Captive insurance is an intriguing option allowing clients to self-insure. However, although the rewards can be enticing (tax breaks and cost savings), there are also risks, and the IRS closely watches self-insurers.
What is Captive Insurance?
Captive insurance is a shared risk vehicle designed to help businesses insure against catastrophic payouts while also retaining an investment for the future. It works like this. A business or professional establishes a captive insurance entity and pays itself in premiums instead of paying a third-party insurance company. The premiums are invested and grow as a retainer against any future claims. Then at some point (usually retirement), the business professional can liquidate the assets as a capital gain and repay themselves with their own money.
Traditional insurance premiums are paid and never recouped, making a captive insurance entity attractive. Another benefit is that the self-insured can still take the Sec. 162 tax deduction for the premiums they paid into their own company.
However, along with the benefits comes a downside. One big drawback is that captive insurance is highly regulated, and the IRS keeps a close eye on them.
Most captive insurance clients use a company that specializing in setting up captive insurance and they pool a portion of the reserves so that if any single client needs a payout, the funds will be there. Of course, this type of cooperative effort exposes the client to the possibility of fraud. Typically, companies in the same industry band together with similar risk profiles.
How to Protect Yourself
One of the biggest dangers of captive insurance is non-compliance with federal regulatory requirements. Unless you are highly skilled in these types of arrangements, you may not know how to properly set up the legal entity or what other requirements you may be subject to.
Another significant issue is the Internal Revenue Service. On its list of the “Dirty Dozen,” the IRS routinely calls out captive insurance companies for fraud, tax abuse, scams, and other illegal activities. Some unscrupulous businesses use a captive insurance company as a front to avoid paying taxes and commit other crimes. In one case, a real estate company borrowed all the funds in its captive insurance company to fund other ventures leaving the insurance pool underfunded had there been any claims. The IRS calls this behavior incestuous.
The best way to protect yourself is to use a reputable attorney to help set up and manage your captive insurance company. Be sure you follow all the regulations and keep up with changes in compliance. Thoroughly vet the shared risk group that you join your funds with and keep everything clean and separate. Finally, do not use your captive insurance company for anything other than collecting premiums and paying out claims. That should help keep you off the IRS' radar and safe from the temptation of any abuse.