Conducting an exercise in Enterprise Risk Management can help small and mid-market businesses, at risk of enormous losses in disasters and other impacts, ensure a continued access to credit and capital when they need it most. Forty percent of small businesses affected by natural or human caused disasters never reopen their doors — one of many reasons that only 30% of family-owned businesses survive into the second generation.
Even the U.S. Government encourages small and mid-size businesses to prepare for a wide range of threats — threats that their insurance policy very likely won’t account for. Consider the impacts of a fire, explosion, hazardous materials spill. You probably haven’t thought about terrorism impacting your business, or the violence wreaked by a mentally unstable former employee. By now, you’ve certainly been made aware what a pandemic can do to your business. There are so many more ways your business could see its last day long before you were planning to sell or retire.
These disasters can affect your ability to keep employees, impact your supply chain and critical infrastructure, interrupt business operations and your ability to meet contractual obligations, and damage customer confidence. All of which can lead to any number of ways to kill a thriving business.
A business can informally self-insure against these threats, setting sizable sums of money aside. But formalizing a self-insurance, or “captive insurance,” can see enormous tax benefits and a nearly doubling of accumulated loss reserves.
Enterprise Risk Management helps businesses assess the possibility of self insurance, formal or otherwise, to address risks beyond the typical core risks (general and professional liability, auto, property, etc.) that a standard insurance supplies. Operational risks (litigation defense, cyber risk, commercial crime, employment practices and more), and strategic risks of disasters, key employee loss, subcontractor default, terrorism and so many more to be considered, are all reasons to assess whether a self insurance plan would be wise.
**What is a Captive Insurance Company (CIC)?**
CICs have been around since the 1950s, insuring businesses in virtually every industry and market sector. These are real insurance companies with policies, policyholders, claims, reserves and a surplus, licensed in an appropriate jurisdiction, and formed to insure the risks of its owners and sometimes third parties. They are generally owned by the same company they are created to insure, or by third parties who have an economic interest in the insured company.
CICs have the added benefit of capturing all the underwriting profits of the business owner(s).
They can replace commercial insurance, including health care, business risks, and company warranties.
**Taxation of CICs**
The IRS taxes any insurance company, no matter how its formed, as a C corporation, and requires that it derive over half its business from issuing insurance or annuity contracts or reinsures risks underwritten by insurance companies. Any CIC can be formed in any state, and in any nation. The location of formation is important, because CICs are not governed by the IRS, they are subject to the laws of the government or state of domicile where they’re formed. The IRS’s impact on CICs is never in how they function, only in how they’re taxed.
How they’re taxed depends on how they’re formed. A traditional CIC has its Underwriting Profits and investments earnings taxed at ordinary tax rates, with the premium income offset by any claims. A “small” CIC is taxed under section 831(b) of the tax code, a section adopted by Congress in 1986 in order to strength US small and mid-sized businesses. This type of CIC sees a 0% tax rate on underwriting profits if the premiums received are $2.3 million or less on an annual basis. Most investment earnings are taxed at ordinary rates.
An important caveat to plan for with your Financial Advisors is the possibility of having investments earnings taxed double when dividends are paid to the owner.
The congressional intent behind Section 831(b) for small insurance companies was to level the playing field for small businesses, assisting small and mid-sized businesses, allowing them to mitigate potential risks and experience greater longevity. A business can pay up to $2.3 million per year in tax deductible insurance premiums, though more commonly its $250,000 contribution, and a Letter of Credit or 20% of annual premium.
The CIC issues an insurance policy for the intended company, and invests the balance of its capital to earn dividends.
Keep in mind, if a company forms a CIC purely to see a tax savings, they may well be denied. Risk management and asset protection must be the primary concern of the CIC, and the IRS is going to want to see the insurance company performing the duties of an insurance company: covering losses.
Your Asset Policy Statement, to comply with the IRS, needs to emphasize liquidity, volatility, yield and tax efficiency, in that order. The CIC must have sufficient liquidity to pay claims that are uncertain in timing and amount; it must manage downside risk and variability of returns to protect its ability to pay claims and prevent large losses for the insured company; it must improve a company’s financial strength by earning a reasonable return, and it must minimize the adverse impacts of taxation.
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