[Editor's Note: This guest post, originally titled “A Captive Conversation,” is from Tony Kenzior, CLU, ChFC, an insurance agent who frequently comments on the blog and with whom I have no financial relationship. The subject, Captive Insurance Companies (CICs), is not one I am an expert on by any means. However, these companies are frequently proposed by insurance agents to physician groups as a way to lower insurance costs, lower taxes, and boost savings. I hope this post will help explain how CICs work, and that it will launch a discussion about them in the comments section. If you have personal experience with a CIC (as an agent or a doc), I hope you would share your experience in the comments, especially if your experience has been particularly good or particularly bad. Tony has a 23 page ebook on the subject which he his giving to WCI readers for free (use coupon code HJ56C) or if you prefer, a video. ]
“Good afternoon Tony. I have about 20 minutes to spare,” said my personal cardiologist, as I entered his office one afternoon recently. The shoe was on the other foot, as the week before I’d been there to make sure my stent was still working OK.
“Thanks, Dan,” I said. “I want to introduce you to an idea that just might represent financial salvation during these uncertain times.”
“Ok, I’m listening.”
I continued, “Your office manager, John, tells me you are now 17 physicians with perhaps 35-40 employees filling various support roles at your two offices. Do you have any plans to grow beyond this?
Dan’s replied with, “I’m one of three of us who seem to have the most to say about the actual management of the practice. I haven’t thought much about expansion. About three years ago, we were two separate practices. But somehow we entered into a discussion about merging the two groups with the expectation of bringing economies of scale to our respective practices and hopefully finding that it was more profitable for all of us. In my group there were 8 of us and the other had 9. It’s worked out well so far and all of us are pleased with the outcome, even if we are working out of two buildings. It’s not been stress free but I’m confident we did the right thing.”
I said, “What I want to discuss with you is a reinforcement of your idea about efficiencies and bringing more dollars to the bottom line. What, if anything, do you know about a Captive Insurance Company?” I asked.
He responded, “I was at a meeting recently and ran into an old friend, also a cardiologist, now practicing in Atlanta. There are only 5 in his group. They started their own captive two years ago. He told me their focus was initially medical malpractice insurance, but has now expanded to include risks they had no idea existed. He says it’s made a huge difference in their expectations about money going forward.”
Definition of Captive
I then said to him, “Well, keeping in mind your limited time today, let me start by saying that a CIC, which is easier to say than Captive Insurance Company every time, is just that. It’s in every respect, an actual, properly registered and capitalized insurance company. The captive part of the name refers to the fact that it exists for the sole purpose of insuring the company that “owns” it, no one else. In other words, it’s captive to the parent company.”
I continued, “It’s a significant idea, but it’s not always a simple concept to grasp. At first you can easily lose sight of the forest for all the trees in the way. To start with, when you talk about a captive for a privately owned medical practice, you realize there is one major risk that physicians face, professional liability. The typical solution is to purchase a medical malpractice insurance policy from a commercial carrier. Regardless of your feeling about it, just remember that if you are like most physicians in private practice today, you either buy coverage from a commercial insurance company, or you go without coverage and hope for the best.”
“While it’s true that virtually every 65 year old physician has been stepped on by a lawsuit, there are many years when nothing bad happens. But along the way, the potential for a dramatic negative financial outcome is real and probably not going away, no matter how careful you are. The financial consequences for some real or perceived mistake can be very, very painful. So premiums are paid and everyone gets on with their lives,” I said.
Then I asked him, “So tell me Dan, is it fair to say all 17 of you have medmal coverage?”
Dan said, “Yes, it’s part of our contractual relationship with each other that we are all similarly covered, even though some of us have different sub-specialties. I’d say on average, we’re each paying about $50,000 a year so the total is about $850,000 annually. Fortunately, the premiums here in Florida have actually being going down for the last few years. But with the pressure coming from the implementation of the Affordable Care Act, we need to find additional efficiencies and ways to improve the bottom line of the practice,” he stressed.
