Captive Insurance Companies – An Old Way of Insurance New to North Carolina
By W. Y. Alex Webb and Jesse Thomas Coyle
In the November 2013 issue of Insurance Law under the Chair’s Column, the author Ted Smyth describes a conversation he had with a tax lawyer concerning captive insurance. That tax lawyer was Alex Webb, one of the authors of this article. And as Mr. Smyth said in that column, prior to speaking to Alex, nobody he knew had any real knowledge about captive insurance. For both authors of this article—Alex Webb and Jesse Coyle—this poses a huge continuing concern. Alex and Jesse as not only partners at Webb & Coyle, PLLC (www.webbcoyle.com), but also as founding members and directors of the North Carolina Captive Insurance Association (www.nccia.org), find that one of the largest problems with captive insurance today is simply the lack of awareness, even among attorneys that focus their work on insurance law.
This would be less surprising if captive insurance was a new concept, but captive insurance is no spring chicken. It is widely believed that the captive insurance industry started hundreds of years ago in England when ship owners met at Lloyd’s coffee shop in London and agreed to share in the risks of their shipping fleet losses. However, for our modern purposes, captives as we know them started in the 1950s. In the 1950s, the term “captive” was first used by Mr. Frederic M. Reiss, who is often considered the “father of captive insurance,” while he was bringing his concept into practice for his client, the Youngstown Sheet & Tube Company (“Youngstown”). Youngstown was engaged in mining operations and the mines solely used by Youngstown were called “captive mines.” When Mr. Reiss helped Youngstown incorporate its own insurance subsidiaries, they were referred to as “captive insurance companies” because they wrote insurance exclusively for the captive mines. And this is where the common terminology got its start.
However, since the humble beginnings of Mr. Reiss’ use of the phrase “captive insurance companies” (herein, “CICs”), much has changed. Now there are domiciles all through the world, and more than 30 domiciles in the U.S. (Note - not all domiciles are actually active in the captive industry even though they have statutes that permit them to be active). Today, states like Delaware, Vermont, Utah, and finally as of 2013, North Carolina, and off-shore domiciles, countries like Nevis, Barbados, Anguilla, Guernsey, Cayman Islands, and Bermuda, are all serious players in the captive industry and have the regulatory infrastructure to handle the administrative requirements needed. The biggest U.S. domicile is Vermont and the biggest off-shore domicile is Bermuda, but with new domiciles being added and other domiciles making aggressive marketing and regulatory pushes, this could soon change. And in regards to North Carolina, we see North Carolina quickly becoming one of these preferable domiciles.
So what exactly is a CIC and how does it work? A CIC is an insurance company that insures the risks of a single company and its subsidiaries and affiliates (single member or “pure” CIC) or a group of companies (multi-member CIC). Multi-member CICs can take many forms—too many to detail here—such as reciprocals, risk retention groups, and association captives. For definitions of these terms, please check out North Carolina’s state-of-the-art Captive Insurance Company Act (Session Law 2013-116)(the “Act”), which the NCCIA was able to help pass. http://www.ncga.state.nc.us/Sessions/2013/Bills/House/PDF/H473v9.pdf. This law was passed unanimously and with avid support from many of Raleigh’s finest legislators.
The creators and owners of the CIC are the same owners of the companies being insured by the CIC, hence the name “captive.” However, please note that the CIC can be owned by children or trusts to accomplish estate planning and asset protection goals as well. The article “Use of Captive Insurance Companies in Estate Planning” by Gordon A. Schaller and Scott A. Harshman in the 2008 ACTEC Journal is a wonderful piece on the topic of CIC Estate Planning/Asset Protection objectives if you desire further information beyond the scope of this entry and are interested in the common intersection of business planning and estate planning and asset protection.
The first thing to truly understand about a CIC is that a CIC is a real insurance company and must be established in a state (“on-shore”) or country (“off-shore”) that authorizes them (“domicile”). Ideally, it would be licensed in a domicile that is favorable to the regulation and expense of operating a CIC. One of these favorable jurisdictions in now North Carolina for reasons discussed later below.
