Thanks largely to expanding educational efforts among financial advisors and CPAs, one increasingly popular option for medical practices that are looking for increased insurance coverage, asset protection, and potential tax advantages is a tool known as a captive insurance company (captive). Widely marketed to all doctors, the captive is a complex and heavily regulated tool that requires a specific fact pattern to be of value. Below is our first look at helping you understand the tool and determine if your practice is qualified to implement a captive of your own.
What is a captive?
A captive is fully regulated insurance company that is closely held and owned by one or more individuals and which typically insures those individuals and their various personal and professional liabilities. It allows you to keep premiums you’d pay someone else in some cases, takes those premiums, gets claims and pays them. It is fully subject to all insurance regulations and reporting requirements in the jurisdiction in which it is founded and must be run with a high degree of compliance and disclosure to be effective for any purpose.
In some cases the captive is used to provide additional coverage on issues already covered by primary lines of insurance, like malpractice. In other cases, captives are used to provide additional supplemental coverage on issues not covered in traditional liability policies. If you’ve followed our discussions in this forum you know that an average practice needs five or more basic types of liability insurance for things like malpractice, employee lawsuits, data reach, general liability, and even "key-man" coverage. Those basic coverage areas are just the tip of the iceberg and the captive provides an affordable way to hedge a variety of other very real risks. Just a few examples of this additional coverage include directors and officers liability, mold and construction defects, deductibles on other polices, exclusions from other policies, credit line default, defense costs, warranties, etc. The list is limited only by the types of risk you can identify and legitimately insure against.
Is there more than one kind of captive?
Yes, there are single parent (one owner) captives, association captives, group captives and "cell" captives. They all seek similar results, but have different structures, expense loads, and contribution limits for the individual owners.
Is it one of those risky "tax dodge" strategies?
Not if done right and managed by experienced and specialized counsel. There are very specific guidelines to make it work, have it protect you, to be compliant as an insurance company, and to get the tax advantages that get doctors and business owners excited. The strategy is employed by almost every major national corporation, all of whom use them effectively and without significant issue. A landmark case in establishing their validity was with UPS, yes, that UPS.
What happens to my premiums?
You pay your captive insurance company premiums, and it reserves and re-invests as much of that premium as possible in a tax advantaged way for the profit of the insurance company, which you own. It also takes a portion of those premiums and re-insures itself against the risks it covers to the greatest extent possible. By re-insuring, it protects itself against massive claims that could wipe out the captive and your "savings" that it accumulates as profit and reserves. Assuming all goes well, at some point in the future you will realize those profits as distributions from the captive you own at a tax-advantaged rate, i.e. capital gains. The premiums may also be deductible as an expense to your business, as opposed to "self-insuring" which is usually not tax deductible and which can’t compete with the coverage you get when buying insurance.
Can I reinsure as little or as much as I want to?
You can cover a very wide variety of legitimate risks that you can choose from. There are very specific actuarial formulas that dictate minimum cash reserves, what the internal costs of reinsurance should be, and what risks you can legitimately insure against, but the list is very long and comprehensive. We have seen some great and creative ways of providing benefits to the captive’s owners over the last few years, including basics like life insurance, disability and long-term care and health care.
This is a 10,000-foot view of captives. In the next few weeks we will cover other specifics, including minimum qualifications and specific due diligence questions you must know and ask when selecting a captive team for yourself.
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