Captive insurance needs grow
Some mid-size companies in Michigan might be able to save money on insurance through the creation of their own captive insurance companies.
That sort of sounds like a Frankenstein's monster tied up in a dark corner of a corporate warehouse — but it's not as sinister as it sounds, and it can be a wise business practice.
Michigan became a captive insurance company "domicile" a little over one year ago, but many companies now legally entitled to start one haven't done so, because "they really don't know a whole lot about it. A lot of these companies hear 'captive insurance company' and they immediately think of something typically reserved for the Fortune 100-type companies. Your captive insurance company is not just for the big guys," said Peter Rossow, a consulting manager who leads the Enterprise Risk Management service at Plante & Moran PLLC.
Section 831(b) of the Internal Revenue Service Code allows a parent company to establish a captive insurance company, limited to $1.2 million in annual premium, to cover a broad range of insurance needs — primarily property and casualty but also errors and omissions and products liability.
The parent company can deduct the annual premium as an ordinary business expense, but the 831(b) captive insurance company doesn't pay taxes on the premium it received. The insurance company is operated just like any other insurance company, with the goal being to make a profit on investments of the premiums, while covering the losses of its parent company and its subsidiaries.
Rossow, who has more than 18 years of experience in this arena, said a captive insurance company is a "legally licensed insurance company, but the fact that it's a captive means that it is specifically designed to insure only the risk of its parent company and its parent company's subsidiaries."
"Usually the cost to maintain a captive insurance company is anywhere from $30,000 to $50,000 a year, depending on the domicile. Currently, 29 states have captive legislation on the books," added Rossow.
Every company has risks, he said, but some mid-size corporations don't carry insurance for some very unusual kinds of risks because it is so expensive, or commercial coverage is difficult to find. A company willing to insure that risk may only offer more coverage than is actually needed, or a policy that doesn't quite fit the need.
"A captive allows the company more latitude in structuring the policy," said Rossow.
The captive is taxed on the investment income it earns, according to Rossow. The parent company can save money by diverting up to $1.2 million of its cash flow into its captive annual premium, which is a deductible business expense. If that invested premium returns 5 percent, or $60,000, the corporate income tax on the investment profit "is nothing compared to what they would be paying on $1.2 million" kept as profit, he said.
A captive insurance company can also be a tremendous estate planning tool for privately held companies, he said, in effect providing a method for a company owner to fund a trust set up for his or her children.
He said a company that wants to set up a captive insurance company has to be profitable, because the tax advantage is one of the key benefits. The companies that typically are interested in and qualify for ownership of a captive insurance company have income each year, and it is not a short-term thing that is clearly set up for the tax advantage. "It's a long-term solution," Rossow said. The company and its subsidiaries must clearly be exposed to risk.
"This is going to apply to companies of maybe $50 million or more" in annual revenue, he said. The form of the corporation can be public or private, "across just about every kind of industry. There are really no barriers in terms of what kinds of companies can do it."
The IRS scrutinizes captive insurance companies to ensure the owners meet specific requirements for sufficient risk transfer. Rossow said if a parent company has a dozen wholly owned, non-single member subsidiaries, the IRS would probably agree that there is enough exposure to risk to justify setting up a captive.
However, IRS ruling 2002-90 requires that each subsidiary has at least 5 percent but not more than 15 percent of the total risk being insured.
"You would not be able to do this with fewer than seven" subsidiaries, he said.
Some large companies and organizations in Michigan have long had captive insurance companies, but up until now, they had to go out-of-state or even out of the country to set them up. The University of Michigan, for example, has one called Veritas Insurance Corp., which was set up in Vermont in 1986. It provides the university with liability insurance for all of its departments, including its heath system. According to its Financial Affairs Advisory committee, U-M had considered a Bermuda domicile when setting up its captive insurance company but chose Vermont because that state offered an established infrastructure, minimal regulations and reasonable oversight.
Captive insurance companies have been around for more than 20 years, said Rossow, "but have largely been a risk transfer vehicle employed by the Fortune 100. The Blue Chips set them up off-shore" in places such as Bermuda, Barbados, Grand Cayman, Ireland and Luxembourg.
The U.S. states "have recognized there is a lot of opportunity" in having legislation that allows captives to be domiciled in this country, said Rossow, especially since enactment of the 831(b) clause several years ago makes captive insurance more attractive to many more companies.
State governments want captives domiciled there because of the annual fees or taxes. Rossow said those amounts "are usually around $5,000 a year, maybe a little less or little more. Relatively speaking, it's a nominal amount."
But it does generate revenue for that state. Rossow said Vermont, with its many years of experience in allowing captive insurance companies, had 557 of them on its books as of last year, while Michigan thus far has only one that he knows of. One may assume Vermont took in several million dollars in fees or taxes paid by captives last year.
Setting up a captive insurance company in Bermuda or other foreign country is no longer cost-effective because offshore domiciles are much more expensive compared to the U.S. states that allow them, he said.
When asked if insurance companies are feeling threatened by captive insurance, Rossow said he did not think so.
"Obviously they prefer to write all that business themselves, but they also recognize it's a common solution that companies employ. The regular commercial insurance companies have plenty of risk they're insuring, as it is," he said.
He said he tells his clients that a captive insurance company is "a solution that is intended to supplement their commercial insurance. This doesn't replace commercial insurance; it complements it."
A key requirement is that the captive company is providing insurance coverage on real risks, shared by a number of separate entities. An arrangement merely set up to serve as a tax shelter will be disallowed by the IRS.
Rossow said there are many mid-market size companies with "holes in their insurance program." For example, a $100,000 deductible can be re-insured through a captive.
"What I always tell my clients is, ‘we are going to look at your insurance program.’ As we set up a captive, it is going to be fully and completely non-disruptive to the commercial insurance program" the company already has.
"We don’t want them to feel like we are dipping into their pocket," added Rossow.
Riser Adkisson LLP is a California law firm that aggressively markets its expertise in setting up captive insurance companies for businesses. Its Web site states that "commercial insurance prices are skyrocketing because of investment losses by the major insurance companies," and a captive insurance company is a way around those "rising insurance costs."
The Web site also states that the IRS, until 2002, had repeatedly but unsuccessfully challenged captive insurance companies as a subterfuge for non-deductible self-insurance. The IRS finally lost a major challenge in 2001 when the court ruled in favor of a captive owned by United Parcel Service.
However, Riser Adkisson maintains that there are "a lot of people who try to put together their own captive and mess it up pretty badly," exposing them and their business to tax liability.