Proper insurance as risk protection is an integral aspect of every business enterprise, whether it is a Fortune 500, mid-sized S Corporation, or a family run LLC/FLP. Insurance, however, has a very broad definition and covers anything from liability to property/casualty to key man life insurance. On the one side of the spectrum, insurance can be seen through “technique solutions” such as corporations, limited liability companies or other risk protection vehicles. We feel it is important for every business attorney to also consider a true “direct insurance” solution: captive insurance. The NCCIA had a leading role with helping to pass North Carolina’s state-of-the-art Captive Insurance Company Act (Session Law 2013-116) NC General Statute 58-10-335 et al (the “Act” Download PDF). This law was passed unanimously with the avid support of many of Raleigh’s finest legislators. This law was then subsequently updated and improved by the Technical Corrects Act (the “TCA”) to the Act (Download PDF). These recent experiences have helped us to reevaluate risk awareness and how to confront insurance/risk protection weaknesses for a wide variety of businesses and their owners.
Typically business owners buy liability and/or property insurance (or against better advice choose to self-insure, i.e. bear the risk of loss by not insuring at all) for their customary risks. If there is commercial insurance available to cover a specific risk of loss that could happen in the normal course of business, and if it is available on the open market for a reasonable price, then the business owner can cover his/her/its needs there. However, if insurance for a particular risk or set of risks is unavailable or is simply too expensive, then the business owner has little choice but to self-insure. This self-insurance requires the owner to pay tax on profits and then set aside money, after tax, to cover potential future losses. This assumes, of course, the business owner has the soundness of mind to create such a “rainy day” fund. Often they do not know or appreciate their full range of risks as the full spectrum of risk is as diverse as the wide range of insurance possibilities.
The unfortunate fact of the matter is that most risks are self-insured. Business owners commonly do not buy insurance for the legal costs of disputes, loss of key employees, loss of key customers, professional fees related to an IRS/NCDOR audit, loss of franchise rights, weather related business disruptions, adverse changes in government regulations, ransom for an employee or owner who is kidnapped, cyber attack (think Target Co!) and hundreds of other potential risks of loss. This is where a Captive Insurance Company (“CIC”, or simply “captive”) can be of use. There are generally two versions of captives: large or regular captives and so-called “mini-captives” or 831(b) captives. The 831(b)s are a creation of the Internal Revenue Code that provides mini-captives with a special tax break. CICs are widely used for unique new risks where coverage is not available in the traditional market.
It is widely believed that the insurance industry started hundreds of years ago in England when ship owners met at Lloyd’s coffer 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 engineer 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”, much has changed. Now there are domiciles all over the world, and more than 32 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, U.S. states like Delaware, Vermont, Utah, South Carolina, and 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 that are needed. The biggest United States 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.
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. See the Act for definitions. For those who cannot afford the cost of forming and operating their own CIC, protected cell captives run by a sponsor provide many of the same business and tax benefits at much less cost.
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 or LLCs 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 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 is now North Carolina, as 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 (but probably not all) of the insurance that the operating business normally purchases from a public insurance company. 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. See, for example, Steere Tank Lines, Inc v. U.S., 577 F.2d 279 (5th Cir. 1978). 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 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 assumed combined state and federal effective 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.
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. Note that even though the domicile of a captive is off-shore, the assets do not need to leave the USA.
Often, one of the primary questions a client will ask is how once premiums are paid into the CIC 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 4 member CIC would cost closer to $100,000 -$120,000 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.
Large corporations setting up non 831(b) captives will usually have more complex insurance programs, and, as a consequence, incur significantly higher start-up costs. To such corporations the true goal is less about a tax savings (although, of course, there will be savings) but rather, the goal is better risk management for the parent and its subsidiaries resulting in a better consolidated bottom-line. If the company is publicly traded, this should contribute to a better stock market performance.
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. The Commissioner, however, has discretion to reduce this amount if not necessary to support a given insurance program. See the Act for the capital requirement of other types of captives.
The benefits of a CIC are great in number, but the primary benefits of a CIC for the business owners are the following:
- Insurance: Any valid risk of a fortuitous economic loss can be insured. CICs can allow a business to acquire cheaper insurance than already possessed and/or insure risks otherwise not typically insurable through the traditional insurance market. Traditional insurance is often modified to provide higher deductibles or stop losses which are then covered by the CIC.
