Captive insurance companies. A tool once reserved for only the largest of companies has continued to see significant growth in utilization. With increased competition from states driving down the cost of entry and the exponential sophistication of small and middle-market businesses this trend shows little signs of slowing down. As the popularity of captive insurance company formation increases so do the questions surrounding the practice. What is a captive? Who is it for? Why would I talk about it? We’ll take a look at some of the most common questions surrounding the practice in order to give you the knowledge necessary to beat your competition and start a conversation around the tool.
1. What is a captive insurance company?
A captive is an insurance company created by a business or its owners to provide coverage to affiliated entities. As a captive insurance company is typically owned by similar economic interests as the operating entity the captive is usually utilized as a method to formally insure risks that were otherwise self-insured (intentionally or otherwise). Although captive insurance companies can be used to insure risks that are currently covered through the commercial market (property and casualty type coverages) more often than not, captives are used to protect against losses for items that are typically informally self-insured by the business owner (contract cancellation, reputational damages, cyber liability, etc.)
2. Who is a candidate for a captive insurance company?
Due to the unique nature of a captive insurance company there really isn’t a specific vertical market or industry that fits best. Industry data tells us that captives are utilized by everyone from financial institutions, contractors, manufacturers, professional services firms….in fact you would be hard pressed to find an industry type that doesn’t use a captive.
Instead of using what type of business the client is in I would instead recommend looking at the way they operate. If your book of business includes organizations that have over $1,000,000 in gross revenue or over $200,000 in "excess" after-tax profits (monies that don’t need to be reinvested into the business or distributed as dividends) they are probably a good fit. Organizations that take a proactive approach to their risk management and are owned by a small number of individuals are tailor-made for owning their own captive insurance company.
3. Why would my client consider forming a captive?
Organizations that implement a captive insurance company into their risk management strategy are the beneficiaries of a stronger business model and are head-and-shoulders above their competition. Captives also provide excellent asset protection (properly structured insurance company reserves are protected from the business owner’s creditors), and excellent advantages when contemplating estate planning/transfer opportunities.
Captives also provide a tremendous opportunity for wealth accumulation. Passed by Congress over 30 years ago the 831(b) election allows "small" insurance companies (companies that take in less than $1.2M in annual premiums) to have their underwriting profits taxed at 0%. What does this mean? If a business owner and their advisors fall into the "status-quo" this business in question would have ~$7.1M in assets after 10 years (assuming annual after-tax profits of $1.2M). If that same business instead elects to form a captive at $1.2M a year the captive owner would have assets of ~$13.1M. That’s an increase of $6,000,000 (~54%) without changing the operations or risk of the insured business and a savings of up to $600,000 in taxes per year, per captive! This result can be multiplied if the business owner has the risk and revenue to own more than one captive insurance company.
4. What’s in it for my firm?
Quite a lot actually.
First: A captive insurance company is not a short-term strategy. Captives survive generational and ownership changes and are the absolute best method of ensuring your firms reputation remains valued for decades.
Second: The increase in assets leads to a significant increase in investment income that otherwise wouldn’t exist. Think of the impact your bottom line could have if your best clients experienced a 50% increase in investable assets. The formation of a captive insurance company is hands down one of the best things a business owner can do to protect their assets and grow their wealth. You want to be the one responsible for making that happen.
Third: Some captive professionals (like my firm) offer the opportunity for revenue sharing. These revenue streams exist as long as the captive does, and our best-practice approach results in some of the best performing captives out there.
And finally: You gain a significant competitive advantage. Even though captives have been around for over 60 years, they have yet to be utilized effectively by the majority of successfully companies. In fact, insurance regulators estimate that only ~1% of all companies that could own a captive do. Being able to provide your clients and prospects with a pathway to captive insurance company ownership places your firm in the best position possible to allow you to attract and retain your ideal client.
