Used appropriately, captive insurance can provide great benefits
A cursory internet search of 831(b) captives might scare some into thinking they’re a bad idea. But midmarket CEOs and CFOs shouldn’t rule out what can be an excellent insurance option—provided the captive is set up for actual insurance purposes.
Do you currently have uninsured risks? Are you a profitable, privately-owned, mid-market company with +$60M of top-line revenue? If the answer to both is yes, you may be a good candidate for a captive insurance program, specifically one that qualifies under the 831(b) election in the U.S. Internal Revenue Code.
What is captive insurance?
In simple terms, your business creates its own captive insurance company, pays an annual premium to the captive, is able to invest that premium and draws reimbursements from the captive when suffering covered losses. It’s essentially a form of prefunding for future losses to the organization.
Distinguishing the wrongdoers from the legitimate users
In 2015, the U.S. Congress essentially reaffirmed its approval of the 831(b) election, while making changes to it for the first time in almost 30 years. The limit increased from $1.2M to $2.2M with an inflation adjustment that is now $2.3M for 2018. It is required that ownership of the captive mirrors the ownership of the operating company. In large part, new ownership requirements were made to combat companies that were abusing the provision by using it as a tax shelter mechanism. And that is a big reason 831(b)s have been getting so much recent (and negative) attention.
So, what does that mean for you? First, it means you should understand that the IRS is not targeting the insurance product derived from the 831(b) election itself. Rather, it’s targeting the bad captive managers, i.e., those who are setting up 831(b) captives primarily for estate planning and tax evasion, rather than for true insurance purposes.
An 831(b) captive is not just a perfectly legitimate insurance option; it can be a great way to leverage more control in your risk management program and, more specifically, purchase coverage for previously uninsured risk. Here are four important points to keep in mind as you explore the possibility of an 831(b) captive. They’ll serve you much better than skimming the headlines:
Understand who your captive manager is
Or to put it another way, make sure you have a provider who knows what it’s doing. Your best bet is to work with a captive manager that specializes in 831(b) formations, more specifically, a company with an insurance and underwriting background that uses independent actuaries to validate their rates. Some of the recent abuses of the 831(b) election have involved professionals like lawyers or financial advisors with no underwriting backgrounds forming 831(b) captives—and charging rates not based on sound actuarial calculations.
Know the audit histories of your potential captive manager’s clients
Be sure to ask if any of the captive manager’s 831(b) clients have undergone an IRS audit. If so, find out what the results were. If the IRS issued letters of “no change” following the audits, that’s good. That indicates, among other things, that it found no issues with the 831(b) captive that was set up. In fact, you might even see captive managers referring to their clients’ clean audit histories in their marketing efforts.
Make sure the risks and the premiums are based in reality
For an 831(b) captive to be legitimate, there has to be true risk. So, for example, you can’t charge yourself $100K for boat liability when there’s no company boat. Likewise, rates have to accurately reflect the risk. Let’s say you put cyber liability in your captive. If that coverage is available in the marketplace for $50K, then you have to charge yourself a comparable rate inside the captive. You can’t charge yourself $250K for a premium just so you can avoid the taxes.
Educate yourself and your trusted advisors
Develop a solid understanding of the 831(b) election by educating yourself on it, but as you do, include everyone who should be in the know—not only those at your company but trusted outside advisors like your lawyer, accountant, banker and investors. Everyone should be working from the same accurate, up-to-date information.
The potential benefits: too good to ignore
If you’re the kind of company that could benefit from an 831(b) captive, don’t get caught up in the current negative hype. Yes, some out there have abused this tax code provision, but you shouldn’t confuse that fact with the solid insurance product that the provision allows. Understand the facts and work with a trusted insurance broker who can help you set up a disciplined, conservative captive program.