The following article appeared in the Steve Leimberg Estate Planning Newsletter
February 12, 2009. The article is reproduced courtesy of and with permission by
Leimberg Information Services, Inc. (LISI).:
Physician-Owned Captives: A View of Why and How They Can Work Well
By Celia R. Clark, J.D., LL.M.
Here at LISI, we encourage varying points of view. When it comes to the
topic of captive insurance companies, LISI subscribers have been provided
with insightful (and sometimes passionate and even contentious) commentary
by some of the country's best and brightest. First came Gordon A. Schaller
and Scott A. Harshman in LISI Estate Planning Newsletter # 1252. Their
commentary was followed by Jay Adkisson in LISI Estate Planning
Newsletter # 1360.
LISI now welcomes Celia R. Clark to the discussion (debate?). Celia R.
Clark, of the Law Offices of Celia R. Clark, LLC, a former senior associate
in Rogers & Wells' Corporate Department, practices in the areas of taxation
and estate planning. She represents individuals and closely-held businesses in
federal and state income, estate, and gift tax matters. A large part of her
practice is the formation and maintenance of small insurance companies for
closely held businesses. In 2006, Celia drafted captive insurance legislation
for the Caribbean Island of St. Kitts.
LISI extends great appreciation to R. Marshall Jones of West Palm
Beach Florida who served as Technical Editor for this commentary.
EXECUTIVE SUMMARY:
Some commentators believe that captive insurance companies rarely work for
physicians. In my practice, I have found the opposite to be the case. In my
experience, physicians in solo practice, or small groups, are attracted to captive
insurance companies because of two common concerns: exorbitant medical
malpractice premiums and asset protection.
Over time, if not immediately, my experience is that my physician-clients pay
less for coverage through a self-owned and administered captive that is
selective about which physicians it insures. The reasons are discussed in detail
below.
FACTS:
MEDICAL MALPRACTICE PREMIUMS
Let's start by focusing on the medical malpractice benefits to physicians who
form captives. The simplest way a physician can benefit by writing coverage
through a captive is to renegotiate commercial coverage to include a higher
deductible or retention amount.
Rather than entirely assuming the risk of a malpractice event through a captive,
the physician is able to preserve commercial coverage at a level at which the
physician is comfortable assuming the risk. A physician with decades of
experience, and few claims, may feel comfortable with a deductible limit of
$500,000, or a high percentage of the insurance mandated by applicable state
and hospital requirements.
The restructuring of commercial coverage can result in substantial savings for
the physician. For example, if policy limits are $1,000,000 per occurrence
with a $500,000 deductible, and the premium with no deductible was $20,000,
the premium with the high deductible could be as low as $6,000, because the
first dollar coverage is more expensive than the excess layers of coverage.
The physician may be able to combine the security of coverage against major
claims with the economic savings of lower medical malpractice costs. It is
important to note that state and hospital requirements will vary in each
situation.
COMMERCIAL CARRIER EXPENSE MARGINS
A reduction in the cost of malpractice insurance premiums is not the only
reason physicians purchase high-deductible policies. It is my understanding
that most commercial insurance carriers are currently increasing malpractice
premiums by an additional margin for potentially adverse outcomes.
These margins can be 5%-20% of the policy premium. Moreover, commercial
carrier expense margins for medical malpractice insurance range from 15%25% of the premium dollar.
By retaining a portion of the risk through a policy issued by a captive, the
physician can realize a significant benefit, even if the physician's claims
experience matches the expectation built into the carrier's premium model.
Physicians who purchase large deductible policies, and thus have some "skin in
the game," tend to improve their risk management, and suffer fewer and more
limited adverse outcomes. This additional profit is then realized by the captive
insurance company.
RISK RETENTION GROUPS
Even greater savings may be available to the physician, or the physician's
group, which joins a risk retention group organized to insure only those
physicians with good claims histories and sound risk management practices. A
risk retention group may be combined with a separate captive insurance
company; each structure will retain a layer of the malpractice risk, and a
highly-rated re-insurer will cover the excess layer.
The risk retention group in this model functions in part as a purchasing group,
enabling the physicians to bargain for lower reinsurance rates than they could
do independently.
ASSET PROTECTION ADVANTAGES
The asset-protection benefits of captives are well known. In general, the assets
of a licensed insurance company cannot be reached by the creditors of the
insurance company's shareholders, or by creditors of the business that set up
the captive. Only the policyholders have a right to require an insurance
company to pay covered claims.
Physicians tend to be highly aware of the risks of creditors' claims, and are
attracted to ways of protecting their assets. For this reason, among others,
physicians often utilize captive arrangements to purchase insurance covering
risks in addition to medical malpractice.
Since the business of medicine is subject to many of the same risks as other
businesses, e.g., property damage and general liability, there is no reason they
should not do so. In addition, medical practitioners are subject to other special
risks that can be covered by captive insurance.
An example of these special risks is the very real possibility that Medicaid
reimbursement for certain treatments will be reduced during the policy period.
In this regard, all risks insured by a captive need to be quantified by an actuary
based on full disclosure of the insured's particular risk factors.
ESTATE PLANNING ADVANTAGES
Savings on medical malpractice premiums and asset protection are two good
business reasons for physicians to form captives. There are estate planning
advantages as well, which were discussed by Gordon Schaller and Scott
Harshman in LISI Estate Planning Newsletter # 1252.
RISK DISTRIBUTION
Some commentators have focused on the difficulty of physicians' captives
achieving the risk distribution required under the tax law. However, the rules
of risk distribution do not depend on the nature of the operating business or
profession setting up a captive.
