b) captives" or “micro captives”.
Congress cares about the risk management practices of small businesses because, per the Small Business Administration, such businesses employ nearly half of all private sector workers, represent more than 99 percent of the country's exporters, and have accounted for nearly two-thirds of all net new jobs created over the last 17 years.
Nate: Sean is exactly right. The 831(b) election helps to level the playing field between the Fortune 1000 captives (and their significant tax advantages) and successful small/mid-market businesses. These businesses are the backbone of our economy and the risks they face are very real. This election provides these smaller business with the opportunity to formally insure their risks, closing significant gaps in coverage and providing protection from significant existing exposures.
Q: How should the captive owner ensure the policies written through the captive stand-up to regulatory and IRS scrutiny?
Sean: The Captive Insurance Company Association (CICA) has published two "best practices" documents. Complying with the recommendations therein goes a long way toward ensuring the legitimacy of one's captive from a regularity and tax perspective.
Nate: It is important to remember that there is more to a legitimate captive insurance company than just defensible policies. Although a captive does not have to operate in the exactly the same fashion as a traditional commercial insurance carrier, they are still insurance companies and must operate as such. Proper legal advice, actuarially determined premiums, appropriate risk distribution/sharing, effective loss control, etc. are just a few of the traits that a legitimate captive should have and help ensure alignment with best practices.
Q: What are the main considerations for a company when assessing whether to establish a micro captive?
Sean: The first main consideration is risk. The U.S. Government's disaster preparedness website, Ready.gov, has a landing page for small businesses that emphasizes and discusses the many relevant risks.
The second main consideration is cash flow. Businesses with lots of risk may nonetheless be unable to cash flow the necessary premiums. The tax benefits afforded by Section 831(b) mitigate the cash flow problem, but not completely.
Nate: I would add that a captive owner also needs to have a relatively sophisticated view of risk. Thanks to better regulation and talented captive management firms, running a captive is not an entirely time consuming endeavor but it does require a change of mindset. These individuals are now owners of an insurance company and as such must operate the captive as such. The ideal candidate for captive insurance company ownership has a high level of accountability for the performance of their risk management programs. Individuals that fit this mold have the most successful and profitable captive insurance operations.
Q: Why is Tennessee a suitable jurisdiction for establishing a micro captive?
Sean: Our home state of Tennessee is an ideal jurisdiction form 831(b) captives. Unlike some competing jurisdictions, Tennessee doesn't just license these captives but it actively regulates them also. The regulators are strict but sensible, which is an all-too-rare combination these days. Businesses forming captives in Tennessee have the peace of mind of knowing that Tennessee's regulators are looking out for them and protecting their interests. Tennessee also has a very modern and progressive captive statute, and a very business-friendly Governor.
Nate: I would agree that the way in which TN regulates their captives is beneficial in ensuring the legitimacy of insurance operations without placing undue restrictions or requirements on a business owner that would diminish their captive’s performance or ability to provide much needed coverage to their insureds. The state has also taken a proactive approach to captive education and has successfully participated in events designed to create legitimate and successful captive insurance companies.
Q: To what extent can the 831(b) tax election be seen as the primary driver of growth in captive use by the middle market?
Sean: In our view, too much is made of this. Undoubtedly more 831(b)s are formed than would otherwise be the case of the tax benefits were not available, but this is, after all, the whole reason Congress makes such tax benefits available--to incentivize desirable behaviors. Additionally, the tax subsidy makes economically feasible insurance arrangements that otherwise would not be. So, clearly, the tax subsidy is an important reason that the 831(b) market has grown.
But, importantly, the tax subsidy of 831(b) has been around for nearly 30 years now, and yet the growth of micro captives is relatively recent. So, if the tax treatment of these arrangements hasn't changed, what has? The answer is cost. Thanks to competition among a growing number of captive-friendly jurisdictions, and resulting increases in the number of professional advisors familiar with captives, the costs of forming and operating a small captive insurance company have fallen by 50 percent or more over the last decade. This, and not taxes, is the real driving force behind the industry's growth.
Nate: I also believe that the increased sophistication of successful business owners and their strategic advisors have had a major impact. Captives have been utilized since the 1950s and the 831 (b) election is nothing new. What is new is that business owners and their advisors are expanding their operations into more advanced and rewarding endeavors. The current economic environment that we operate in demands that businesses take advantage of all of the tools available to them in order to remain competitive and help to ensure survivability into the future.
About Assurance Partners:
As one of the largest providers of risk management services in the Midwest, we specialize in partnering with strategic advisors and their clients to help them guide them through the process of determining risks that are unique to their organizations. We then translate those risks into a legitimate insurance program allowing them to obtain the protection and financial benefits that are unavailable in the traditional insurance marketplace, all while strengthening the advisors’ value and providing their clients opportunities for significant wealth growth and asset protection.
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