After a two week hiatus to cover the recent IRS defeat in the Securitas captive insurance case, we finally turn our attention to the finale of our Top Ten Captive Myths. It’s critical to address these myths because they so often cause business owners to miss out on the benefits of captive ownership or the benefits of a captive insurance company (CIC) reaching its full potential.
All captive myths are fomented by misinformation – in some cases the misinformation is accidental or caused by the application of excessive caution. For instance, those CPAs, attorneys and other advisors who have little to no prior experience with captives have little to gain and (in their minds) potentially much to lose by “signing off” on a captive structure. And, the reverse is also true: They have little to lose and potentially (in their minds) much to gain (protection from potential liability for something they don’t understand) by being dismissive.
In other cases, the misinformation is caused by large company bias, which carries a particular set of assumptions and blinders. And, the worst kind of misinformation is outright marketing deception disguised as “education”. The perpetrators of this type of misinformation are most typically “Old Guard” types who resent the encroachment of financial planners, wealth managers, life insurance producers and other “New Wave” types upon their traditional turf.
And this brings us to the number one captive myth: That captive insurance companies are somehow uniquely prohibited from deploying their assets in the same manner as other companies, including banks and CFOs of large corporations. More specifically, our Captive Myth Number 1 is that life insurance is somehow a taboo asset for captives. We list this as our number one myth simply because it is so pervasive and because the opportunity cost of not employing certain types of life insurance inside of a CIC can be enormous—potentially multiple millions of dollars.
The country’s largest commercial banks typically invest a significant portion, often 20 to 40 percent, of their “tier 1 capital” in BOLI—bank owned life insurance. And nearly 70 percent of Fortune 1,000 companies fund their non-qualified deferred compensation plans for their most senior executives with COLI–corporate owned life insurance–carrying millions or in some cases billions of dollars of cash surrender values on their balance sheets as a result. There are important reasons why the nation’s most sophisticated financial professionals, officers and directors of the country’s largest commercial banks and Fortune 1000 CFOs make use of life insurance in these contexts, and most of those reasons apply equally to captive insurance companies.
However, just like you would never form a bank or a company just for the purpose of purchasing life insurance, no business or business owner should set up a CIC for this purpose either. The primary purpose of a captive is always risk management, but all insurable risks are ultimately financial, and managing the asset side of an insurance company’s (or a bank’s or a Fortune 1000 company’s) balance sheet is financially just as important as managing the liability side. A financially strong CIC is better positioned to manage future risk. Including life insurance among a CIC’s assets gives a company certain financial advantages that cannot be easily replicated in other ways or with other instruments.
Given the obvious advantages of life insurance, what are the sources of Captive Myth Number One? There are really three sources. The first is ignorant (or willful) misinterpretation (or usually a more subtle “misimplication”) of the law and the Internal Revenue Code (IRC) regarding captive insurance companies and life insurance. The second is misunderstanding of life insurance in general. Finally, the third is the Old Guard captive managers find attacking life insurance to be a useful way of disparaging, and hopefully undermining, their New Wave competitors.
Let’s start with the first. A common point of misunderstanding occurs because the Internal Revenue Code (IRC) forbids businesses from deducting life insurance premiums. However, a business owner with a legitimate captive is NOT deducting an expense to purchase life insurance merely because the captive itself invests in life insurance. Rather, the business is taking a deduction to purchase property and casualty insurance protection, or other forms of insurance, from its captive insurance company (a legitimate deduction under IRC 162 that is been upheld time and again in U.S. Tax Court).
The second reason for the source of misunderstanding on this point involves the nature of high cash value life insurance contracts themselves. When the topic of life insurance and captives was being debated on the internet a while back, one ignorant or naïve internet critic proclaimed, “how can a captive invest in life insurance?… Someone has to die for the captive to get its money back to pay claims.” Sadly, this naïve sentiment is not uncommon. Banks purchase BOLI and other corporations purchase COLI not for the death benefit per se but rather for the substantial cash surrender value that accumulates within such policies on a tax-favored basis over time.
The third source of our Number One Captive Myth is outright deception by the Old Guard. To read about “Old Guard” thinking, CLICK HERE. Also, for additional perspective, CLICK HERE to read “Feeding Trolls.” Truth be told, even the most outspoken and biased critics of life insurance, such as Jay Adkisson and Beckett Cantley, have themselves advocated for the inclusion of life insurance within captives, and in some cases have personally sought to induce their clients or prospective clients to do so. Cantley has gone so far as to offer clients a discount on his legal services if their captives invest in life insurance policies that he, or entities he controls or influences, brokered.
CIC Services just attended the Tennessee Captive Insurance Association’s annual conference. We are members of the TCIA, and we regularly attend to stay abreast of regulations and trends in the industry. At the conference, Deryl Bauman, Senior Vice President of the Commercial Banking Group, Captive Banking Division at First Tennessee Bank spoke on captive banking, requirements and asset management strategies for captives. Importantly, he noted that the FDIC limit for bank deposits is $250,000. He outlined the following guidelines for managing captive assets:
– Remember it is an Insurance Company
– Match Assets and Liabilities
– Safety, Liquidity and Growth
– Proper Platform
– Minimize Taxation
Properly structured life insurance delivers on all of these. Policies can be designed to be almost fully liquid, which is important since the timing and amount of future claims is unknown. Assets placed with highly rated insurance companies are remarkably safe, and policies are further backed by state guarantee pools in most instances. They can be designed to offer market-based returns without the full risk of the market. And, finally, life insurance is extremely tax efficient.
As small business owners and champions, it distresses us to see myths propagated in the industry at conferences and on web-sites and blogs. Every business decision comes with risk, and the decision to employ life insurance in a captive is no different. But entrepreneurs are accustomed to risk. They engage in cost/benefit analysis all the time, weighing the likelihood and possible extent of both the upside and downside, and then making a sound business decision. But the decision making process is tainted when the inputs and basic assumptions are blurred by ignorant or biased advisors. Allocating to life insurance isn’t right for every captive, but the only way you’ll know for sure is to engage in the requisite cost/benefit analysis. Don’t just take a pundit’s word for it either way.