MailBag: Are 831(b) Captive Insurance Companies A Legitimate Financial Planning Strategy?

Posted by Michael Kitces on Thursday, August 1st, 11:04 am, 2013 in MailBag

Many readers of this blog contact me directly with questions and comments. While often the responses are very specific to a particular circumstance, occasionally the subject matter is general enough that it might be of interest to others as well. Accordingly, I will occasionally post a new "MailBag" article, presenting the question or comment (on a strictly anonymous basis!) and my response, in the hopes that the discussion may be useful food for thought.

In this week's MailBag, we look at a question about what are 831(b) Captive Insurance Companies (CICs), whether they are a legitimate planning strategy or just an insurance scam, and what to watch out for and consider.

Comment/Question: I just had a client stump me yesterday by asking what I thought about him forming an 831(b) Captive Insurance Company. I didn’t feel too stupid because his corporate attorney had never heard of such a thing either.  I've since done some research on it, and found this apparently reliable source online from the NY Times, but was wondering if this is a strategy you have ever come across or evaluated for your clients?

Indeed, the 831(b) captive insurance company (CIC for short) is definitely a legitimate strategy, though CICs have generally been the domain of much larger businesses and are only more recently coming “downstream” in the past few years. That NYTimes article does a very good job covering them, and Jay Adkisson (cited heavily in the article) is a very high quality and credible source on the subject.

As the article notes, the basic concept of a CIC is pretty straightforward - instead of paying premiums to an insurance company to cover your risks, you pay the premiums into your own "captive" insurance company instead. The premiums may not be any different, but to the extent that you don't have any claims (and/or the claims are less than the premiums), the excess profits flow back to you as the owner of the CIC, instead of the shareholders of a publicly traded insurance company. In some cases, the CIC might be owned by the next generation as a way to indirectly transfer money/value to them from an estate planning perspective. In other scenarios, it's simply a way for profits of the main business to be redirected to the CIC and then distributed from the CIC as a dividend (which may be more favorable than drawing the profits directly from the original business, especially if it's a pass-through entity subject to ordinary income tax rates), or maintained in the CIC in a more asset-protected manner. And small CICs with less than $1.2M in premiums have some tax preferences of their own to mitigate the impact of double-taxation of the CIC (once at the corporate level and again as a dividend). Sometimes a CIC is simply a way to try to insure a risk that can't otherwise be insured in the marketplace.

The primary challenge to these in mind my is simply the acknowledgement that ultimately, all you’re doing is setting aside your own money to pay your own claims. That’s only insurance in the loosest sense of the word. As a business owner, I can put aside $100,000/year (or whatever amount I want) into my “emergency reserves” or into my CIC, but the fact remains that if I have a $100,000 expense/claim because something bad happens, whether I liquidate my emergency reserves or take a claim from my CIC, all I’m doing is spending my own money. And with CICs, they're often billed as a way to "save" on insurance premiums, but there can be a risk that, for serious events, the CIC might not have enough in premiums set aside yet to even cover the claim, in which case the client is in serious trouble with what is essentially an undercapitalized insurance company (at least if the CIC didn’t reinsure, and while reinsurance can often be obtained at cost-effective rates for the risk, it's yet another cost that reduces the relative efficacy of the strategy). In general, be very wary of tax schemes that do nothing more than help people pay their own expenses with what would have been their own money in the first place. Yes, you can make deductible contributions to the CIC and receive the claims tax free, but the net is that may ultimately be the exact same result as just keeping the money and using it in a deductible manner for the business expense (that was paid as a claim) anyway.

The appeal for larger organizations is that insurance is generally run on a for-profit basis, has some administrative costs, and can be reasonably predictable in large numbers – those are situations where a larger company having a CIC becomes appealing. In the very small business owner context, I’m still largely unconvinced. I rarely find the tax savings – which ultimately is just tax deferral, and maybe converting some income from ordinary to qualified dividends – is really worthwhile, unless literally the business already pays hundreds of thousands (or millions?) in insurance premiums for various risks (which is true for a 100-person company but not a 5-person small business and certainly not a sole proprietor). As the NY Times article notes, a lot of these are pitched from a pure tax perspective, and most I find don’t hold up at all once the math is really scrutinized, unless it’s a business with many millions in revenue (by the time there's a million+ in insurance expenses already the math starts to get interesting). The fatal flaw is the setup and ongoing costs of the insurance company (which the NY Times article notes can be $25,000 up front for setup and $36,000 annually to maintain!), often to just get a tax deduction that the business would have gotten just by keeping the money and spending it on future needs anyway - again, unless the business is sizable, administrative costs can be managed, and claims can get reasonably predictable.