How a CIC Provides Lower Premiums
To which I replied, “OK. I’m jumping ahead a bit here, but there can be real advantages to all of you with a properly conceived and structured CIC. The idea will be for you to buy your medical malpractice insurance from someone willing to offer large discounts, as much as 50%, for high deductibles. And then use your CIC to insure the deductible. There are dozens of ways to play this, but it all boils down to being properly insured, with as much premium left in your pocket as possible. ”
I continued, “The revised premium flow will result in several benefits. One is the coverage premiums will not have commercial insurance company costs built into it: overhead, commissions, advertising, rent, and profit. Every commercial carrier on the planet builds into its rates a percentage for profit. It’s how free enterprise works. None of that exists with a CIC. The other principal benefit, of course, is that if you do manage your risks successfully, all the money that remains in the CIC belongs to you.” [Editor's note: And if you manage them poorly, you may have been better off paying someone else to take that risk for you.]
Low Premiums Not the Main Benefit
“I can show you mathematical proof that this works. Your first reaction might be to think that simply lower premiums is the whole point of this exercise. In truth, it’s to gain a financial benefit by turning an expense into an asset. And that asset can be accessed by any or all of you at a later date. Right now if you take money out of a CIC to spend on something, it’s treated as a capital gain. [Meaning taxed at the lower LTCG rates rather than your marginal rate – ed] How long that lasts or if it does last, is simply a guess. Right now it’s a real advantage. Whatever the case, if you do this the right way, you will have created a pile of money for yourselves with money that today is flowing out the door to commercial carriers.”
I finished this thought by saying, “Ultimately, the size of your pile will be a function of many variables, including time and how successfully you manage the risks you face in the coming years.”
What Happens to the Money in the CIC
“OK,” says Dan. “If I understand it so far, you are telling me we can remain fully insured as we are now, but with a different premium structure that says if we participate in active risk avoidance and management, and if there are few or limited claims going forward, we get to keep some of the money. Instead of paying lower premiums, we effectively get a rebate if we keep claims to a minimum. Do I have it right?”
“Yes, exactly right,” I said.
“Ok,” he said. “Now, down the road, there is a pile of money somewhere that belongs to us.” Who, exactly, controls those dollars? Are they invested somewhere?”
I replied to his questions by saying, “Early on, you are going to want to keep the money very liquid. What if there is a claim that has to be paid? But as time passes, and you as a group control your claim history, you are going to want to put this money to work by investing it. Common sense will rule the day. In reality, the owners of the captive are whichever of you push this forward and make it work. If it’s all 17 of you, then each person will have a share of the pile. And it’s reasonable for each of you to perhaps want to influence how your “share” of the pile is invested or put to work.”
To which Dan said, “I think I like this idea. Insurance companies across the planet build up reserves and surplus to deal with claims that surface from time to time. Is that what we are doing here?” Dan then asked.
I answered, “Those funds are called reserves and surplus. That’s what commercial companies do, which makes well run companies so valuable and allows them to own and work out of those huge buildings you see and to sponsor athletic events. I’m not suggesting you do that with your reserves and surplus; I think you will enjoy them more as supplemental retirement income or something else that has value to you individually.”
[Editor's Note: Insurance agents often sell permanent life insurance policies bought with some of this money in the CIC, one of the few ways in which insurance policies can be bought with pre-tax dollars, but you can really purchase any investment with those same pre-tax dollars. Just like outside the CIC, the earnings on regular investments like mutual funds are taxed. This tax is at the corporate marginal rate. If the CIC bought a life insurance policy, it could borrow from it tax (but not interest) free. Upon withdrawing money from the captive, you would pay at the capital gains rate, whether that money had been invested in mutual funds or life insurance. (I'm still not 100% sure on this one and am looking into it. Will put updates and especially links to reliable information as I come across them. It appears there is a great deal of controversy on this subject due to unclear guidance from the IRS.) Certainly do not purchase life insurance inside your CIC before reading this warning published earlier this year in Forbes by Jay Adkisson, who has guest posted on this blog before.]
The Cost of the CIC
He said, “That sounds great, but what does it cost to implement and to maintain a CIC? None of us has a clue about running an insurance company and I certainty don’t want to have to learn!”
I replied this way, “Over the past decade, the cost of setting up a CIC has dropped significantly, as CICs have become increasingly accepted by the legal and accounting fraternities for their clients. The cost for you is going to be a function of how complicated you want this to be and how many dollars there are flowing into the captive every year. The max to set one up is typically $50,000 but could be much less. The cost to maintain it every year again depends on how comprehensive you want it to be. Medical practices are usually pretty simple and straightforward, and cost less to maintain than say a captive for someone who owns several car dealerships.”
