How does your business face your "uninsurable" risks? Do you even know what they are?

Over 90 percent of Fortune 1000 companies and many successful middle market businesses have 831(b) Enterprise Risk Captives. The name 831(b) Captive comes from the actual US tax code provision that was enacted as part of the 1986 Tax Reform Act enacted by Congress and signed by President Ronald Reagan into law during his 2nd term – U.S. Code, Title 26, Subtitle A, Chapter 1, Subchapter L, Part II, section 831, subsection (b), of the United States Internal Revenue Code, titled “Alternative tax for certain small companies.”

Theses 831(b) Captives, are also referred to as "Micro-Captives", “Mini-Captives” or “Enterprise Risk Captives”, and are used by profitable, cash flow positive mid-size companies looking for cost-effective ways to finance and transfer risk that the traditional insurance marketplace cannot "insure". When properly structured, there are numerous benefits of owning an 831(b) Captive including possible financial, estate and tax advantages, such as:

• it provides a business the means to accumulate a loss fund, in a tax favorable way, to provide the liquidity to pay for a loss that may not normally be insurable in the traditional insurance marketplace,
• premiums paid by the business to the captive would be a legitimate, tax deductible expense,
• the 831(b) Captive pays no Federal income tax on the premium collected but the captive company makes an election at its inception to pay tax only on its investment income,
• the underwriting profits of the captive may be returned to the captive owner(s) as a capital gain instead of ordinary income, and
• the captive may be owned by the individual owner(s) of a business, or by others not related to the business including family members.

From the benefits above, you can see why the use of an 831(b) Captive is one of the most popular choices for middle market companies to help manage their risks. However, there are limitations to the captive: the captive will have maximum annual premium limitation of $2,200,000; and the captive cannot directly pay a third party, it can only reimburse the insured business for covered losses that occur. Because of these limitations, it is predominantly used to insure risks that no traditional insurance company will cover, or to fill holes in an existing traditional insurance program.

There are innumerable other kinds of exposure and risks that your business faces in your daily work activity that you may, or may not, recognize as being a threat to your success and perhaps your future existence.  Various other types of risks include, but are certainly not limited to the following:

• Political risks — civil unrest, terrorism, war or intentional violent acts
• Regulatory — unintentional loss of personal or business licenses, statute changes
• Contingent Liabilities — weather, lack of materials or manpower
• Trade Credit — diminution of values, accounts receivable
• Business — loss of a key client, franchise or supplier relationship; loss of Bonding Capacity; material price fluctuations
• Financial Risk — interest rate fluctuations, foreign exchange rate fluctuations
• Reputation — brand value, key person and/or corporate image
• Competition — price wars
• Service Contracts — furniture, appliances, autos, equipment, homes
• Non-ERISA Medical Plan losses — HRA’s
• Large Deductible Losses — workers comp, medical plan, liability

The types of exposure noted above truly only “scratch the surface” of what a business may protect from loss through the use of an 831(b) Captive.  You may also think of numerous other risks that are not typically insurable, or perhaps not affordable, through the commercial markets.  One way to identify risks that are not being traditionally insured by you is to open your liability and property insurance policies and read what is describe as not being covered (such as paved surfaces, bridges, or underground property) or specifically excluded (such as your product, your work, or intentional acts of an employee).  Most of those exposures may be insured non-traditionally with an alternative market approach such as an 831(b) captive.

Important Note

There have been IRS and court challenges to the 831(b) captive product, but if the rules and regulations are followed, the captives have prevailed in most cases. The two most critical issues that an 831(b) Captive insurance programs will face scrutiny of are Risk Transfer and Risk Distribution.

• Risk Transfer
• There must be clear, documented transfer of the risk from the operating company to the insurance company.
• The risk transfer is accomplished via the issuance of an insurance policy, with actuarially determined premiums and a clear set of insuring conditions and policy terms.
• Risk Distribution
• The insurance company needs to have third party business (unaffiliated to the single operating company) within the insurance company’s written premium.
• There is no current regulation that determines the required level of third party business, though most insurance professionals focus on levels ranging between 30% to 50% of the total written premium of the company.
• Third party business may be acquired in a number of ways, including the pooling of various exposures with other captives, simply purchasing unrelated insurance business from other carriers and even some insurance policies that the captive may issue might qualify as unrelated business.

Now, after reading all of this, you might be thinking that the federal government does not like 831(b) captives, that is not the case.  In fact, congress passed the 2015 Appropriations Bill under the Obama Administration that actually increase the maximum allowable premium for an 831(b) Captive from $1,200,000 to $2,200,000. The Federal Government clearly understands the need for and benefits of a properly structure 831(b) Captive, they are simply trying to keep the use of these from being abused.