Journal of Financial Planning: March 2015
Jerry A. Miccolis, CFP®, CFA®, FCAS, CERA, is a founding principal and the chief investment officer of Giralda Advisors (part of Montage Investments). He is former chief investment officer of Brinton Eaton Wealth Advisors (now Mariner Wealth Advisors), and co-author of Asset Allocation For Dummies®.
Gladys Chow, CIMA®, is managing director and a portfolio manager of Giralda Advisors. She has spent more than two decades in the investment and wealth management industry, managing money for regulated investment companies, foundations, trusts, family partnerships, and institutional, corporate, and individual clients.
As planners, we occasionally encounter clients with substantial family businesses. Often, these are closely and privately held companies, and can represent an outsized share of the client’s wealth. Considered as a component of the family’s overall investment portfolio, the enterprise is typically not only the largest but also the riskiest investment in the portfolio. It would, therefore, be prudent to explore effective ways to expertly manage the risk of that investment.
In our opinion, there is a particular risk management device that is very well suited to this task. It was developed decades ago by large corporations to provide themselves very customized and tax-efficient risk management, and has been increasingly used by small businesses for similar purposes. The approach involves creating, within or alongside the family business, a wholly owned insurance subsidiary—a “captive insurance company.” One of us, in a prior career as an actuarial and risk management consultant, was involved in the financial management of a number of captives for corporate and institutional clients, and saw first-hand how effective they can be to manage risk when used appropriately.
What should be particularly noteworthy to planners, though, is this: beyond their risk management benefits, captives, if properly structured, can provide significant income tax, business, and gift/estate planning advantages to wealth management clients.
Background and Essentials
Captives owe their popularity and growth to the recurring phenomena of “insurance crises.” Certain types of insurance are near-essential for many businesses—product liability coverage for manufacturers; premises liability insurance for retail establishments; professional liability coverage for attorneys, architects, engineers, and health care practice groups and institutions; to name a few. But these coverages can periodically become unavailable or unaffordable as the insurance industry undergoes often dramatic underwriting cycles.
In response to these crises, many companies took matters into their own hands by self-insuring their risky exposures. In primitive form, this entailed setting aside funds to pay future contingent claims against the company. In even more primitive form, it represented simply paying claims, as they came due, out of operating income. A more sophisticated approach involved setting up a captive insurance company to take the place of the commercial insurer and paying the captive an arms-length bona fide insurance premium to provide the coverage.
Risk Management and Income Tax Benefits
Captives can provide substantial benefits relative to both self-insurance and commercial insurance. Unlike payments made into a self-insurance fund, legitimate premiums paid to a captive are typically tax deductible to the parent company. And unlike most traditional insurance, captive coverage can be specifically customized to suit the parent’s unique risk management needs. Moreover, captives are not subject to the availability/affordability vagaries of the commercial market.
A captive insurer has direct access to the reinsurance market, which can provide protection to the captive against catastrophic claims. The coverage terms available from reinsurers are generally much more flexible and negotiable than those from primary insurers, allowing for greater customization. Reinsurers can also be quite creative in designing coverage that is ideally suited to the client’s business.
Another risk management advantage of captives is the fact that claims against the insurance policies are naturally less subject to disputes, as can often occur with unaffiliated claims adjusters. Most captives are allowed to choose an independent, third-party administrator to act as their claims division; however, depending on structure, the reinsurer may have requirements in place that restrict the options available.
In addition to the deductibility of captive premiums, there are other income-tax-related benefits to the structure. To the extent that premiums exceed claim payments (presumably the likely outcome, as most domiciles will require an independent actuarial determination of the premium), the captive will accumulate underwriting profit. If the insurance subsidiary meets certain criteria under IRC Section 831(b), it may qualify as a “mini-captive,” which would exempt from taxable income net annual premium income that does not exceed $1.2 million. Thus, the underwriting profit can build up on a tax-deferred basis within the captive, leaving it liable for income tax on only its realized investment income. Should the captive be liquidated at some point, the distribution to the owners would generally be taxed at capital gains rates. And being astute about the captive’s ownership structure can help secure additional income tax benefits as well as wealth transfer advantages such as those outlined below.
One more word about income taxes: captives can be headquartered in tax domiciles different from the parent’s, creating the opportunity to shop for relative tax havens.
Business and Wealth Transfer Planning Benefits
We mentioned how captives can facilitate the customized design of insurance protection to meet the unique risk management needs of the client’s family business. This is advantageous from a pure business management standpoint as well, and there are other benefits along these lines. The periodic premium payments paid to a captive can be made more stable than the potentially erratic premiums charged by commercial insurers, over which the client has no control. This can allow more reliable expense projections for business planning purposes within the parent company. Additionally, building up assets in a captive insurer may help the client protect those assets from potential third-party (business and personal) creditors more effectively than if the assets remained at the parent.
But it takes a change in perspective, from corporate risk management to personal wealth management, to uncover perhaps the most meaningful benefit to financial planning clients. That benefit relates to wealth transfer tax planning.
Suppose, when the captive is established, the primary business owner’s family members (for example, children and/or grandchildren) are set up as the shareholders of the captive. Alternatively, a trust can be the captive’s owner, with the family members being the trust beneficiaries. Any income of the captive would then inure to the benefit of those family members without generating a gift or transfer tax liability. Additionally, some domiciles have favorable laws with respect to captive owners borrowing from, or receiving dividends from, the captive. These features could represent very tax-efficient ways to transfer wealth out of the estate of the primary business owner of the parent.
In a similar vein, preferred shares in the captive might be distributed to key employees of the parent to be redeemed at retirement—the capital gains treatment on the redeemed shares should be favorable relative to other means of deferred compensation.
While the benefits can be sizeable, care must be taken to properly establish and maintain a captive insurance company. Qualified professional advice should be sought before embarking down this road. There are many insurance regulatory and statutory compliance issues to be dealt with. In particular, the captive must meet strict standards with respect to the validity of its insurance operations.
The IRS has provided useful guidance regarding how premium payments to a captive can qualify as an insurance transaction. In short, there must exist: (1) business purpose; (2) risk transfer from the parent to the captive in exchange for the premium payment; and (3) risk distribution. Risk distribution may be the most challenging for a family business—it demands that at least 50 percent of the premium be attributable to covering the risks of entities economically independent of the parent. One way to accomplish this (which can be facilitated by a savvy consultant or third-party administrator) is for the parent to pool a portion of its risks (a high excess layer of liability coverage, say) with other similarly situated small businesses.
There are significant up-front and ongoing costs involved in running a captive. Initial capitalization requirements as well as continuing fees for actuarial, underwriting, claims, investment, accounting, and tax expertise need to be funded.
Captives are not suitable for all clients with small businesses, but given their potential benefits, they seem to be well worth investigating. For appropriately situated clients, captives represent an opportunity for planners to provide real value, in a very creative way, to help manage these clients’ most significant investment.
In the preparation of this column, we are indebted to Jerry’s former partners at Towers Watson, to our current Montage Investments colleagues at Enterprise Risk Strategies, and to the tax professionals at Satty, Levine & Ciacco, CPAs, PC. Any errors in the interpretation of the information they have provided are strictly our own. Nothing in this article should be construed as legal or tax advice.