I continued, “In my opinion, the threshold for justifying the cost of establishing and maintaining a CIC is a gross operating income of $300,000 per year. Some people have less than that and it works for them. You also have to have a business model where risk is an issue. If you are a consultant, making $400,000 per year working out of your house without so much as a secretary, you are probably not a candidate for a CIC. But a medical practice is like low hanging fruit; the medical malpractice issue alone is usually enough to justify the cost of a feasibility study. Add to that lots of other risks that can be identified and priced, and you find yourself growing money on the side that can be asset protected and available whenever it is needed. Those are details that we’ll talk about later. ”
Dan asked, “How much will a feasibility study cost us and how long will it take? The reason I ask is it’s already the middle of August and if this makes sense, we may want to have one in place before the end of 2014.”
I answered him this way, “A feasibility study will cost about $2000 and take perhaps two weeks. For a privately owned construction company, with several projects going at any one time, with the owners having varying amounts of ownership, it’s going to cost more. And you’re right about getting this done quickly. Under normal conditions, it takes about 4 – 6 weeks to get everything in place, once your whole team is on board with the idea. But at the end of the year, everyone and his brother wants one in place before January 1st, so it gets a little frantic.”
Selling the Idea to your Partners
“What’s the best way to get everyone on board?” asked Dan.
“My suggestion will be for us to schedule a meeting to which all your key people are invited. I’ll set up a webinar with one of the principles of the CIC management company with whom I usually work, and everyone in the room will participate for about 30 – 45 minutes. By the end of the webinar, you will have enough solid information to at least develop a consensus, one way or another. You will all be exposed to the details and hear from someone with 20 years of experience with captives. There will be visuals and dialog that speak to the critical points that are important to all of you in the world of medicine. In the meantime, I’ll provide you with access to an ebook I wrote on the topic that’s free to download. It might take you an hour to read. You’ll have a real understanding of some of the other variables that make this such a powerful idea..”
“Sounds good,” he said.
“Dan, my 20 minutes are up and I now think you are starting to see this as a way for all of you to keep more of what you earn. The beauty of this idea is that as each of you end your career in medicine, there should be a pile of money available to supplement your retirement, to send your grandchildren to college, whatever. And much of it comes from money that today is either going to the IRS or to commercial insurance companies.”
What do you think? Do you have a CIC? Have you considered one? Share your experience in the comments section below!
A CIC is not a bad idea to create a low-cost PLI (professional liability insurance) option for a larger physician practice. There are a couple of problems with this approach, if your group isn’t huge. I think a CIC needs to carry more in surplus than the above example would allow for, in order to be reasonably stable, in case of a major loss. This is especially so in states with little or no tort reform. If the CIC only insures one practice, there is a high probability that one bad case could kill your insurance company, especially if multiple providers are named, and then you would be left bare, or worse. Also, if the CIC insures only one practice or business entity, there is also a chance that your med-mal premiums you pay would not be tax deductible, whereas they usually would be if you are self-employed. (Consult your tax attorney on this.) Very small insurance companies may also have more trouble with investing their loss reserves and surplus, as small mistakes with investments could really hurt when the total surplus is low.
Why not join a larger captive/risk retention group/mutual insurance company, which is owned by its insureds, and which insures multiple businesses? There are a lot of these. Many of these companies are members of an organization called the PIAA (https://www.piaa.us). (The PIAA companies focus on med-mal, and probably will not be writing your life insurance policies, etc, though.)
One of the biggest benefits of commercial medmal coverage is the huge, highly experienced legal defense team that comes with it. If my group started a CIC, would we then have to open the Yellow Pages and find our own defense attorney? If that is the case, that would seem like a big downside to this strategy.
Remember you’re still going to be buying a malpractice policy to cover the catastrophic amounts. You’re just using the CIC to self-insure a small portion that allows you to have a high-deductible policy. Your maximum payout should still be quite limited. Kind of like having an emergency fund and taking the highest deductible on your insurance coverage.
Ive looked into this myself and my determination is that it is just a very bad idea for almost all of us. It isn’t really transferring the risk (assuming you aren’t creating bogus insurance which is another issue) and any person promoting this with insurance as the investment piece isn’t likely caring about what’s best for you. One of the major problems with people who promote this stuff is the lack of disclosure of all the extreme negatives let alone their conflict of interest. The funny thing is that insurance is just such a bad investment and the commissions are just so high that people become so creative on trying to figure out ways to push it on you.
