Captives the devil's in the details.

Many financial executives are already familiar with the concept of forming and operating a small captive insurance company for risk management and wealth-building benefits--and those can be considerable.

In a nutshell, profitable closely held businesses can form a separate, domestic-licensed insurance company to insure business risks. If done properly, the operating company can pay up to $1.2 million a year in premiums to the new insurance company. That amount will be fully tax-deductible to the operating company, and yet the new captive will pay no taxes on those funds, pursuant to section 831 (b) in the Internal Revenue Code--a potential net benefit of roughly $480,000.

The result is: a) the creation of a pre-tax reserve against potential future losses; b) a reduction in third-party insurance expenses; c) a reduction in current tax-able income; d) a deferral of tax events; e) a conversion of ordinary income to capital gains; and f) a potential efficient transfer of wealth to the next generation. And all of this is possible because of clear, black-letter law and specific "safe harbor" Revenue Rulings issued by the IRS in 2002.

So, what is the problem? There are none--as long as your captive provider is very careful with critical details and issues. Otherwise, these details can derail the expected benefits of a captive or worse, increase your costs and create potential economic losses beyond your comfort level. What follows is designed to give readers a roadmap of the key issues involved in forming and operating a section 831(b) captive insurance company so each CFO can better advise company owners.

* Underwriting: The most common shortcoming with most captives is that those who create them do not understand how to underwrite the risks to be transferred to the captive. Too often, captive providers put the risk analysis last rather than first, which is its proper place. Since the tax rules are a very important part of the economics of these captives, providers are typically accountants and lawyers with little or no risk underwriting experience,

As a result, their captives tend to carry too few risks, or the wrong types or wrong amounts of risk. This means that the new insurance company may not create the desired underwriting profit that is an important motive for forming and operating a captive insurance company.

Properly designed captives should hold a carefully diversified portfolio of risks, much like an investment portfolio. Selecting risks with too much frequency-claims activity can inundate the captive owner with significant amounts of paperwork simply within the process of trading minimal amounts of dollars between the operating company and the captive.

Likewise, selecting severity-type risk with large loss potential could bankrupt the captive in its early solvency-forming years. Taking a deep analysis of a client's existing third party insurance program, and under-standing how the risks are priced--while applying knowledge about the current insurance market cycle--are all important factors in creating coverage and layers of risks to ensure long-term profitability and sustainability within the captive structure.

* Feasibility Study: One of the first things that the IRS looks for if auditing a captive insurance structure is whether there is a feasibility study supporting it. This study should be unique to each company, with a full explanation of the business purposes for forming a captive insurance company.

A careful analysis of the risk profile of both the company and the proposed captive is necessary, as is a complete financial analysis of potential captive results, including reasonable loss and expense assumptions and a detailed explanation of how the captive will obtain "risk distribution."

While the study need not include a full actuarial report at this stage, the captive provider should arrange for an actuarial analysis of the captive's risks, premiums and reserves before the captive applies for an insurance license. The alternative is to "guess" at the premium, a position not favored by IRS auditors.

* Risk Distribution: The hoped-for tax benefits of a section 831(b) captive depend on an arcane concept known as "risk distribution." Many judicial cases, books, articles and lectures have addressed this issue, and this article cannot provide an in-depth analysis of the subject. For most companies, however, the concept means that the new captive must insure some risks of other companies in addition to your own.

On its face, this "third-party risk" can be scary to clients. And, depending on how the captive provider proposes to meet this requirement, it can be either well-managed or fatal to a company's captive program. But risk distribution is absolutely necessary in order to comply with the tax rules, so the important issues companies need to deal with are: a) Does the mechanism comply with IRS requirements? b) What is the true economic exposure to my captive as result of this mechanism? c) Whose risk is my captive assuming? And d) what are the "tail" exposures?

The "safe harbor" Revenue Ruling 2002-89 states that in order to be an insurance company for tax purposes, the captive must have at least 51 percent of its premium coming from independent third parties. Since your captive cannot (nor do clients want to) sell insurance to other people, how can it find this outside risk?

