Find out how you can potentially reduce your risk, decrease your taxes and build your wealth with this insurance strategy.
Captive insurance can be an especially effective way for ultra-high net worth individuals – including athletes, entertainers, and celebrities – to supplement their current insurance program in a tax efficient way.
Origins of Captive Insurance
Captive insurance isn’t new. It was established in the 1950s to help businesses of all sizes properly manage their risk, and have a legitimate plan in place to handle adverse events. Most Fortune 1000 organizations use captive insurance to take advantage of its many benefits.1
While a handful of global risk management providers dominate this market, they work primarily with large, publicly held corporations – not small business owners. That’s part of the reason why this insurance strategy is relatively unknown.
However, Morgan Stanley offers the same asset management and custodial services for captive insurance companies that it offers to other clients and accounts.
How Captive Insurance Works
If you own a business, even if it’s a limited liability company (LLC), then as a business owner, you need to determine how to best protect yourself against business risk.
In a typical business risk scenario, you periodically pay money to an insurance company through your premiums. In return, the insurer reimburses you if a loss or claim occurs, subject to the policy’s limitations.
Captive insurance is a form of self-insurance. Instead of paying money to an insurance provider in exchange for financial protection, you essentially pay the premiums to your own insurance company, let the premiums accumulate in an account, and pay for any claims from that account.
To do this, you need to establish your own insurance company. Unlike major insurance corporations that have many clients, your captive insurance company primarily covers the risks associated with your business – and that’s it.
Financial Benefits of Captive Insurance
Captive insurance might make sense for you financially because it can allow you to do the following:
Keep your premium payments: With traditional insurance, the money you pay through your premiums never comes back unless you experience a loss. As your premiums sit in the captive insurance account, they can be invested to potentially appreciate in value, as well as earn interest and dividends. However, you could also experience claims losses greater than the premiums paid, leaving you with no investable assets.
However, with captive insurance, you can typically pay up to $2.2 million (and possibly more) each year in premium payments to yourself. Those funds remain in the captive insurance account, and build over time. For example, if you contribute the full amount annually; you’d have $11 million in the captive insurance account after five years – as long as you didn’t withdraw any money to pay for a loss or other expense2.
Reduce your tax burden: If your captive insurance company is properly established, your self-insured premium payments are a fully deductible expense against your earned income, so you can significantly decrease your tax liability each year.
Make tax-efficient withdrawals: You’re allowed to withdraw funds from your account for other types of expenses beyond insurance claims. While those distributions will be taxed, the tax rate on those dividends can be significantly less than ordinary income tax rates.
For instance, let’s say you wanted to buy a home. That type of withdrawal is treated as a qualified dividend, and taxed at the long-term capital gains rate of 20% for high-income individuals. With the 3.8% Medicare surtax added, the effective tax rate on the withdrawn funds is 23.8%.
In contrast, without using a captive insurance strategy, you’re likely facing a combined 37-50% tax rate with your federal and state taxes on those funds. So, you’re potentially decreasing your taxes by up to 50% when you deposit the funds into your captive insurance account. That’s why it can be a tax-efficient strategy.
Protecting Your Business
Athletes, entertainers, and celebrities face unique risks.
Captive insurance may be able to mitigate these types of risks often overlooked by basic business insurance coverage. Independent licensed actuaries work with you to evaluate and determine applicable coverages for your captive insurance. Some specialized coverages that may be available to you through captive insurance include3:
- Brand rehabilitation
- Legal defense reimbursement
- Product recall
- Copyright infringement
- Loss of key contract
- Loss of key personnel
Creating Your Insurance Company
There’s typically little involvement from you – or even your business manager.
There are usually three primary stakeholders involved with the process:
- Business owner
- Captive administrator
- Account custodian
The process starts by you (or your business manager) hiring a captive administrator and account custodian. The administrator normally selects a licensed, independent actuary to objectively assess your business risk through a feasibility study. The actuary reviews your operations, determines the insurance risks associated with your company, and sets the premiums for each type of applicable insurance coverage.
After reviewing the findings of the study, you can decide which risks you want to insure, as well as the policy limit for each coverage.
Make no mistake, these captive insurance programs need to be done correctly, as congress has acted to curb micro-captive abuses4.
Once you’ve made your decision, the captive administrator coordinates all the necessary steps to create your captive insurance company, such as processing the legal paperwork, issuing the policies, collecting the premiums, paying any claims, and handling the annual accounting.
Meanwhile, the custodian establishes your account, and manages your funds – which are the premiums you pay. Those funds will be held by your captive insurance company, and are typically invested in highly liquid, diversified assets that have the potential to grow as well as generate income. (Morgan Stanley can act as your account custodian.)
Once the account is established and initially funded, there’s not much activity required from your business team other than paying the ongoing premiums and administering any claims – just as you would with a typical insurance policy.
Again, captive insurance isn’t designed to replace all your traditional insurance coverage. Instead, it can complement your current risk management strategy. And, in the process, it can enable you to enhance your overall risk coverage, reduce your income tax payments, and potentially build your wealth.