The basic scheme is two-fold, without looking at whether or not you buy life insurance inside it.
1) You might get lower overall insurance costs if you’re particularly good at managing risk.
2) You get some of your pay at LTCG rates instead of your full marginal rates.
Whether those two benefits overcome the additional cost and hassle of the CIC is the question.
But I agree that this can be another creative way to sell life insurance. It doesn’t have to be, but I’ll bet that a good percentage of the time it is proposed it is proposed with a life insurance investment component.
The problem is you can’t actually really be good at managing risk for malpractice and know it ahead of time. Now if you are going to try and set this up for alien abduction insurance or flood in an area of no rain etch then I imagine you could “manage that”.
Sounds funny, but lots of CICs that have gotten into trouble were insuring against stuff like terrorist attacks. Obviously it doesn’t make much sense to spend $500K a year to buy a $2 Million policy against terrorist attacks in Iowa. The insurance needs to be legitimate.
I agree with your point that you can’t know in advance what your risk really is, but the act of self-insuring against some of it ought to make you a better risk manager in and of itself as it removes the moral hazard inherent in paying someone else to take that risk.
No question that life licensed agents are going to try and benefit from this by promoting the idae of using money in a captive to buy life insurance. The smart MD or office manager is going to resist this, at least until the CIC has been on the books for a while and there are reserves and surplus accumulating. The simple advantage of having a supplemental retirement income coming to you subject to capital gains rates vs ordinary income rates should be enough to cause you to look at this, assuming you have enough cash flow to justify it in the first place.
Rex – managing risk is inherent for any small business. You can solve most any problem if you throw enough money at it. But if you are looking for efficiencies, and along comes a captive management company that helps you incorporate internal protocols and procedures that change the culture of your practice, designed to limit or eliminate the chance of a large lawsuit, you are well on your way to success with a captive.
Can you help me better understand your remark about ‘extreme negatives let alone their conflict of interest”. What are you talking about?
I think that comment is just about the manner in which permanent life insurance policies are sold to physicians in general. Agents tend to leave out or downplay the negatives of investing in insurance and don’t reveal just how much they have to gain from the sale of the policy.
Mindful that many of us have ideas already about captives, colored by what we’ve heard, read or been told, whether or not it might work for you is a function of what you want to gain by implementing one. For example, someone commented already about the legal team in place to help you from your existing commercial carrier. Don’t for a minute think that is a free benefit. On the other hand, one of the ways I approach this is to have the client purchase a very high deductible policy from a commercial carrier and then use the CIC to protect against having to pay the deductible. You can very easily get caught in the weeds here unless you find an expert that you trust to give you accurate information.
The best way to use captives is to cover those “excess” risks. As discussed here, captives work best to cover the high deductibles but it essential that you have the right team in place when putting together your captive insurance company. By the right team, I don’t just mean insurance professionals. You need financial experts, attorneys and more. One way to get around this is to use the services of a one-stop shop. Look online for such companies or just google something like “turnkey captive insurance services”.
Captives Insurance Companies are sophisticated solutions to relatively sophisticated problems. They require significant expertise to get it right and make sure the IRS is not coming after you. The IRS only agreed to let these happen after many failed trips to the Tax Court to try and make them go away. That being said, ask lots of questions, find out the costs, get a feasibility study done up front even if it costs you $2500. If you think that is too much, then don’t bother thinking about a captive. Without cost, however, you can have in depth conversations with people who do these all the time and are prepared to do it right. The group I use has done hundreds, of which at least 45 are known to have been audited for one reason or another, none of which suffered any changes or put-downs.
Who are the major players in this space?
What is a typical range of start up costs and annual expenses?
I would be interested in a captive, but there is such a lack of transparency and shopping around usually entails hour long pitch meetings.
Welcome to the financial services industry. Until something becomes almost commoditized, it’s a real pain.
My comment on the WCI site appeared seven + years ago. Much has changed since then. Here’s my URL where you’ll find new information about captives, how they are now structured, and how you can get a free presentation based on your circumstances. My contact info can be found on the site or call me at 352-332-0749. https://capaltriskmodel.com/