The most common answer throughout the insurance industry is the use of an insurance exchange or reinsurance pool. The idea is that insurance companies (such as captives) each contractually agree to pay for a part of the losses of the other insurance companies in the pool.

So, each captive is obligated to pay some amount if another captive in the pool suffers a loss covered by the pool agreement. In addition, if, say, your captive pays a loss to its insured (your operating company), it will be partially reimbursed by the other captives in the pool if the loss is covered.

There are many pools available for captives. Most of them, however: a) do not comply with IRS requirements; b) are structured in a way that imposes too much economic risk on each captive to be comfortable to clients or sensible from a risk perspective; or c) have a potential financial obligation that extends well beyond the policy year (tail). One question to ask a provider when discussing this point is, "If a tanker goes down off the coast of Africa, will my captive have to write a check?"

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Unfortunately, for many pools, the answer may be "yes."

Ideally, your captive should join a pool that allows only other section 831 (b) captives to participate. The captive manager should be able to disclose what risks are insured by the pool and in what amounts. In that way, you are sharing risk with other like-minded business owners who each have limited the risks in their own captive and thereby manage the exposure to your captive.

While non-disclosure agreements likely will conceal the names of the fellow insureds in the pool, a captive provider should be able to provide an overall risk profile, showing the types and limits of risks in the pool and a precise estimate of dollar exposure under a variety of loss scenarios. A company can then compare that possible exposure to the other financial benefits of forming its own captive and make a rational decision regarding risk distribution.

But here is where the devil really is in the details. Some providers structure their reinsurance pools in order to minimize the real economic exposure to make the pool more palatable to clients and argue that, overall, the pool satisfies the requirements of Revenue Ruling 2002-89. Unfortunately, while that structure may entice clients, the test is not simply a mathematical one.

The IRS has made clear at recent captive conferences that it will look carefully at the actual loss history of captives within a pool. If the actual losses fall within a range that the pool exempts from reimbursement, the fact that other larger losses might have triggered reimbursement from pool participants will not be enough to deliver the required risk distribution.

* Investments: Who controls the money? Although the captive is a new, separate entity for risk management purposes, if the company also owns the captive, its assets are still the company's. Some providers structure their program so they, the provider, control the investment of almost half of the captive's funds for more than a year. In some cases, the provider may also keep the investment returns on that portion of the money. Insurance laws allow investing captive funds in virtually anything; using the "prudent man rule," choose a captive program that also gives that complete freedom.

Forming and operating your own insurance company requires a thorough analysis of the risks a company is assuming, as well as disciplined and adequate pricing, which, if managed properly, can become a very powerful tool in risk management and wealth accumulation programs. Selecting partners who are experienced in risk, tax and captive structural issues will allow the company to maximize the value of its investment, ensuring long-term profitability and sustainability.

RELATED ARTICLE: TAKEAWAYS

* Profitable closely held businesses can form a separate, domestic- licensed insurance company to insure business risks. If done properly, the operating company can realize a $480,000 net benefit.

* Whatever the actual benefits, they can evaporate unless the captive provider pays close attention to a series of details and mandates monitored by the internal Revenue Service.

* If underwriting is given short shrift, captives tend to carry too few risks, or the wrong types or wrong amounts of risk. Selecting severity-type risk with large loss potential could bankrupt the captive in its early solvency-forming years.

* The hoped-for tax benefits of a section 831(b) captive depend on an arcane concept known as "risk distribution." For most companies, this means that the captive must insure some risks of other companies, in addition to its own risks.

JAMES LANDIS, JD, MBA ([e-mail]) is Managing Partner of Intuitive Captive Solutions (ICS), and RICK ELDRIDGE ([e-mail]) is Founder, President and CEO of Intuitive Insurance Corp., parent corporation to ICS. HOWARD H. POTTER, JD, MBA ([e-mail]) is a Managing Partner of Intuitive Captive Solutions and assisted on this article. He is a Director of the Colorado Chapter of FEI and chairs its Career Services Committee.