- Control: As the insured business or its owners own the CIC, the business/owners can exercise absolute control over the CIC and thus guarantee that the premiums paid are properly invested, and claims are paid without conflict or dispute.
Primary Tax Advantages
- Tax Savings: The ability to deduct the premiums paid by the business to the CIC is a huge financial advantage that can save substantial dollars every single year (and the CIC itself – if a 831(b) – will not need to report the payment of premiums as income). Regular CICs (non 831(b)s) are allowed to accrue loss reserves to shelter CIC income. Remember, simple savings for self-insurance are not tax deductible.
Versus a Qualified Plan
Many of the benefits of a CIC can better be understood by comparison to the more commonly known rules affecting qualified retirement plans (“QP”s)
- Premiums or 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. In contrast, for example, many qualified plans (“QPs”) (including Defined Contribution Plans such as a profit-sharing plan [even with 401(k) features] and Defined Benefit Plans) can receive only up to approximately $50,000 and $250,000 in contributions, respectively.
- Investment Assets: CIC funds can be invested in prudent business projects in coordination with the insured operating entity and/or its owners. See NCGS§ 58-10-440. Similar QP investments would probably either disqualify the QP (a disastrous tax event) or subject the participants in any such “prohibited transaction” to severe non-deductible excise taxes and/or penalties.
- 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). QPs also generally receive considerable asset protection under ERISA, but IRAs are limited to $1,000,000 in creditor protection. Further, the only permitted creditor claimant against a CIC is the insured of the CIC (i.e. the operating entity that paid the premium, which is usually the same as or related to the owners of the CIC).
- Distributions or Dividends: Distributions from a CIC can be taken at any time by the CIC owners (subject only to solvency/capital requirements of the domicile, see NCGS§ 58-10-375 infra.). As “qualified dividends”, those distributions would be taxed currently at only 15% (federal). In contrast, except for a loan up to a maximum of $50,000, all QPs severely punish withdrawals before age 59 ½ with a 10% penalty on top of ordinary income tax rates. In addition, unlike QPs there is no required minimum distribution from a CIC at age 70 ½. Accordingly, CICs are great supplementary retirement planning tools.
- Loans: Limited from QPs to $50,000 and then can only be made to the QP participant, not the operating entity that sponsors the QP. QP loans must be paid back within five (5) years. Loans from IRAs are prohibited. Loans from a CIC to its insured operating entity are generally permitted by most domiciles (including NC), subject only to regulatory approval (to protect solvency and liquidity). The IRS is hostile to over-use of “loan-backs” so care and prudence are required.
- Liquidation: When a CIC is liquidated or sold to a third party, the smaller capital gains tax rate is owed, as compared to the higher ordinary income tax rate on cashing out a QP. QPs cannot be sold of course, or even assigned except for a Qualified Domestic Relations Order.
- Gift Tax: Due to the fact that “full and adequate” consideration has been paid to the CIC for actuarially sound insurance premiums, even though the business owners’ children (or a trust for them) own the CIC, there is no gift in the transaction, and therefore no gift tax imposed.
- 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 business assets is also reduced. Every dollar placed into any QP or IRA (and all subsequent growth) is includable in an individual’s estate and taxable upon death. In addition, the heirs must eventually pay income tax (at higher ordinary rates – federal and state) on the entire QP (unless it is a Roth).
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 now one of the more favorable domiciles for CICs.
The statute begins at N.C.G.S. Section 58-10-335 and using that as a starting point, we are going to give you a nuts and bolts summary from there:
The purpose of the Act and definitions for terms used in the Act are set out in Section 58-10-335 and Section 58-10-340, respectively.
In Section 58-10-345 it is made clear that no CIC can operate in NC unless a license is received, there is at least one Board meeting in the state each year, the CIC maintains a principal place of business in the state, and there is a registered agent in NC. In order to get the license, the organizational documents of the CIC must be submitted to the Commissioner of Insurance, along with a statement under oath of its president and secretary showing its financial condition, a plan of operation, evidence of amount and liquidity of its assets, biographies of the CIC’s directors/managers, and evidence of its loss prevention plan. This section also states that a certain amount of capital has to be paid into the Commissioner in accordance with Section 58-10-370(as discussed below). Application forms and instructions can be found at www.nccaptive.com.
Section 58-10-350authorizes the Commissioner to hire consultants and other professionals to expedite and complete application reviews, examinations and other regulatory activities. Cost charged to the CIC.
