Why?

- The Rationale for Captive Formation

Occasionally a new set of circumstances stampedes the insurance industry herd. Day Care Centers, Fungus and Mold, Products Liability, Malpractice Issues, E. coli and other scares have been met by withdrawal from markets and major premium increases, with the result that insurance became unavailable or unaffordable or both. We all love free markets but insurers portray themselves as the oil and grease that enables the wheels of commerce. Take away the oil or grease and the commerce machine slows down or stops. To help deal with these occasional glitches, Congress created legislation intended to provide more underwriting capital for insurers and make it more feasible for business owners and professionals to effectively insure themselves on the tax favored basis that admitted insurers enjoy. Captive Insurance has been sanctioned by Congress. A Captive owner can fund a fair part of his/her business risk with federal and state income tax savings that result from the Captive. A Captive that is viewed by the IRS as an insurance company can turn a tax payment into tax savings that can be used to fund other business matters and/or increase shareholder distributions. As consequences of the above: The IRS has provided safe harbors. These are guidelines that define what the IRS views as legitimate insurance ventures (as opposed to tax avoidance scams). New opportunities for Pre-tax wealth accumulation have surfaced; Insuring difficult risks has become easier and less expensive. The overall cost of risk management is dramatically reduced for captive owners. Captive insurers have become profit centers and the impetus for major job safety gains. Specific Observations Asset Protection One role of an insurance commissioner is to assure that the insurers under his or her jurisdiction are capable of handling extraordinary loss. Consequently, the assets of insurance companies are difficult to attach. As with any other insurer a Captive s assets are protected.

Leverage with Commercial Insurers The more money that you spend on insurance, the more that you are of interest to commercial insurance companies. If you are big enough to own a Captive Ins. Co., the prospect of competing for your business becomes more challenging to the big commercial insurers. Or, they may want to insure you above a large deductible. Either way, you get more respect. Availability of Coverage Certain types of coverage are unavailable or difficult to obtain due to things such as poor loss experience for an industry or occupation. Medical malpractice is a good example. With a captive, a business can self-insure such risks on a tax deductible basis. Additionally, the Captive creates access to reinsurance markets that have a better overview of real risk. Avoid commercial insurance premium fluctuations A Captive can charge consistent premiums while building surplus to sever its owners from premium fluctuations associated with commercial insurance. When commercial market premiums are low, as is often the case when interest rates are very high, the Captive s risk manager can step outside the captive to take advantage of artificially low rates. Captives encourage more careful work habits When employees become aware that the owner s money is on the line they tend to adopt safer work habits and to pay closer attention to their products and operations. In an environment where insurance is provided by a commercial insurer, there is no potential to profit other than a vague suggestion of lower premiums at some uncertain point in the future. But with a Captive, employees come to know that their special effort pays dividends to their employers. Recognition by upper management enhances safe thinking. Cash Flow Benefits The owner of a captive receives income earned on premium and claims reserves. Premiums are paid up front while claims are paid out over a longer period. Reserves accumulate quickly to the owner s benefit. To the extent that the sum of premium income plus interest income exceeds the sum of losses, loss adjustment expense and the portion of premium income used to buy excess and stop loss insurance, the Captive profits. For the first several years (and subject to actuarial review), nearly all the profits are typically used to boost loss reserves and are therefore not taxed.

Control over claims handling

The Captive contracts with a third party administrator (TPA) to manage many of the Captive s affairs, particularly the investigation and settlement of claims. Claims are settled with the Captive s money. There are times when most businessmen want to pay a claim to please an important customer and times when they will want to fight tooth and nail to not pay a claim. In neither of the foregoing situation will a commercial insurer likely be helpful. Captives permit some latitude in these situations. Cost reductions When a business owner pays a premium to a conventional insurance company he gives that insurer, on average, between 35 and 40 cents out of every dollar to cover the insurer s costs, taxes, profits and obeisance to Wall Street expectations, however wrongheaded they may be. With a closely held, privately owned Captive insurance company, costs and profits are internally controlled. Moreover, there is no padding for losses suffered by careless competitors. Also, when the owner s dollars are on the line, safety tends to improve, as does loss experience. An Additional Profit Center A captive can write insurance for third parties. For example, homebuilders, manufacturers, dealers and retailers use captives to provide warranty/extended warranty cover for their customers. Claims profiles for this type of business are very predictable, so the captives make money. Estate Planning Business owners who have estate planning objectives will find that Captives can facilitate their accomplishment. This is one of the main reasons that Captive Dynamics places so much importance on the selection of a Captive manager that is well versed in estate planning as well as asset protection, taxation and law. Reinsurance Reinsurance is available to insurance and reinsurance companies only. Reinsurance bought directly by a Captive is generally less expensive than the reinsurance component of premiums payable to conventional insurers. The Captive advantage allows a business a wider array of insurance products at less expense. Subsidiaries Get Extra Benefit From Corporate Muscle For Captive owners whose subsidiaries are decentralized there may be significant differences between the levels of risk that each subsidiary can comfortably retain. The Captive makes it possible for every subsidiary to have large deductibles and retentions in their commercial insurance policies, thus reducing the parent company s overall insurance costs. It is accomplished by enabling each subsidiary to

purchase insurance to pay for jumbo deductibles and retentions. Small subsidiaries gain muscle from the parent. Taxation Nearly every web site and book that discusses captives will emphasize that tax benefits should not form the rationale for establishment of a captive insurance company. True, but taxation is an important consideration in virtually every business transaction. When considering, planning or forming a Captive insurance company a prospective owner will do himself a favor by seeking out a Captive manager who is proactive on the issue of taxation. All too often, Captive management consultants who soft-pedal on tax issues simply do not have sufficient understanding of tax law to confront_the_IRS. The single biggest advantage of a Captive (an opinion) as opposed to a Combination of Commercial Insurance and Self Insurance is that the Captive permits its owner to create loss reserves for otherwise uninsured losses, and to do so on a consistent, systematic and tax deductible basis. The uninsured losses are typically such things as Deductibles, Self Insured Retentions and losses excluded by standard insurance policies. There are many exclusions and the insurers don t want to cover them so they are dumped in your lap. In addition to the foregoing, there are dozens of specialty lines of insurance, many of which are only of interest to a fraction of the business community. They are policies that some business owners would like to have but cannot afford. They can be written by a Captive at an affordable price and are tax deductible. When you are self- insured without a Captive, losses happen, you pay for them and you have tax deductions. With a Captive, you routinely set aside premium to pay losses that the Captive will cover. Paid-in premium in excess of paid claims is moved to reserve accounts for succeeding years. Your premium payments are tax deductible. Actuarially justifiable additions to claim reserves of the Captive are not taxable. You begin to see how commercial insurers have grown so large. When a Captive owner introduces loss prevention technology or rigorous safety and operational procedures his Captive can charge his constituent companies premiums comparable to those of commercial market insurers. When his vision of improved loss experience pans out, all the savings that result from it will flow into the Captive. Commercial insurers rarely return more than a small fraction of such savings, and even then it is after they have used your money for a year or more. Therefore, Captive insurers create major incentive for safe operations. By reducing net risk management costs they enhance profitability and competitive stature.