Usually, a CIC sells insurance to the owner’s operating business to cover risks that are normally uninsured, or simply too expensive to insure. In some circumstances it may also make sense to replace some of the insurance that the operating business normally purchases from a public insurance company. This can include the risks of cyber attacks as discussed in the November 2013 issue of Insurance Law. The premium paid to the CIC for that insurance is completely deductible to the operating company, reducing the tax owed by the business owner (as opposed to non-deductible self-insurance “reserves” on the books of the business). Then, in certain CIC versions, the CIC does not have to pay tax on the premium received from the operating company. This is neither magic nor is it suspicious. Congress has specifically exempted these special “small” insurance companies from paying tax on the premium collected (maximum of $1,200,000 per year) under I.R.C. Section 831(b). As expected, the CIC will however have to pay tax on the net investment income earned on the money accumulated in the CIC. The CIC has to “elect” this special treatment.
Example: If the combined state and federal tax rate on profits is 45%, then a $1,200,000 deduction reduces tax liability by $540,000! If this is a multi-member CIC and each member owns 25% and can pay $300,000 in premiums, then each member’s operating company will reduce tax liability by $135,000. (Note - a 45% combined tax rate is used here as an assumption.)
Once the CIC receives the premiums, the CIC’s assets can be invested nearly wherever and however the shareholders decide to invest it (subject to the domicile’s regulatory rules). That can be at the local bank, with a local financial advisor, or anywhere else in the world that makes sense for the asset allocation preferred by the shareholders. This creates a huge amount of flexibility for the CIC to achieve whatever its desired level of asset growth may be.
Often, one of the primary questions a client will ask is, “once premiums are paid into the CIC, how is the money then subsequently accessed?” The answer is simply this – just like any other proper insurance arrangement, if there is a loss by the operating company that is covered by any policy issued by the CIC, then the operating company is entitled to payment under the policy. Note: one of the non-tax reasons for a CIC is to avoid “coverage” disputes with a big commercial carrier! If there is no loss covered by the policy, then the money will remain in the CIC. But in addition to paying out on claims by the operating company, the CIC can make distributions to its owners. Since this is untaxed money, and since the asset protection inside a CIC is very high, this should not be the first place an owner goes for funds. However, when the time comes, distributions from the CIC are taxed as qualified dividends and if the CIC is dissolved, the gain is taxed as long-term capital gains (assuming the CIC has been in place for more than a year). The federal tax rate on qualified dividends is currently 15%, and for long-term capital gains it is also 15% (but will rise to 20% for some taxpayers under current tax law).
Because a CIC is a real insurance company, the initial setup of the company is not cheap. For example, the initial setup of the company involves the legal work in forming the company and drafting the legal documents that control the CIC’s operations (and interaction between shareholders of a multi-member CIC); the legal approval of the company and its shareholders by the licensing domicile (due diligence); underwriting, actuaries, and other policy issuing costs for the first year’s policies; feasibility study; business plan; captive manager fees and a number of details required to get a brand new insurance company off the ground. For a single member CIC, this initial setup cost can easily be between $50,000 - $100,000 (annual costs thereafter are about $50,000 per year for accounting, annual fees to the government, captive manager fees and expenses related to issuing insurance policies each year). But for the right client, this means that $50,000 - $100,000 can save $540,000 in taxes (EACH YEAR). For a multi-member CIC, the complexity of the legal agreements is greater, the due diligence is multiplied by the number of shareholders, and each policy still requires individual underwriting and actuary costs. The result is thus that, for example, a four-member CIC would cost closer to $100,000 to start. Then future operations would probably cost $70,000-$90,000 per year (split among the members). If these expenses are too steep, the business owners should consider the more cost effective approach of having a “cell” in a protected cell captive.
These formation and operation costs are in addition to the after-tax capital that the domicile regulators will require before issuing a license. For a pure captive, in N.C., this will normally be $250,000. See the Act for the capital requirement of other types of captives.
