For decades, Fortune 1500 companies have set up captive insurance companies to protect themselves from various risks. Now, middle-market companies with between $10 million and $100 million in gross annual revenue are realizing that they, too, can self-insure using what’s called a micro captive. It’s never been easier or cheaper to self-insure as more states vie for the domicile business, offering competitive taxes on premiums and lower setup fees. More than 30 states now allow micro captives, the most popular being Vermont, Delaware and South Carolina. Florida recently passed its own captive legislation.
Business owners often explore self-insuring after experiencing a loss not covered by a traditional policy. The disappointment of receiving no benefits for their premiums adds to their dissatisfaction with a policy whose exclusions start on the second page.
Many CFOs dislike the nonsensical market cycles in which there are no storms and few claims. When they try to cover a particular risk, they find that policies are expensive or nonexistent.
Micro captives solve these problems by covering exclusions such as errors and omissions, mold, discrimination, health record privacy, administrative actions, employment practices liability, wage and hour, construction defect, credit risk, and cyber or privacy breach liability. Manufacturers can offer product warranties via their own insurance company. Property owners can write coverage to self-insure for the risk of tenant default.
In South Florida, micro captives can supplement expensive programs with narrow terms and big deductibles. Insurance underwriters apply a hefty 5 percent wind property deductible to policies. That deductible can apply to building, location, campus, occurrence or unit, and amount to a lot of out-of-pocket expense. Some property owners have an existing fund for wind deductibles that has been a natural fit to be paid into a micro captive as premiums. The same practice can be applied to funds set aside for general business legal defense costs.
The operating company that forms a captive deducts the premiums from its taxes. With an IRS code 831(b) election, the micro-insurer pays no taxes on underwriting profits when receiving annual premiums of less than $1.2 million. The micro insurer company is a C corporation that then pays taxes only on investment income.
Depending upon the corporate structure, the financial benefits are $300,000 to $1 million a year, and annual costs can be $60,000 or less. Underwriting profits are realized each year when the premiums exceeding losses are kept as retained earnings in the captive.
Middle-market companies that have thought about forming a micro captive, but decided not to move forward, based their decision on erroneous conclusions: policies are no cheaper than bank-required coverage; the insurer takes too much time to operate; costs outweigh benefits; their company is too small for a micro captive; and thought that this structure was a group captive that they previously researched and rejected.
Once owners sit down with tax and legal professionals to study the costs and benefits, they find decades of rulings that present a true picture. Yes, the maximum annual premium paid into a micro captive is capped at $1.2 million annually. Yes, carriers do not have an A.M. Best rating or letterhead, so they cannot replace insurance policies that lenders require. And, yes, shareholders enjoy the tax exemption that all the other micro-sized carrier owners enjoy.
Those truths miss the main point: tailoring a truly custom coverage. Despite the significant wealth planning advantages, a micro captive is foremost an insurance company with underwriting, policies, management and claims. Seasoned advisers in this field offer cost-effective guidance on setting up a micro insurer and a have long track record of satisfied clients. Many owners use their own existing tax and legal guides for those respective needs.
Owners of middle-market companies that set up micro insurers can expect to be pleased with the results. They will achieve the peace of mind that comes from knowing that they are properly insured, that their cash reserves are at work, and that this new enterprise is not a burden, but a benefit to everyone involved. Download PDF
Andrew Kiernan is director of captive services for Franklin Street, a full-service commercial real estate firm. Email him at [email protected].