Typically, business owners buy insurance (i.e., shift risk to another) or self-insure (i.e., bear the risk of loss themselves). If there is insurance available to cover a specific risk of loss, and it is available for a reasonable price, then the business owner should buy that insurance. If insurance is not available or is too expensive, then the business owner has little choice but to self-insure. This self-insurance requires the owner to pay tax on profits and then set aside money, after tax, to cover potential losses.
What risks are you self-insuring?
The fact is that most risks are self-insured. Business owners do not buy insurance for legal costs of disputes, loss of key employees, or key customers, professional fees related to an IRS audit, loss of franchise rights, adverse changes in government regulations, and probably hundreds of other potential risks of loss. Think carefully about risk exposure and check your commercial policies. You are very likely to find that there are dangerous risks for which you have no (or inadequate) coverage. Remember: deductibles and exclusions represent self-insured risks.
What is a captive insurance company (CIC)?
A CIC is an insurance company that insures the risks of its owners, hence the name “captive”. If the CIC losses and expenses are low, then the CIC owners make money. A CIC is a real insurance company licensed in a jurisdiction (called a “domicile”) that is favorable to the regulation and expense of operating a CIC, such as North Carolina. The CIC must be properly capitalized and operated like a legitimate insurance company, such as having binding, written policies.
What is the financial benefit of having a CIC?
The CIC will issue insurance to the owner’s operating business to cover its risks that are uninsured, or too expensive. The premium paid to the CIC is deductible to the operating company, reducing the tax owed by the business owner. In the type of CIC that we generally recommend, the CIC does not have to pay tax on that premium. Congress has specifically exempted these special “small” insurance companies from paying tax on premium collected (maximum of $2,200,000 per year). The CIC will have to pay tax only on the investment income earned on the assets accumulated in the CIC.
How do I get money out of the CIC?
First, if there is a loss by the operating company that is covered by any policy issued by the CIC, then the operating company is entitled to payment under the policy. Second, when the time comes, distributions from the CIC (as approved by the domicile) are taxed as qualified dividends and if the CIC is dissolved the gain is taxed as long-term capital gains. Rates on both qualified dividends and long-term capital gains are currently 15%.
Summary
For an operating business that self-insures many risks every day, a Captive Insurance Company can address the financing of these risks in a manner that saves substantial income taxes and adds to the bottom line. If you are interested in learning whether this planning can be beneficial to your company, then please contact us.
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