Practice Management

Captives save business owners money

Special-purpose insurer ideal for pretax wealth accumulation, asset protection, other goals

Oct 5, 2008 @ 12:01 am

By David T. Phillips

Through the creation of a captive insurance company, businesses can cut their taxes and increase the value of their estate.

A business creates a captive insurance company to insure its risk; the captive can issue property and casualty insurance. It can also collect and invest premiums, as well as pay claims.

To be sure, the business can also use the captive for pretax wealth accumulation, to protect assets, for efficient estate planning and to retain key employees.

The business determines the policy terms, whether to write new or renewable policies and the types of insurance coverage to write.The strategy works best for companies that generate at least $1 million in annual net income, making it viable for physician groups, associations, franchisees and other businesses.

For instance, Stan and Joan Smart, 60 and 55, respectively, own ABC manufacturing company. They seek better risk management and estate planning.

After meeting with their financial adviser, Stan and Joan decide to retain an experienced captive insurance manager to form and supervise a captive.

A captive will allow them to buy deductible coverage for workers' compensation insurance, cover exclusions in their current product liability insurance and provide a litigation expense policy to provide a "legal war chest" in case ABC is sued. Also, additional insurance coverage can be considered in the future.

Combined, these premiums cost $1 million a year, though because they are tax-deductible, ABC will save $400,000 in taxes annually.

To ensure that the Smarts' estate attains their estate-planning goals, a limited liability company will own the captive, which in turn is 99% owned by a trust, for their two children. Stan and Joan retain 1% ownership and control the LLC.

As a result, the captive is accumulating wealth outside the Smarts' estate, and there are no gift or estate tax issues.

Working with their financial adviser, the Smarts invest the $1 million into a diversified portfolio of investments, which might include stocks, bonds, mutual funds, real estate and other investments.

Each year, the captive will receive an additional $1 million to invest in the form of premiums from ABC.

In addition, to satisfy estate- planning goals, the Smarts decide to allow the captive insurance company to loan $250,000 a year for 10 years to an irrevocable life insurance trust. The money is used to buy a $16 million joint and survivor life insurance policy.

Captives were established more than 30 years ago, and today, there are more than 6,000 captives and $100 billion in annual insurance premiums.

There are two broad ways to employ a captive.

First, a captive can replace existing insurance, such as workers' compensation, general liability, medical malpractice, auto liability, property or other conventional insurance.

Through a captive, the overall cost of insurance is reduced, and the captive owner can capture underwriting profit and investment income.

Second, the captive can purchase insurance that covers exclusions, deductibles and self-insured risk.

In the event that claims don't materialize, the captive will capture a substantial pretax nest egg that can be used for future business risks, or it can be used for distributions to owners, family members or key executives at favorable tax rates.

Moreover, under the U.S. tax code, if the captive receives less than $1.2 million in insurance premiums a year, the entire amount is received tax-free by the captive. The insured business might then deduct the $1.2 million annually, saving about $500,000 a year in taxes.

Remember that premiums paid to a captive aren't taxed and can be invested in stocks, bonds, mutual funds, real estate and other investments.

A captive can also hold life insurance.

Generally, these are specialized life insurance policies with a high cash surrender value to ensure that the policies qualify as a proper investment under insurance regulations. The captive can hold the life insurance directly or loan money to a life insurance trust to buy the insurance.

Also, the death benefit of the life insurance is outside the estate. This means that because of the captive, a $10 million or even $25 million death benefit is created for the estate's beneficiaries without any gift or estate tax liabilities.

David T. Phillips is the founder and chief executive of Estate Planning Specialists LLC in Chandler, Ariz., a national network of estate planners. He can be reached at

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