This is the third and final installment in a three-part series of articles on the ten questions all prospective captive owners should ask themselves (or, that their financial representatives should ask them) to help in the captive formation decision making process. Part 1 in the series can be found here, and Part 2 can be found here.
Forming a captive insurance company is an incredibly big decision. To help decide if you should form a captive, please answer the 10 questions, the last three of which are presented below.
Am I comfortable placing money into a business enterprise for an extended period of time?
When forming the captive insurance company, the insured — the person forming the captive — must place money into the captive so that from day one, the captive can pay claims. While some people use jurisdictions that have a low initial capital requirement, the Internal Revenue Service will look at the captive's ability to pay the actual claims underwritten, making a low initial statutory capital requirement moot.
In addition, the captive can't do anything to jeopardize its financial position regarding the risks it has underwritten, so removing money via dividends or loans can't be considered until the captive has developed adequate reserves and surplus (usually 3-5 years minimum). So, after placing capital into the captive, you have to leave it there. Are you financially able and willing to do this?
Am I committed to lowering the cost of my risk?
Captives should be used in conjunction with an overall plan to lower the cost of insurance coverage. As such, are you ready to undertake risk minimization strategies?
For example, if your captive underwrites a cyber-risk policy, are you willing to purchase anti-hacking services from third-party vendors? If you underwrite an employment practices policy, are you willing to hire a third party human resources company to help with your internal HR policies?
Am I willing to add another set of corporate responsibilities to my schedule?
Remember, you're starting another business. That means you now have additional corporate responsibilities to undertake — more reports to read, another set of corporate meetings to hold, etc. A properly run captive has at least one annual meeting, quarterly reports and standard ongoing conversations with the captive manager about a variety of issues. Do you have the time to engage in this activity, and do you even want to?
You'll notice that I've specifically mentioned nine items, and yet the title of the article states there are 10 questions. In theory, the tenth question to ask is, do you want to lower your taxes — which is a trick question because everybody would answer yes.
Underneath the captive transaction is a tax mitigation event. In each year in which the insured pays a premium, he is also lowering his taxable income. This money is placed into an insurance company, which, if it writes less than $1.2 million in premiums, can elect to be taxed on its investment portfolio rather than its gross income. And when the insured sells the captive (or liquidates it after 15-20 years of operation) the transaction is a capital gains transaction.
However, if this is your primary motivation in forming the captive, you will run into a legal buzzsaw called anti-avoidance law, which stands a high probability of taking away the deductions associated with the insurance premiums (but only after you've claimed them for a few years, creating an even bigger headache). In short, this should not be the primary reason to form the captive, but is instead a happy benefit thereof.