As frequent speakers to physicians and business owners on asset protection and tax-favored wealth planning, we are often asked about captive insurance companies (CICs) and how they can be used for both types of planning. This has been especially true in the last year, as federal income tax rates have increased. Certainly, CICs can be ideal tools, if established and maintained properly, and if suited to the organization’s economic need. In this article, we will examine the benefits and costs of CICs and then demonstrate a case study of a medical practice using one.
What Is a CIC?
The CIC we will address here is a legitimate insurance company, licensed to write insurance in the U.S., registered with the IRS, but typically based in an offshore jurisdiction, such as Bermuda or the British Virgin Islands. Most CICs are established in these countries because of their favorable insurance laws and tax treatment, although the funds in the CICs can be maintained and managed in the U.S. In fact, offshore CICs have grown in number to over 4,000 companies, writing an estimated US$60 billion in premium per year, or more than a third of the total commercial insurance market in the United States. While Fortune 500 companies have long used CICs to protect assets and gain tax advantages, it is only in the last decade that individuals, business owners, and professionals have begun to take advantage of them as well. Moreover, very recently states here in the U.S., such as Delaware and Arizona, have passed legislation making it even more feasible to create the CIC domestically..
The business owner’s CIC may be used to insure all, or portions of, the business’s significant risks, such as high liability non-malpractice risks like wrongful termination or sexual harassment (see following discussion of CIC as asset protector). Alternatively, the CIC might be used to insure relatively low liability risks like weather-related damage to the office or inventories. Regardless of the type of risk, the CIC – like most insurance operations- will transfer most of its risk to another re-insurer. Thus, the CIC can be structured to have as much or as little economic risk as the business owner chooses, while allowing the significant tax benefits described below.
CIC As An Asset Protection Tool
The CIC has a number of asset protection advantages. First, businesses can use the CIC to supplement their existing insurance coverages. Physicians can use them to supplement their malpractice coverage. Such “excess” insurance protection gives the business owner the additional security of knowing that he/she will not be wiped out by a lawsuit award in excess of traditional coverage limits. As businesses see more and more outstanding jury awards in employee lawsuit claims and errors and omission cases, this protection can be significant. Further, the CIC may even allow the business to enhance existing insurance, as the CIC policy will step in to provide additional coverage, if needed.
Self-insuring a business using a CIC also gives the business owner flexibility in using customized policies which one would not get using large 3rd party insurers. For example, many physicians would like a malpractice policy that would pay the doctor’s legal fees (and allow full choice of attorney), but would not be available to pay creditors or claimants (what we call “Shallow Pockets” policies). This prevents the physician from appearing as a “Deep Pocket” – a necessary asset protection strategy today.
In addition, the business owner’s CIC has the flexibility to add coverage for liabilities ignored by traditional insurance policies, such as wrongful termination, harassment, or even HCFA violations. Given that the awards in these areas can be over $1 million per case, businesses would be well-advised to use the CIC for this alone.
Although businesses can sometimes purchase policies like the ones described above from traditional 3rd party insurers, they would not enjoy the powerful tax advantages described above. In essence, the question becomes thus: if you are going to use insurance to protect your assets, why give away the potential profits to the insurance company, when you could own the company yourself? Let’s examine this more closely.
Compared With Self-Insuring: Annual Deductions & Superior Asset Protection
Because our society has become so litigious in recent years, many businesses have been “self-insuring” against potential losses like the ones named above. These businesses have simply saved funds – which will be used to pay any lawsuit expenses which arise. While this planning may prove wise, a business owner would be better off using a CIC to insure against such risk. That is because – as discussed above — premiums paid to the CIC are fully tax deductible, while amounts saved to “self-insure” are not. The CIC in other words, allows the business to get a full deduction each year – protecting against the same risks they previously “self-insured” against.
Moreover, when a business owner “self-insures,” the funds stay in his/her name, or the name of the business. Thus, they are available to any lawsuit claimants, creditors, divorce proceeding, bankruptcy trustees, etc. who may attack the business’s assets. Simply put, there is no asset protection tool shielding the “self-insured” funds, especially you are operating as a corporation. Conversely, by using the CIC, the business owner has transferred such funds to an independent operating, fully-licensed insurance company. Any lawsuit, claim, divorce, tax or other action against the business owner or his/her business is completely separate from the CIC. Thus, the funds in the CIC are ideally asset-protected against any litigation risks of the physician.
