Level 5: Captive Insurance Companies
Certainly the best form of asset protection for a business owner is to insure the risk with a commercial carrier. However, the cost of insurance is often prohibitive. Moreover, coverage for certain types of risks may not even be offered by commercial carriers. Therefore, self-insurance is quite common. For example, many physicians find it economically unreasonable to purchase adequate malpractice insurance coverage. Thus, they take on some or all of the risk rather than pay insurance premiums. In such event the physician is self-insuring for that risk whether he/she realizes it or not. A captive insurance company ("CIC") allows for a debtor to reserve for these self-insured risks in a tax-advantaged way.
Structure. A CIC is essentially a private insurance company that writes limited risks, generally those of its owners. A CIC only insures the risks its owners want it to take, and none others. Most often, a CIC is a form of self-insurance for minor risks, with catastrophic losses covered by means of reinsurance from a commercial carrier. CICs have direct access to commercial insurance underwriters and enjoy substantial discounts and credits often based on the insured's history rather than industry standards. CICs may be formed in certain states. However, they are more typically formed in an offshore jurisdiction, such as Bermuda or the British Virgin Islands, because of more favorable insurance laws and tax treatment. Funds owned by the offshore CIC can still be maintained and managed in the United States. Set-up costs for CICs range between $50,000 and $100,000, and annual maintenance costs between $25,000 and $50,000.
Benefits. A CIC allows the debtor to custom-tailor the insurance to fit the debtor's needs, and to include or exclude certain risks as desired. For example, a physician might use a CIC to supplement his/her traditional malpractice coverage in order to have a larger deductible or to lower the limits, thereby reducing the premiums. Coverage can also be provided for liabilities usually not offered by traditional carriers, such as wrongful hiring/ firing, economic losses, HCFA or HIPAA violations, or losses due to terrorism or governmental action (such as changes in environmental laws). Another type of coverage that can be provided is for litigation expenses (i.e., attorney fees, expert witness expenses, etc.). Such coverage is particularly helpful for a business exposed to frivolous claims where the likelihood of the plaintiff prevailing is low, but the defense costs are high.
Another benefit to a CIC is that it allows the debtor to resolve his/her own claims. The debtor can decide to settle early on in the judicial process, or to refuse to settle if that is in the debtor's best interest. It also allows the debtor to choose his/her own attorneys to defend the lawsuit as opposed to those attorneys selected by the insurance company. In short, a CIC allows the debtor to have substantial control over the litigation process.
Taxation. Premiums paid to a CIC can be fully tax deductible. In contrast, amounts saved to "self-insure" are not. In other words, a CIC allows the debtor to get a full tax deduction each year - protecting against the same risks the debtor previously self-insured against. However, in order for the premiums to be fully deductible, an actuarial firm must determine the premiums and reserves required based upon the types of risk to be undertaken and the levels of risk to be assumed by the CIC as compared to the reinsurer. If the premiums paid are actuarially sound, there should be no risk of a fraudulent transfer. Moreover, when a debtor self-insures, the funds stay in his/her name (or in the name of the business). Thus, the funds are readily attachable by creditors. In contrast, the funds in the CIC are separate from the debtor and, therefore, protected.
Wealth Transfer. An added benefit of a CIC is that it permits a debtor to transfer value out of his/her business in a legitimate and tax efficient manner. Wealth that would have otherwise been accumulated in the business or distributed to the debtor is removed from the reach of creditors. For example, assume a business is able to justify premiums of $200,000 per year to its CIC which holds those premiums as actuarially calculated reserves to pay future claims, or as a surplus once its reserves have been met. Over ten years, $2 million has been quietly removed from the business, plus the income and gains from investing the premiums paid.
The CIC may be able to invest in the debtor's related businesses and/or in new business ventures. In addition, the CIC may function as a secured lender to strip equity from the debtor's unprotected assets (see Level 3). Finally, by having all or a portion of the CIC owned by the debtor's children, grandchildren and/or trusts for their benefit, substantial wealth can be transferred free of estate taxes! A CIC is one of the best risk management, asset protection and wealth transfer tools available for professionals and business owners, but it does not come without significant responsibilities and costs.
Conclusion
When designing and estate plan, most persons need only concern themselves with death taxes, probate, and determining how and when to distribute assets to their heirs. However, persons subject to personal liability, such as professionals, must add asset protection planning to that list of concerns.