Because this a lot of new information to digest for most people, a summary of benefits might help clarify things for you, the reader:
- Insurability: Any valid risk, with only very limited exceptions.
- Contributions: Any CIC can receive any actuarially justified premium of any amount. Most Fortune 500 companies have CICs. The smaller 831(b) version of CICs can receive up to only $1,200,000 in premiums per year.
- Investment Assets: CIC funds can be invested with a great degree of variety in coordination with the insured operating entity and/or its owners. Subject to regulatory approval.
- Asset Protection: CICs are asset protected regardless of the amount of their funding (and receive an even greater layer of protection if owned by a properly designed LLC and/or trust).
- Distributions: Distributions from a CIC can be taken at any time by the CIC owners (subject only to solvency/capital requirements of the domicile). As “qualified dividends,” those distributions would be taxed currently at only 15% (federal).
- Loans: Loans from a CIC to its insured operating entity are generally permitted by most domiciles (including N.C.), subject only to regulatory approval (to protect solvency and liquidity).
- Liquidation: When a CIC is liquidated or sold to a third party, the smaller capital gains tax rate is owed.
- Estate Tax: If structured so that the CIC is owned by a trust held for the business owner’s family, every premium payment to the CIC (and any asset growth within the CIC) is outside of the business owner’s estate. In addition, by lowering the value of the operating entity, any tax due on retained assets is also reduced.
However, it is important to remember that domicile selection is essential to the creation of a CIC as it will affect the advantages of the CIC and the ability to administer it. We believe North Carolina is one of the more favorable domiciles for CICs for the following reasons:
- No fees (except for special purpose financial captives)
- No mandatory Department of Insurance examinations
- Possible exemption from annual audit requirements for
captives writing less than $1.2 million in premium
- No investment restrictions except for association captive insurance companies and risk retention groups
- No Insurance Commissioner “pre-approval” required for
attorneys, auditors or actuaries
- Competitive premium tax rates with a $100,000 premium
- Competitive capital requirements
A very dedicated and easily accessible captive staff, regulatory team, and Insurance Commissioner who understand that captives are not to be regulated the same as traditional insurers, and who are focused on a consistent and sensible pro-business approach to regulation.
We are also pleased in this article to be able to note that with a very quick turnaround, the N.C. Department of Insurance has licensed the first three Captive Insurance Companies and the first Protected Cell Captive Insurance Company after enactment of the N.C. Captive Insurance Act. The Protected Cell Captive was submitted by Synergy Captive Strategies, LLC, a captive manager in Las Vegas, Nev., and doing captive work in a number of foreign and domestic domiciles. Our law firm, Webb & Coyle, PLLC, provided legal advice to Synergy and are proud to have aided Synergy in this historic formation.
The other three captives formed were submitted by Atlas Insurance Management, Ltd., of Charlotte which is headed by President Martin Eveleigh. Martin is also a Board member of the NCCIA.
In summation, there is no other more versatile vehicle for insurance than a captive insurance company. From what/who it can insure, to its flexibility in investments, and tax advantaged treatment of contributions/distributions, the captive insurance company is simply unparalleled and every attorney in the insurance arena, even if only tangentially, must be aware of them for the sake of their clients.
W. Y. Alex Webb, J.D., C.P.A., P.F.S., Board Certified Specialist in Estate Planning & Probate Law, Managing Partner at Webb & Coyle, P.L.L.C. in the Sandhills Region of North Carolina, Chairman of the North Carolina Captive Insurance Association.
Jesse Thomas Coyle, J.D., LL.M., Partner at Webb & Coyle, P.L.L.C. in the Sandhills Region of North Carolina, licensed to practice law in Illinois and North Carolina, Secretary of the North Carolina Captive Insurance Association.
Views and opinions expressed in articles published herein are the authors' only and are not to be attributed to this newsletter, the section, or the NCBA unless expressly stated. Authors are responsible for the accuracy of all citations and quotations.