Captive Insurances: Why Doctors Should Form Their Own Insurance Company
Of the many government tax incentives offered to businesses, the idea of captive insurance usually doesn’t come first to mind.
In fact, not many business owners are even aware of the potentially substantial tax benefits associated with what is, essentially, starting your own insurance company.
What is captive insurance?
Is it self-insurance? It’s a form of self-insurance but more formal. Basic self-insurance involves business owners (typically sole proprietors) who decided to forego traditional insurance coverage to insure against losses themselves. This usually involves setting aside money in a savings account to pay for future losses.
Self-insurers transfer all risk of loss from the insurance company to themselves but save money in premiums paid to insurers.
Captive insurance is a more formal arrangement than pure self-insurance involving the creation by the business of its own insurance company that is formally regulated by state administrators but that benefits from significant tax incentives not available to self-insurers.
By creating its own insurance company, business owners can not only protect their business against catastrophic losses, create customized coverage to account for unique risks that may not be available through traditional insurance companies, and most importantly, grow the contributed premiums (i.e., war chest) by taking advantage of pre-tax premium payments that can be invested in a variety of asset classes including alternatives, which we’ll save discussing for another day.
Many business owners who are presented with the idea of captive insurance are initially hesitant. Why?
Many reasons have to do with the burden of administration or the potentially not having enough to cover a truly catastrophic loss.
Here are some of the most common myths I’d like to dispel about captive insurance preventing business owners like many physicians from starting their own captive insurance company:
A Catastrophic Loss Can Wipe Out Everything –
Captive insurance companies can protect themselves against catastrophic losses by buying cost-effective reinsurance coverage.
Captives are Expensive to Administer –
For sole proprietors or small businesses, the costs of administration should be nominal when compared to the significant cost savings.
Traditional insurance premiums include a significant markup to pay for the insurer’s expenses, acquisition costs (including marketing and broker commissions), administration, overhead, and, of course, profit.
Captives Don’t Cover All Risks –
The truth is captive insurance can cover risks that traditional insurance companies are unwilling to cover such as cyber liability. Captive insurance can be used broadly. In general, any issue that could be viewed as a risk to a business is on the table for consideration.
Let’s take a look at a physician who runs her family practice as a sole proprietor. She forms her own captive insurance to self-insure against malpractice, general liability, her own family’s health insurance, etc..
The doctor incorporates the captive insurance company, owns all its shares, and pays an annual premium of $150,000 to her own insurance company. Her medical practice still gets the same Sec. 162 tax deduction that she would have gotten if she had bought a traditional insurance policy.
Here’s the big difference between owning her own insurance company and paying someone else to cover her risks:
During the life of her captive insurance company, the pre-tax funds contributed to it can be invested and grown tax-free to be used for any potential future claims tax-free.
When the doctor retires, she can liquidate the captive insurance company. The investments made over the years can earn substantial returns and once the funds are liquidated there is no penalty and gains are taxed as long-term capital gains.
The benefits of creating your own captive insurance company can be substantial.
Instead of paying premiums to an insurance company that you’re never going to see again, other than when claims need to be paid out, why not grow that money through investments and keep the reserves for yourself when you retire?
It’s like having a 401(k) but where you direct the investments and where you can take money out without penalty regardless of age.