Done right, though, the 831(b) captive insurance company strategy is definitely legitimate, and can work. I've seen a number of scenarios for businesses with dozens or a few hundred employees, and a few million of profit (on tens of millions of revenue) where the math worked and it made sense. But for a lot of “mere millionaires” scenarios (i.e., businesses $1M to $5M of value on what may only be a million dollars or less of profits, and not all that much really spent on insurance premiums anyway), it's harder to find scenarios where numbers ultimately hold up and are justified once accounting for the costs and recognizing that the strategy often doesn't save taxes but merely defers them (which isn't worth nearly as much).

For an extended credible source on the subject, I highly recommend Jay Adkisson's "Captive Insurance Companies: An Introduction to Captives, Closely-Held Insurance Companies, and Risk Retention Groups" book. Adkisson also supports an additional database and forum for information on CICs here.

I hope that helps a little?

  • Frederick Dunn

    “But it is a gray area. ‘You’re doing something that is technically in compliance with the law but you’re violating the purpose of the law,’ Mr. Adkisson said.” (from the NY Times article)

    This sort of legal(and clever but not ethical, I assert) behavior is what keeps making the tax regulations so complicated. Now the IRS will have to come back with something to realign the law with the original purpose. And so it goes.

  • Roccy DeFrancesco

    I’m disappointed that you were stumped by a question about the legitimacy of CICs. You’ve been receiving my educational newsletter for years and I’ve done a number of articles on CICs and three different webinars discussing their viability. Maybe my newsletters got caught in your spam box or you didn’t find them worth reading?
    I’m equally disappointed that you are recommending Jay as an “expert.” What Jay’s an expert in is getting himself a lot of press and putting forth his biased view on most topics including CICs.
    There are many risks that are uncovered in a business that could be covered by a CIC. Businesses are self-insuring those risks when they could be paying premiums to a CIC owned by the owners individually or by trusts who have family members as beneficiaries (or some combination thereof). CICs can be one of if not the most powerful risk management tool available that also can turn into a nice wealth accumulation tool with a good claims history.
    There are CIC structures that allow smaller businesses to use them as viable tools where the setup fee is as low as $5,750 per $100,000 in annual budgeted premium with ongoing admin fees as low as 12% of the new premiums paid ever year.
    As most of your readers I’m sure know, you are a very bright guy, but before pontificating on CICs, I recommend doing more research and using more credible sources to obtain your information.

    • Michael Kitces

      Regarding being “stumped” by a question about the legitimacy of CICs, you may wish to re-read the article. The person who was “stumped” was the one who wrote to me and asked the Question/Comment, to which I was responding. Those were the words of the advisor who asked the question that prompted the article.

      Regarding risks that are uncovered in a business that can be covered by the CIC, as long as the CIC is solely funded by the premiums of the business, it’s STILL nothing more than structured self-insuring. The only premiums in the CIC are the ones the business put there, unless it’s some kind of pooled CIC arrangement (which of course risks that the client’s contributions could be depleted by someone else’s claim), or unless it’s reinsured (which may be difficult if the CIC is underwriting already-difficult-to-insure risks). Given that those scenarios seem unappealing for at least most of the CICs we’ve seen, it ultimately still comes down to the client’s own money paying for the client’s own risks, just through a self-created self-funded CIC intermediary. As I noted in the article, that can certainly still be appropriate, if there are savings from the tax treatment of the arrangement (especially if the risks never manifest as claims), or if there are insurance pricing efficiencies, but either way the benefits must still outweigh the hard dollar costs of the strategy.

      As for CIC structures with lower costs, certainly no disagreement that lowers the bar to breakeven on the benefits. I had not seen any offerings with costs as low as you’re mentioning here, but perhaps our clients have simply been unlucky in the providers offering CIC arrangements to them.

      In terms of Jay Adkisson’s credibility and information, I cannot say I’ve had the same negative experiences you apparently have. When so much of the information coming directly from the CIC providers presents them as though they are the greatest thing since sliced bread (though I’ll grant at least a few give a more balanced view of themselves), I find having an ‘outside’ perspective like Adkisson’s that isn’t being paid to implement the CIC to be very helpful. But you’re certainly welcome to suggest alternative resources in the comments here.

      Overall, though, I have to admit that I’m a bit puzzled by the overall tone of your comment. You would seem to be an advocate for the use of 831(b)s, and I specifically acknowledge that they are an entirely legitimate and reasonable strategy in the article, as long as the size of the risks and premiums and the benefits outweigh the hard costs of setup and maintenance. What exactly are you disagreeing with, short of suggesting that these arrangements have gotten cheaper recently and that they could perhaps go slightly further “down market” than the thresholds I mention in my article here?

      – Michael

  • Michael Kitces

    Using CICs is not a gray area of the law. The “gray area” Jay was referring to were those who are trying to invest the money inside of CICs in life insurance and use that money to pay a death benefit outside of the estate.

    That’s a separate messy matter from just the standard approach of using CICs (which is not gray).

    But yes, there are definitely some aggressive and shady and “gray” versions of complex CIC strategies out there.
    – Michael

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