Section 58-10-355 authorizes (but does not require) the Commissioner to perform an organizational examination before issuing a license to an applicant.
Before a captive insurance company can be issued a license, the CIC must report to the Commissioner the name and address of the NCDOI approved captive manager retained to manage the captive insurance company (and the Commissioner must approve). Section 58-10-360.
Unsurprisingly, the CIC cannot choose a name that is deceptively similar, or likely to be confused with any other existing business name registered in North Carolina. Section 58-10-365.
Section 58-10-370 is very important as it specifies the capital and surplus requirements for the different types of captive insurance companies. Specifically, this Section requires the following capital requirements: Pure captives, $250,000; Association, $500,000; Industrial Insured, $500,000; Risk Retention Group, $1,000,000; Protected Cell / Incorporated Cell, $250,000; and Special Purpose Financial Captive, $250,000. Note: as to all captives the Commissioner can require additional capital, but only as to pure captives, he can reduce the statutory capital.
Under Section 58-10-375, a captive insurance company must receive prior approval from the Commissioner before paying a dividend or other type of distribution out of capital and surplus.
Section 58-10-380 sets forth the various requirements for the formation of a captive insurance company, including what entity type each captive variation can be and the like. It should be noted that any business type entity – corporations, LLC and even a trust – are eligible to be CICs. At 380(e) is the requirement that every CIC have at least one of its key managerial or control representatives be a North Carolina resident. In this regard NC is like all other captive domiciles (except Kentucky). The intention, of course, is to get some economic development benefit for the home state from licensing the CIC.
In accordance with Section 58-10-385,every captive insurance company is required to report to the Commissioner within 30 days after a change in its executive officers or directors. This section also prohibits directors, officers and employees of a captive insurance company from receiving any personal benefit as a result of any investment, loan, deposit, purchase, sale, payment or exchange made by or for the captive insurance company.
Section 58-10-390 requires that a captive insurance company adopt a conflict of interest policy for officers, directors and key employees.
In accordance with Section 58-10-395, any material change in a captive insurance company’s previously filed business plan must receive prior approval from the Commissioner. Any immaterial change in other information included in the application must be filed with the Commissioner within 60 days but does not require prior approval.
Section 58-10-400 prohibits any person in or from North Carolina to act as a managing general agent, producer or reinsurance intermediary for a captive without the authorization of the Commissioner.
Section 58-10-405 states that no annual reports will be required of any CIC except for pure CICs and industrial insured CICs.
However, even though there is no annual report requirement, there must still be an annual audit performed by an independent CPA (to be an independent CPA for purposes of Section 58-10-420, Section 58-10-422 prescribes certain conditions and procedures for the CPA). The annual audit is to include a statement of actuarial opinion prepared by a qualified actuary evaluating the captive insurance company’s loss and loss expense reserves (additional requirements also exist within this Section as well). Section 58-10-420. But, beneficially, a CIC in NC with less than $1,200,000 in annual premiums (i.e. an 831(b) CIC) may request to be exempt from this requirement. North Carolina is one of the few states that permit this exemption.
Section 58-10-425 allows the Commissioner to request additional capital for security if the Commissioner finds it necessary.
The Commissioner is authorized to conduct an examination of a CIC whenever the Commissioner determines it to be prudent. Section 58-10-430. Any examination conducted pursuant to this section is to be paid for by the captive insurance company being examined.
Section 58-10-435sets forth the following reasons that a captive insurance company license may be suspended or revoked:
- Insolvency or impairment of capital or surplus;
- Failure to meet the capitalization requirements;
- Refusal or failure to submit an annual report;
- Failure to comply with its own charter, bylaws, or other organization document;
- Failure to submit or pay the cost of an examination;
- Improper corporate management that cripples the utility of the CIC;
- Failure to comply with the laws of NC;
- Failure to commence business according to the CIC’s plan of business within two years of being licensed;
- Failure to carry on insurance business in NC; and
- By request of the CIC.
Section 58-10-440 generally provides that, except for association captive insurance companies and risk retention groups, all other types of CICs are not subject to any restrictions on allowable investments unless the Commissioner believes that an investment may threaten the solvency or liquidity of a captive insurance company.
CICs may provide reinsurance and take credit for the reinsurance of risks ceded if certain criteria are met under Section 58-10-445.
