Publicly traded Fortune 500 firms know the benefits of captive casualty insurance companies (captives). Now successful small to midsize businesses are discovering many of the benefits larger companies have long enjoyed. Planners should know the pros and cons of captives to help business-owner clients assess the viability of establishing one.

Forming captives may be one of the best risk management and wealth planning tools available to business owners. Captives can help control the rising cost of insurance, provide added insurance protection by filling the holes and exclusions of current policies and provide gap coverage for either self-insured or non-insured risk. Other benefits include current and future income tax savings, asset protection, investment diversification and estate-tax mitigation through ownership flexibility. Legislative changes and safe harbor rulings have opened the door for many business owners to look at captives as a viable planning option.

A captive is a property and casualty insurance company established by businesses and individuals to insure a broad range of risks for affiliated companies. For example, a group of attorneys can form and own a captive to insure against legal malpractice risks. The captive can even insure against risks unrelated to legal malpractice, such as loss of a key employee, wrongful termination, loss of license or loss of electronic information. Captives established under IRC 831(b) are often referred to as wealth captives.

Captives can be formed in 39 states or in a foreign jurisdiction, depending on the needs and concerns of the captive shareholders. A business owner in California can form a captive outside the state of California and retain all of the benefits irrespective of the domiciled jurisdiction. Captives domiciled outside the United States must file a U.S. federal corporate tax return and pay yearly corporate income taxes on any taxable gains regardless of where they are domiciled.

REDUCING RISK

Physicians are a group of business-owner clients who could benefit from captives. In many areas of the country, the cost of medical malpractice insurance has spiraled out of control. In states like Florida, malpractice premiums for certain specialties have become unaffordable, forcing physicians to eliminate specific high-risk procedures from their practice or move out of the area and establish a practice in a more physician-friendly state. And due to higher malpractice costs, physicians are electing to forgo coverage.

To provide relief for healthcare providers, many states capped medical malpractice judgments for pain and suffering, hoping to help reduce runaway malpractice premiums. This has had little impact on overall malpractice costs, however.

Establishing a captive allows physician groups to underwrite medical malpractice insurance for shareholders or other doctors and achieve two strategic goals: control the quality of coverage and monitor the expenses and claims-paying process. Malpractice attorneys are familiar with the process and know that it's often better for an insurance company to settle a case rather than risk a substantial jury judgment. The decision to settle is often out of the control of the practicing physicians, but they suffer the damages to their reputations, increased premiums, and even loss of privileges and license.

Captives put physicians in full control of their coverage, letting them respond to claims, hire attorneys and agree to settle or pursue legal action to fight claims. And if the claims are effectively managed during the life of the captive, the insurance reserves inside it can be paid out to the physicians upon retirement (or sooner).

Commercial insurance is typically priced at a 50% loss ratio, meaning that only 50 cents of every dollar in premiums is expected to be paid out in claims. The insurance company uses the other 50% for overhead and profit.

Captives may allow business owners to retain a portion of their premiums. For example, a group of physicians can form a captive and pay $1 million in total malpractice premiums to the captive. If the group has average claims, members can keep the extra $500,000 per year inside their captive, and as they retire they can cash out their stock in the captive-a lofty $5 million after just 10 years, not counting investment income.

In order to protect against catastrophic claims, physicians can obtain reinsurance to limit excess exposure per claim. In addition, physicians have a better feel for who should be allowed to participate in their captive. If a group of physicians come together, form a captive and manage the risk exposure by limiting the group to physicians with a small number of past claims, their future claims exposure could be much lower than that of a large group of physicians.

SAVING ON TAXES

Captives also provide tax benefits to businesses and high-income business owners. The IRS provides favorable tax treatment for insurance companies in part to encourage them to provide adequate business and liability risk management protection. Regardless of business structure, small and midsize companies that pay premiums of up to $1.2 million per year for certain business insurance can take current premium deductions. The premiums received by the captive aren't subject to current taxes, since such premiums are necessary to cover current actuarial losses. The insurance captive is taxed annually on taxable investment gains. Captive directors and owners must know tax-efficient investment management techniques to minimize corporate income taxes.