Exactly the same difficulties are faced by closely-held businesses of all types
when they form a captive insurance company. Most closely-held businesses,
including physicians' groups, find risk distribution to be a significant hurdle to
overcome.
According to IRS rulings and several cases, risk distribution means the
spreading of risk among a large group. In Revenue Ruling 2005-40, the IRS
set twelve as the "safe harbor" number of insured entities that must purchase a
significant portion of the insurance issued by a company in order for the
company to qualify as an insurance company for tax purposes. Unless the
closely-held business has eleven affiliates, it must insure unrelated entities to
be certain of achieving risk distribution.
THE IMPORTANCE OF RISK RETENTION GROUPS
When used in conjunction with separate captives, risk retention groups can
achieve risk distribution for captives. Preferably, this would be done with nonmedical malpractice lines of business risk liability coverage.
The risk retention group would underwrite this coverage for each participating
member. A quota share of the pooled risk would then be reinsured by each
separate captive.
Outside of a risk retention group structure, physician-owned captives can
insure each other's practices for various types of non-medical malpractice risk.
Physicians are often aware of other medical captives through medical societies
and other networking sources. Alternatively, a captive can reinsure a portion
of an unrelated risk pool identified by an insurance broker.
Like any coverage underwritten by a captive, the policies issued to achieve risk
distribution must be market-comparable and must represent real, economic,
insurable risk. In addition, the premiums must be actuarially determined.
Of course sham or bogus arrangements where there is no true risk distribution
are not in compliance with the tax law. This is true of any captive insurance
arrangement.
CASH VALUE LIFE INSURANCE
Some commentators focus their analysis on the investments of captive
insurance companies, and in particular on investments in cash value life
insurance. They consider these investments to be potentially abusive when
employed by physicians. (e. g. See LISI Estate Planning Newsletter 1360).
In this regard, the National Association of Insurance Commissioners (NAIC)
publishes model standards for investments by insurance companies. Life
insurance is not a prohibited investment for insurance companies under the
NAIC's Investments of Insurers Model Act (Refined Standards Version; see,
e.g., Section 4(A) http://www.naic.org/index.htm). Life insurance
investments would be permitted under the Model Act once minimum asset
requirements have been satisfied by classes of investments specifically
authorized for that purpose.
Like all insurance company investments, investments in life insurance should
be determined by the overarching goals of security, liquidity and expected
return. The tax efficiency of investments is specifically permitted to be taken
into account in shaping the portfolio of an insurance company. See, Model
Act, Section 5(C).
In a small captive insurance arrangement, where the captive has an appropriate
relationship with the person whose life is insured, the proceeds of a life
insurance policy owned by the captive may be received tax-free under Section
101 of the Internal Revenue Code; the annual growth in the value of a policy
may also be exempt from tax, although the impact of the alternative minimum
tax must be considered.
If the life insurance carrier selected offers a high degree of security, a high
cash value policy design would seem most appropriate for the investment.
Despite the assertion by some commentators that high cash value reduces
liquidity, my opinion is that exactly the opposite is true.
The cash value, among other factors, determines the amount immediately
available to the policy owner by means of a policy loan. A captive insurance
company, like any insurance company, must carefully monitor the liquidity as
well as the security of its investments. As a profit-seeking business, it also
properly attempts to maximize investment return, taking taxes into account. \
DIVERSIFICATION
A separate but related issue is diversification. Some commentators believe that
a "modest amount" of life insurance is appropriate. The NAIC model rules do
not include any specific requirements relating to the portion of an insurance
company's assets which may be invested in any type of investment. The rules
state that they do not preclude an insurer from the use of "modern portfolio
theory" to manage its investments. See, Model Act Section 6(C).
It is beyond the scope of this article to determine whether a life insurance
policy should be considered as a single investment for this purpose, or, if it
represents an investment in a diversified securities portfolio held by the carrier
for the account of the policy owner. The specific terms of an investment policy
would need to be analyzed from the point of view of diversification as well as
security, liquidity and investment return.
There is no apparent reason, however, why life insurance investments by a
captive insurance company should be seen as abusive - per se. In a small
captive situation, where the captive may be owned by the business owner's
children for estate planning reasons, an investment in a policy on the life of the
business owner could be particularly appropriate.
Whatever business reasons exist for investing in life insurance or other
securities, they exist equally for physician-owned captives as for captives
formed by other types of closely-held businesses.
TECHNICAL EDITOR'S COMMENT:
Risk Retention Groups are often a highly useful solution for many physician
groups because of the difficulty of setting up a "pure captive" with ongoing
annual premiums of $1 million or more to be economically viable.
State insurance departments pay closer attention to RRGs than pure captives
because an RRG failure affects many businesses. If the pure captive fails, it is
simply unable to pay all of its claims to the parent company. It's a political
thing for the State Insurance Commissioner. For example, after a couple of
construction company RRGs failed in one state, the commissioner stopped
approving all captive insurance applications for some administrators until they
convinced the insurance department that their RRGs were not in danger of
failure.
Probably that the most challenging task is not the creation of the captive
insurance company but rather setting up and managing what one of my friends
refers to as the "pre-nuptial" and "divorce agreements"—how you qualify to
become a member and what events trigger a buy back of your interest.
Otherwise, you may end up sharing the claims cost of bad insurance that
would not have been issued by commercial carriers.
HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE
DIFFERENCE!
Celia Clark
Marshall Jones – Technical Editor
CITE AS:
LISI Estate Planning Newsletter # 1419 (February 12, 2009) at
http://www.leimbergservices.com Copyright 2009 Leimberg
Information Services, Inc. (LISI). Reproduction in Any Form or
Forwarding to Any Person Prohibited – Without Express Permission.