5. Doesn’t introducing a captive insurance company reduce my income/revenue?
Absolutely not. This is unfortunately a common misconception that originates from the traditional insurance marketplace. Reputation and relationship benefits aside, a successful captive insurance company opens doors to investment opportunities for your clients that would otherwise be typically unobtainable. Reputable captive professionals will enter into formal cooperation and non-disclosure agreements, protecting your valuable relationships helping to increase your value and agency revenue.
6. How time consuming and complicated is the process?
The formation documentation, computations and regulatory red tape take about 60 days to complete. Good news for you and your client is that almost all of this happens behind the scenes. On average our captive insurance company clients spend about 10-12 hours in total on the formation process. This time is spent mostly at the front-end of our conversations as we discuss risks, determine ownership configurations, decide on domiciles, work with actuaries etc. After the captive has been formed the ongoing interaction with captive ownership takes up about 5 hours of their time a year.
7. What do I need to watch out for?
Above all else captives are a sophisticated risk management tool that are designed to better protect the assets of the business and captive owner. CAPTIVE INSURANCE COMPANIES ARE NOT A TOOL FOR AVOIDING TAXES. Yes, there are numerous benefits that a captive provides (and tax-efficiency could be one of them), but they come along for the ride with a properly formed and managed captive. Remember: The foundation for a captive needs to be based in risk. All risk is financial, it’s our job to identify and quantify that risk so that your client can make an educated decision.
It would also be my recommendation to avoid "one-man shops". Captives are a long term strategy and the professionals involved should have some skin in the game just like the owner does. Individuals that exist for the formation transaction only aren’t typically in it for the long haul. Be wary of firms that utilize in-house attorneys to provide opinions or in-house actuaries to price policies. We only recommend independent firms to eliminate the possibility of any appearance of conflict of interest.
8. What are some of the requirements that have to be met?
As you could imagine, there are quite a few hoops that need to be jumped through when you own an insurance company. Outside of the requirement that the captive first and foremost solve a risk issue there also some rules and regulations that need to be met in order to be considered a legitimate insurance company in the eyes of the government. We form captives within the "safe-harbors" published by the IRS. These standards outline requirements for risk distribution and risk sharing and should be followed by all captive operations. Don’t be fooled by talk about "case law" or Private Letter Rulings. If the captive isn’t legitimate then the owner misses out on almost all of the benefits that I outlined above.
9. Who would not be a good fit for a captive?
More often than not this is a more appropriate question that what was asked in Question #2 above. Organizations that don’t meet the revenue and financial guidelines above are obvious. Although not necessarily a complete disqualification, companies that need to use profits for acquisitions, buy-down of debt or other large capital expenditures might not be ideal. Once the debt is paid, acquisition complete, etc. then it makes the conversation easier. Also organizations that have numerous ownership interests can be a challenge. Getting 15-20 people together to agree on what to get for lunch is a challenge let alone aligning that many ownership entities on the same page. It can be done (we have done it) but realize that it can be a significant hurdle.
10. How do I start the conversation and where do we go from there?
In the words of one of my colleagues: "Captives operate at the intersection of insurance law, tax law, accounting, actuarial sciences, and risk management. It is a highly specialized industry." Like with many other specialized tools in business, the most successful advisors are incredibly effective at identifying prospective cases, starting a conversation with the client, and then engaging an expert to move the process forward.
Take a look at your clients and prospects and compare them with the ideas and recommendations above. If you see some commonalities and are comfortable with the initial conversation, go for it. Then, reach out to a reputable and experienced captive service firm (like Assurance Partners) and have a discussion regarding logistics and specifics.
Have I raised more questions that I attempted to answer? Give me a call. I will be happy to discuss our approach and your business/client situation and see if there’s a fit. We discuss strategy and potential approaches with our business partners on a daily basis and I would be happy to do the same for you. Let’s find a way to make sure that the first time your best clients hear about a captive it came from you and not your competition.
About Assurance Partners:
As one of the largest providers of risk management services in the Midwest, we specialize in partnering with strategic advisors to help them guide their clients through the process of determining risks that are unique to their organizations. We then translate those risks into an acceptable 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 opportunities for additional revenue.
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