No Loss of Control
When investigating the merits of a CIC, many clients are concerned with losing control of the funds paid to the CIC. While the business owner’s concerns are certainly justified, the proper CIC structure allows for complete and disclosed control by the business owner. There is no need to trust any other person or entity with their assets – a drawback of some of the other asset protection structures we use as planning professionals, such as irrevocable trusts. Further, while the CIC is typically established outside the U.S. – to keep administrative costs low – the business owner’s funds can remain in the U.S., in American stocks, mutual funds, money management accounts, etc.
As previously mentioned, the CIC structure must be properly created and maintained. If not, not only may all asset protection and tax benefits be lost, one may suffer serious tax penalties as well. For these reasons, using professionals who have expertise in establishing CICs for businesses is critical – especially the accountants and attorneys involved. While using such experts and a real CIC structure may be more expensive than some of the cheaper alternatives being touted on the internet or at fly-by-night seminars, this is one area where “doing it right” is the only way to enjoy the CIC’s benefits and stay out of trouble with the IRS.
Can You Afford a CIC?
Setting up a CIC requires particular expertise, as explained above. Thus, as might be expected, the professionals most experienced in these matters charge significant fees for both the creation and maintenance of CICs. Set-up costs are typically around $75,000 and annual maintenance costs another $25,000-50,000, although CICs can often be established for a group of businesses (where all funds are segregated for each business owner) for about $25,000 per business. While these fees are significant, given the CIC’s potential tax and asset protection benefits, they are viable options for many businesses and/or physician groups practicing in high-income, high-liability, specialties. Let’s now look at a case study to illustrate how the CIC actually improves your bottom line and helps you accumulate wealth:
Case Study: Joe’s Car Dealership
Dr. Steve is a successful surgeon who was concerned about protecting his assets from a judgment beyond his $1 million/$3 million policy and wanted to build tax-favored wealth beyond his profit-sharing plan. He established a CIC individually. Let’s take a look at the benefit Dr. Steve enjoyed from his CIC in just year 1. Also, let’s take a look at how the CIC will continue to build a tax-favored nest egg for Steve in the future.
Dr. Steve and his CIC: Effects on His Practice’s Bottom Line
|Before Creating The CIC||Year 1|
|Insurance Protections||Traditional $1/$3 million coverage||Traditional coverage plus $2 million in additional coverages|
|Practice income (net)||$1,000,000||$1,000,000|
|CIC premium paid||$0||$500,000a|
|Personal income: stock transactions||$75,000||N/A|
|CIC income : stock transactions||N/A||$75,000|
|Federal & state income taxesb||$415,000||$215,000|
|Adjusted after-tax wealthc||$660,000||$860,000|
|Increase in Bottom Line Benefit to Steve||$200,000|
aDeductible premiums can be as high as $1.2 million per year
bAssumes combined federal and state income taxes at rate of 40%, capital gain rate of 20%
cExclusive of transactions costs
Dr. Steve and his CIC: Building His Tax-Free Nest Egg
|Before Creating The CIC||Year 1||Year 2||End Year 5 (projected)|
|Annual premium paid to CIC||N/A||$500,000||$500,000||$2,500,000|
|CIC income: return on prior reserves||N/A||$25,000*||$51,250||$400.955|
*Assumes 5% compunded return on investments. The CIC will pay no tax on its earnings.
This chart shows what kind of assets can be built inside a CIC over just a 5-year period for a business owner in Steve’s situation. As you can see, over $2.9 million could be accumulated in such a vehicle over the period. This is quite a substantial asset base which, of course, Steve owns. When he wants to close the company and access the funds, there will be a number of options available to him.
It almost goes without saying that, if Steve had just continued to pay his outside insurer, not one dollar of the $2.9 million would be his. The insurance company would have it all.
Conclusion: CICs are ideal vehicles for physicians
Because they have both significant and minor risks to insure against, because they generally have high income tax liabilities and can use significant tax deductions, and because they are interested in building tax-favored wealth over the long-term, CICs are important planning tools for all types of business owners, although they are a difficult fit for those in real estate. This match of problem and solution is even more pronounced with physicians who are high-liability specialists. or those in businesses who are expending great sums to insure their business for weather related damage. In short, CICs should be considered as an integral part of any high earning business’s planning strategies.