New tax rules boost captive insurance for smaller firms.

Risk management has just gotten easier for privately held, middle-market companies. In light of difficulties in certain insurance markets, such as Florida and the Gulf Coast, this may appear hard to believe.

But by combining an in-depth "risk optimization program" with the creation of a captive insurance company, financial executives can now better manage and finance their self-insured risks. Fairly new tax rulings have now made captive insurance companies a very efficient risk management tool, as well as a vehicle for long-term wealth planning for owners of closely held businesses.

Risk optimization is the process of evaluating a company's risk tolerance, based upon financial performance, historical insured and uninsured exposures/losses and other risk management procedures. More often than not, mid-sized companies are either over-insured or grossly underinsured. The goal of risk optimization is to find a balance between risk retention and risk transfer.

Companies that may be over-insured can usually afford to retain more risk and thereby release cash for more productive uses than buying insurance. Under-insured companies, however, run the risk of loss and damage to their capital base.

Once a company identifies its acceptable level of retained risks, it faces the issue of how to finance those risks and how to prepare financially for a possible loss. Typically, companies simply keep enough cash on their balance sheets or establish lines of credit to be used in an insurance emergency. These methods are not, of course, very efficient.

Virtually all of the largest corporations in the U.S. have long addressed this problem by forming their own captive insurance company. These captives typically have few, if any, tax benefits, but find efficiencies through better control over the risk management of retained risks and through access to the (sometimes) less expensive reinsurance market. Smaller companies, however, always found that forming a captive insurance company was difficult to justify on the basis of the economics of the transaction.

New Changes in the Tax Law

But, things have changed. Captive insurance companies are no longer just for the large corporations with armies of accountants and lawyers. Recent tax law changes now favor the formation of fairly small captive insurance companies, creating a useful risk-transfer mechanism in a tax-efficient environment for mid-sized companies.

Few financial executives or their advisors are aware that the Internal Revenue Service (IRS) has issued new "safe harbor" revenue rulings that finally clarify the tax consequences of forming and operating a captive insurance company. These rulings, plus existing sections of the Internal Revenue Code, create very favorable tax results if the new captive insurance company is able to comply with those rulings.

Essentially, once a company has determined its tolerance for self-retained risks, those risks can be transferred to a newly formed domestic (not "off-shore") licensed property and casualty insurance company, typically controlled by the shareholders of the operating company. If structured properly, the operating company can deduct the premiums paid to this captive, yet the premiums can be received by the captive tax-free.

In effect, operating companies can now create a pre-tax, off-balance sheet reserve against losses that are not covered by third-party insurance.

Example

As an example, consider a large printing company in Southeast Florida. The company suffered damage to its roof during the 2005 hurricane season. Although the roof was fixed, its carrier dropped the company's coverage for 2006. The only available insurance required the company to retain a larger portion of the risk through a large deductible.

By forming its own captive insurance company, this company can, in effect, turn a potential expense into an asset, while reducing its own current taxable income. If the company suffers more wind damage, it (and its insurance carrier) knows there is a reserve set aside in a separate company for covering those losses. If, however, the company is spared from further hurricane losses, the assets in that captive can later be transferred to its owners at favorable capital gains rates.

Having deducted the premiums against taxable income, the subsequent distribution of captive assets, after the payment of any losses, has, in effect, converted ordinary income into capital gains. Once the risk management component is in place, the wealth-planning opportunities of such a result are varied and exciting.

Understanding business risks and the relative efficiencies of various risk-transfer mechanisms can enhance a company's bottom line. By making a properly formed and operated captive insurance company part of that process, financial executives can also cut their company's tax bill and create wealth for the company's owners.

James P. Landis ([e-mail]) and Howard H. Potter ([e-mail]) are Managing Partners of Intuitive Captive Solutions LLC of Denver, Colo. Potter is also a director of the Colorado Chapter of FEI.