Captive insurance companies are generally wholly owned by their insureds and only write policies to insure the risk of its owners. Captives allow businesses to set aside tax-advantaged premiums to insure risks that are often too expensive to obtain in the traditional insurance marketplace or do not meet their needs.
A microcaptive company is a small captive insurance company organized and taxed under Section 831(b) of the U.S. tax code. It allows small, non-life insurance companies that meet certain requirements to elect an alternative taxation method that only taxes investment income, not premium income.
Both captive and microcaptive insurance companies allow a business to shift and distribute their financial risk. Every business has risks — both tangible and intangible — and many of those may fall outside of traditional insurance. The Covid-19 pandemic and its aftermath identified many underinsured or uninsured risks that owners were previously unaware of.
In this article, we will specifically address microcaptives that elect under Section 831(b) of the tax code and refer to these microcaptives as 831(b) plans.
As the founder of a strategic risk company that administers 831(b) plans, I’ve seen how the advantages of these plans can be significant. In addition to the risk mitigation strategy, premiums paid to an 831(b) plan are tax-deductible business expenses and the premium revenue earned by the 831(b) can be excluded from taxable income. However, these tax benefits can quickly disappear if the IRS determines that the plan is abusive.
What makes an 831(b) plan abusive?
Know the five warning signs and be prepared to ask questions if things appear too good to be true.
1. The primary motivation is taxes.
If you’re creating an 831(b) plan only to lower your tax bill, then it may be abusive.
Misrepresenting your income by deducting business expenses that aren’t ordinary and necessary can land you in hot water with the IRS. When structured properly, an 831(b) plan lets you defer taxes in order to mitigate specific risks that you won’t find coverage for with a traditional commercial insurer.
831(b) plans can help mitigate risks such as (but not limited to):
• Supply chain disruption
• Business interruption
• Warranty claims
• Data breach
• Adverse weather
• Reputational damage
2. Coverage is unnecessary, vague or duplicates existing coverage.
Insurance should provide coverage for a business risk that is likely to affect your company. If the insured risk is for an unlikely event, the plan may be considered abusive. For example, a catering business in Wyoming with hurricane risk insured through an 831(b) plan would meet the unnecessary and implausible risk threshold.
Insurance contracts should be written to clearly define the insured risk and terms of insurance. If the coverage provided in the insurance contract is vague, ambiguous or illusory, consider this a red flag. The policies should also be issued with written effective and expiration dates and provided to you promptly following the insured’s initial premium payment.
Additionally, the plan should not duplicate coverage. Your 831(b) plan should provide coverage for gaps in traditional insurance and not replicate coverages already insured through a traditional commercial insurer.
3. Premiums are expensive, inconsistently paid and set to meet specified results.
Insurance premiums should be reasonable and determined by an independent third-party underwriter or actuary — the premiums shouldn’t be arbitrary or set to meet a specific requirement. For example, plan premiums should not exceed the premiums charged by commercial insurers for similar coverage. If you’re not sure, ask if there is a defined methodology to determine premiums and coverage; if there isn’t one, ask how premiums were calculated.
Similar to commercial policies, premium payments should have a set schedule, perhaps monthly or quarterly. The following would be causes for concern: no payment schedule, no required regular payments and/or lack of follow-up on missed payments.
4. A claims procedure does not exist.
As we discussed earlier, the purpose of insurance is to shift and distribute financial risk. That includes paying claims when a covered loss occurs. For example, if your business is damaged from a tornado, you would submit a claim to your insurer following their claim procedures.
When an 831(b) plan fails to outline clearly defined written procedures for how to submit claims, this may indicate that it does not intend to pay out many claims. Simply put, there would appear to be no intent to transfer the risk away from the insured to the insurance company.
Furthermore, if the insured has a potential claim under their 831(b) plan and does not submit the claim, that may be further evidence of no intent to transfer the risk away from the insured to the insurance company.
5. Reserves are inadequate to honor coverages.
When an insurance company doesn’t have adequate reserves to assume covered risks, it presents solvency issues. Without proper reserves, the insurer may not be able to pay claims.
Plans should follow defined investment guidelines (usually provided by the plan administrator) to preserve funds and liquidity in order to honor coverages. An abusive plan’s reserves may have investments in illiquid or speculative assets that insurance companies don’t usually hold.
If you’re going to participate in an 831(b) plan, seek consultation from a risk professional and have them administer your plan. (Disclosure: My company specializes in 831(b) plans.) Be careful of individuals who may abuse 831(b) plans as tax planning or wealth preservation tools. A good CPA, tax attorney, estate planner or other trusted advisor should refer you to an 831(b) plan admin, just as they should refer you to a 401(k) admin to manage your 401(k) plan. An 831(b) plan should focus on risk shifting and distribution for the business owner, with the tax benefits being secondary to the risk mitigation these plans allow for.