Section 58-10-450 sets forth that a captive insurance company does not have to join a rating association and prohibits a captive insurance company from joining or contributing financially to any plan, pool, association, or guaranty or insolvency fund in North Carolina or from receiving any benefit from any such plan, pool, association or guaranty or insolvency fund. Accordingly, a CIC must be able to stand its risk exposure on its own (or, perhaps, with help from a reinsurer).
Section 58-10-455 cross-references Article 8B, Chapter 105, entitled “Taxes Upon Insurance Companies” as source for the premium tax rates for captive insurance companies. Therefore, the NC Department of Revenue handles all premium tax reporting and audits.
Section 58-10-460 authorizes the Commissioner to adopt rules to carry out the provisions of the Act.
Section 58-10-470 authorizes the Commissioner to adopt rules to establish standards to ensure that a parent or its affiliate company, or an industrial insured or its affiliate company, is able to exercise control of the risk management function of any controlled unaffiliated business to be insured by a pure captive insurance company or an industrial insured captive insurance company, respectively.
Under Section 58-10-475, and in accordance with Article 30 of Chapter 58 of the North Carolina General Statutes, there are specific terms and conditions for supervision, rehabilitation and liquidation of CICs.
Section 58-10-480 authorizes any defined public body to expend public funds for the purchase of capital stock in a CIC or to provide guaranty capital in a mutual captive insurance company provided that at the time of expenditure adequate insurance markets in the United States are not available to cover the risks, hazards and liabilities of the public body or that the needed coverage is only available at excessive rates or with unreasonable deductibles. In many states, municipalities form “risk pools” to share coverage for otherwise difficult to obtain insurance.
The penalties for violating any provision of the Act or any rule or regulation authorized by the Act are stated in Section 58-10-485 and including suspicion of the CIC’s license as well as payment of fines.
Section 58-10-495 provides that any CIC that reinsures life insurance policies must maintain reserves that are actuarially sufficient to support the liabilities incurred by the captive insurance company in reinsuring life insurance policies.
The subsequent sections of this statute (NCGS§ 58-10-500 thru 58-10-650) deal specifically with the establishment of Protected Cell CICs and Special Purpose Financial Captives. These are extremely important provisions that provide great flexibility in regards to the types of CIC structures available in NC, but a thorough discussion of these entity types are outside of the scope of this article.
In summation of the Act, please note the following as some of the primary benefits of the Act as compared to laws of other domiciles:
●No licensing 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 (generally only 0.4%) with a $100,000 premium tax cap ($200,000 cap for large protected cell companies).
●Competitive capital requirements (including the unique ability to lower pure CIC capital required).
In addition, from our work with the North Carolina Department of Insurance, we find that they possess a very dedicated and easily accessible captive staff, regulatory team, and an 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.
Lastly, please note that we believe the Act became even stronger via the 2014 TCA.
For many reasons, we believe that CICs are going to be a great advantage for our fine state and its business owners. The greatest benefits we foresee are the following:
● Increased state revenue due to the premium tax rate on any NC CICs. (Instead of going to another state or foreign country!)
● Increased state revenue based upon the annual meeting which is required to occur within NC (revenue will come from hotel sales, conference rooms, entertainment of our visiting guests, etc.). Vermont claims almost “$10 billion” in economic benefit from its captive industry.
● Job creation for attorneys, accountants, actuaries, captive managers, and other professionals that will be needed to support the captive industry.
● Job creation (or security) for the NCDOI employees.
● Increased risk management awareness for NC businesses.
● Better insurance protection for businesses due to the tailored nature of captive insurance.
● A convenient and local domicile for NC businesses.
In summation, a CIC is a uniquely remarkable vehicle for businesses and business owners alike- it allows a business to self-insure otherwise overly expensive or uninsurable risks and then receive a substantial tax deduction for the premiums paid, all while the business or business owner owns the CIC itself and controls its investments. Also, if so chosen, the CIC can then either pay dividends or be liquidated for a long-term capital gain. Truly, a CIC is unrivaled as a risk management (self-insurance), asset protection, and business/tax planning tool.
*As noted prior, the preceding article was republished with permission from the North Carolina Bar Association (“NCBA”) and with permission from the articles authors – W. Y. Alex Webb and Jesse Thomas Coyle. This article was featured in the NCBA’s Business Law Section Newsletter – Notes Bearing Interest – and was entitled “Captive Insurance Companies- a New Law Creates a New Way for N.C. Businesses.” North Carolina Bar Association Business Law Section Newsletter, Notes Bearing Interest, Vol. 35, No. 4 (June 2014).