Private equity firms face a unique struggle. Their portfolio’s are full of companies from all different industries. And then they have their own company in its own unique industry. There’s a lot of risk involved, and that risk is in far-reaching, niche areas. It can be difficult to find an insurance company that will blanket these liabilities without charging an extraordinary premium. To combat this, some private equity firms have chosen to open their own captive insurance. Unfortunately, this doesn’t always turn out as planned.
What Is Captive Insurance?
Captive insurance is an insurance company created by a business with the sole purpose of insuring them. At first glance, this type of system makes sense. The business can tailor their insurance plan to precisely their needs. Unfortunately, many businesses have no experience in the insurance industry and don’t understand how to set up these plans, and the insurance business as a whole, up properly. In the end, creating a specialized insurance company can create more risk for a private equity firm than it’s worth—not to mention the potential legal issues that it can bring forth.
What Are The Potential Downfalls Of Captive Insurance?
Tax Shelter Priority
One of the biggest, and most illegal, mistakes that private equity firms can make is creating a captive for the wrong reasons. Rather than the priority of the captive being to mitigate risk, it is being used as a tax shelter. If a captive is being sold as a way to save taxes rather than a function of managing risk, it’s not a captive. And because the focus is on reducing tax, the important aspects of the captive are ignored, leading to schemes of buying life insurance with pre-tax dollars, a lack of true risk distribution, the insurance of non-existent risks, highly overpriced premiums, inadequate capital, and other flaws. These negligent acts matter to the IRS and they will pursue them.
Risk Pool Confusion
In the simplest terms, a risk pool is an insurance arrangement that allows businesses, with too few subsidiaries to pass the “multiple insured” test, to still cover all their risk with a pool of other captive owners. A risk pool is legal. The IRS has validated the concept. But it has to be run correctly. Too often it’s not.
Many times there isn’t an equitable sharing of risks. This creates large premiums that are not realistic or actuarially sound. This can quickly turn into tax fraud when it becomes clear that the premiums were priced too high with no loss history. It gives the appearance of risk-shifting without it actually happening.
Because, as previously mentioned, many captives are set up as tax shelters, the premiums bear no relationship to reality. This can get a business into big trouble in tax court. The first mistake businesses make when setting up a captive is not getting an actuary involved, or getting a corrupt one involved. Instead, they rely on a tax attorney and an insurance manager who find out how much tax savings is desired and then build a premium around that. This isn’t how a captive’s premiums should be set up. Such an unreasonable premium won’t survive a legal challenge, even if an actuary signed off on it.
Lack Of Preparation
Captives are too often established without any background studies being conducted. This takes a lot of time and money so many avoid it. However, a feasibility study needs to be made to validate the economics, viability, and whether the captive achieves the critical tests of risk-distribution and risk-shifting, as well as taking a closer look at all aspects of the potential captive. Without this thorough investigation, a firm can get into legal trouble, as well as simply wasting their time when a commercial option would have been a better fit.
Firms that jump into the captive trend a little too quickly forget that they don’t have experience in designing policies or assessing risks. They want to protect themselves so they overshoot the likelihood of many risks. This doesn’t look good to the IRS. It looks like a tax shelter, even if it’s not.
State Tax Ignorance
This is probably where firms trip up the most. State taxes are intricate and complicated. And they certainly can’t be ignored or swept under the rug. Abiding by these policies is essential as well as time-consuming. This is especially true when the firm operates in multiple states or wants to open the captive in a different state than where they do business. By not being extremely diligent, a firm can go astray and learn some hard lessons—legally and financially.
Lack Of Capital
From a tax standpoint, the more capital a captive has when being established, the safer it is. The realistic minimum capital requirements for starting a captive are almost always much higher than the minimum jurisdiction requirement. But this isn’t just a problem when the captive is being established. If the capital isn’t sufficient, a problem can surface if the owners are taking too much of the profits or there are excessive claims.
Captive insurance isn’t necessarily a bad idea. It can work. But it is challenging to get right. If even the littlest aspect is ignored, whether on purpose or by accident, a firm can be caught up in legal battles and financial stresses for years. Yes, it is challenging to find the perfect insurance plan that covers every risk for every subsidiary in a portfolio appropriately. Yes, it is frustrating to search for a fair premium. But it’s important to remember that commercial insurance companies that work closely with specialized industries, like private equity, are around. They can create plans that closely align with what firms need and want, without the hassles and risks of setting up a captive. To find out more, contact us.