[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!