Combining Captive Insurance Companies With Estate Planning

There has been a lot of “buzz” in the marketplace about captive insurance lately. A lot of confusion accompanies the talk since understanding what captive insurance is, how it works and who it works for can be a little complicated at first. It is not something new, nor is it particularly aggressive. In fact, estimates are that 400 of the S&P 500 companies operate their own captive company. What is most important to know is that in the right circumstances, captive insurance can be a powerful planning tool.

First, every successful business pays for various types of insurance, normally to a commercial insurance carrier. These payments may be for property coverage, employee disability, worker’s comp, business interruption and a myriad of other risks. Often these premiums represent a large portion of the business overhead and the premiums can vary unpredictably and greatly from one year to the next. The good news is that when purchased through a social security administration, most insurance premiums are tax deductible to the business as an ordinary and necessary business expense.

While insurance is a necessary cost of doing business, it can also be a source of frustration for the business owner. However, what if the business owner could establish his own insurance company that would insure some of the risks of his particular enterprise and what if that company paid out less in claims and other costs than it took in premiums (like most insurance companies)? Then the profit would accrue to the new insurance company and its owner. This essentially is what captive insurance is. Obviously, it’s a little more complicated both in structure and by regulations but the concept is like all other insurance.

What makes captive insurance intriguing for the appropriate company? There are several reasons. First, as said before, insurance is a necessity for every business. If it’s possible to take on some of the lower risk items and retain some of the profit that would otherwise go to a commercial carrier, then there is a compelling economic incentive and another profit center.

Next, the captive insurance company is a new, separate business entity. As an estate planning and wealth accumulation tool, a new captive company may be unsurpassed. To establish a new captive insurance company, a new business entity must be formed. If wealth transfer to heirs is a desired goal, then when the company is being formed, ownership interests can be given to children or trusts for children or other heirs so that wealth from profits can inure to their benefit. The premium payments, which are deductible to the business, are not subject to gift tax limitations and the captive company can be outside of the business owner’s estate from the very beginning of its existence.

Furthermore, many businesses can take advantage of a special provision for “small” captives, those with annual deposits up to $1.2 million. In this instance, even though the premiums are deductible by the paying corporation or business entity, the captive does not pay income tax on the premium deposits it receives. Once again, this allows for a great wealth building tool for the business owner. This means that along with all of the other estate planning tools a business owner can use, it is possible to transfer as much as $1.2 million a year in addition. While some expenses occur annually and some claims will necessarily be paid, the potential wealth transfer can still be quite powerful.

Case Study

Take the case of Jack and Maureen. They are in their late 50s and own and operate two successful businesses in the Midwest. Currently their net worth is around $50 million and like many business owners most of their wealth is reflected in the value of their enterprises. Both of their daughters are working in the businesses and are expected to develop the capabilities to take over the leadership of the companies over time. The businesses employ over a hundred employees and have a lot of inherent risk in them. Jack and Maureen are interested in developing an estate plan that will successfully transfer the businesses to their two daughters in time but would also like to make certain that there is adequate liquidity available to the girls should something unforeseen happen before the girls have matured into their future roles. During the course of their planning, it is discovered that they have plenty of excess cash flow and very high third party insurance costs.

During the development of their planning, it is suggested that they establish grantor deemed owner trusts (GDOTs) for the benefit of their daughters and then to sell non-voting stock in their corporations to the trusts in exchange for a note. This is a common “estate freezing” strategy and one that will work well for them. However, as an additional strategy, the GDOTs will form a captive insurance company (CIC) that will insure some of the risks of the business. An actuary determines that a premium level of $500,000 per year is reasonable based on the current risks and insurance that are in place. Since the GDOTs are the owners of the CIC, the profits will ultimately become available to Jack and Maureen’s two daughters. By utilizing this structure, Jack and Maureen are transferring wealth without making taxable gifts or utilizing any of their existing estate exemption.

With all of these potential benefits it would seem that every business should utilize some form of this structure. Unfortunately, captives aren’t for everyone. Normally, a business should have $15 million in sales and have enough net profit to comfortably deposit $500,000 per year into the Captive Company. Set up and operating costs currently limit the marketplace to somewhat larger concerns.

There are many additional considerations regarding the captive structure that are beyond the scope of this article. Where will the captive be located, onshore or offshore? What risks will be insured and at what level? How much will capitalization be in order to provide economic substance? Who will administer the captive and pay the claims?

Obviously many questions need to be answered before undertaking such a major commitment. However, the resources have been developed to make this process less cumbersome and threatening than it appears. Finding the expertise from an estate attorney to help you through this new territory can provide huge benefits for many business owners and is certainly worth the effort.