By David B. Mandell, JD, MBA and Carole C. Foos, CPA
Attorneys and law practice executives are often looking for ways to protect the practice from potential claims, reduce risks, and pay less in taxes. If your practice currently generates over $3,000,000 of revenues and you would like to take advantage of opportunities to improve and protect the financial success you realize from your hard work, then this article may prove to be valuable information for you.
Small Insurance Companies (or “SMICs”) are often referred to as captives, closely-held insurance companies, or a number of other names. Like any corporate structure, SMICs can be ideal tools if they are created for the right type of practice and the corporate formalities are maintained properly in a legitimate jurisdiction. The purpose of this article is to briefly describe appropriate uses, potential benefits, and approximate costs of SMICs. To better illustrate potential benefits, we offer a case study where the use of an SMIC significantly enhanced many areas of the client’s comprehensive financial planning.
The SMIC we will discuss here is a properly-licensed, U.S.-based insurance company, domiciled in one of the states that have special legislation for small insurance companies. While some advisors promote insurance arrangements in small international jurisdictions to take advantage of lower creation and maintenance costs, we think it is advisable to domicile SMICs in the U.S. As a number of states’ recent captive insurance statutes allow formation for reasonable costs, we find domestic options to be financially feasible like never before.
Further, President Obama recently signed into law new legislation that significantly impacts SMICs. Under the new law, the annual premium limitations were raised by nearly 100%, after being stagnant for thirty years, while new restrictions on ownership were also enacted. Thus, if you haven’t looked at a SMIC lately – or if you have one and are unsure how the new law impacts you – now may be the time to review the SMIC again.
The SMIC must always be established with a real insurance purpose. Insurance companies have been well defined in the vast array of tax laws, revenue rulings, private letter rulings, and case law. There are requirements for an insurance company to be a facility for transferring risk and protecting assets. Practitioners who specialize in this area have found ways to manage risk to maximize long term profit while reducing unnecessary risk within the insurance statutes. How risk is managed and how much risk can be insured in a captive will be answered based on your particular situation. The nice thing is that there is a great deal of flexibility in how the SMIC can benefit a client.
One specific way clients can use the SMIC is to supplement their existing insurance policies. The SMIC can insure deductibles, copayments, and excluded risks. Such “excess” protection gives the client the security of knowing that the company and its owners will not be wiped out by a lawsuit award in excess of traditional coverage limits. In this case, you could think of the SMIC as a tax-efficient, asset protected war chest to cover potential future losses.
Most attorneys are acutely aware of legal malpractice, but there are many other risks to lawyers as employers. The SMIC can be used to protect the attorney and practice from employment liability and a variety of other risks that will vary based on your practice size, revenue, number of employees. This protection can be of significant value and potentially very profitable to the SMIC if you manage risk well. In some instances, the SMIC may even allow the client to reduce existing insurance, as the SMIC policy will provide additional coverage.
Some attorneys choose to use an SMIC to provide flexibility in using customized policies not easily found in the commercial space. For example, you may desire a liability policy that would pay your legal fees (and allow full choice of attorney) but would not provide any benefit to creditors or claimants (what we call “Shallow Pockets” policies). This prevents the client from appearing as a “Deep Pocket” (a prime lawsuit target).
The SMIC has the flexibility to add coverage for liabilities excluded by traditional general liability policies, such as wrongful termination, harassment, or even ADA violations. Given that the awards in these areas can be over $1 million per case, the SMIC can provide valuable protection here. To illustrate how the SMIC can be used, let’s examine the case study of Justin and Harry.
Justin and Harry are attorneys who each own successful practices. Justin feels like he is paying too much for his firm’s malpractice and commercial liability insurance policies. After our firm introduced Justin to an attorney and actuary who specialize in SMICs, he created one to issue policies that cover the least significant, most common legal malpractice and commercial liability claims (under $100,000 per occurrence). This significantly reduced his existing insurance premiums because he then had much higher deductibles for his third party insurance policies.
Justin believed he could reduce his insurance premiums to commercial insurance companies, implement successful risk management programs, reduce the claims of the practice, and reduce his overall payments and costs. Ultimately, he hoped that the SMIC would help him increase profits. He was right. While a significant portion of the $1.5 million in total payments was paid out to cover claims, there was still over $1 million in his SMIC reserves after five years.
Harry had a different approach. He established an SMIC to insure lesser risks that were not covered under commercial insurance. After five years, Harry’s SMIC paid limited claims. At this point, most of the premiums are still growing as asset-protected reserves of the SMIC to be used to pay future claims. If there are very few future claims, the SMIC may become a profitable investment for Harry and his family.
Harry was also considering bringing younger partners in to his practice. He plans on using the SMIC as part of an exit strategy for his practice as well, with each new partner responsible for paying some of his buyout –from both the practice and the SMIC.
SMIC Compared to Self-Insuring: Because our society has become so litigious, many attorneys have been “self-insuring” against potential losses like the ones named above. These lawyers have simply saved funds on an after tax basis to pay any expenses that may arise if a risk comes to fruition. This is the proverbial “rainy day fund.” While a rainy day fund may prove wise, the client would be better off using an SMIC to insure against risks. That is because the formal payment of premiums to the SMIC may be tax-deductible to the practice. Those funds in reserve of the insurance company enjoy the highest levels of asset protection (+4/+5), can be structured to grow outside the taxable estate, can be structured to layer into a practice exit strategy, and can generate very significant long term tax advantages as well. None of these benefits are found with the traditional “rainy day fund.”
Avoiding Land Mines: It cannot be overstated – the SMIC structure must be properly created and maintained by insurance experts. If not, all risk management, asset protection and tax benefits may be lost. For these reasons, using professionals who have expertise in establishing SMICs for clients is critical – especially the attorneys, actuaries and insurance managers who need to be involved. While using such experts and a real SMIC structure may be more expensive than some of the cheaper alternatives being touted on the internet or at fly-by-night seminars, this is one area where “doing it right” is the only way to enjoy the SMIC’s benefits and be 100 percent compliant.
Who Can Afford an SMIC? Setting up an SMIC requires particular expertise, as explained above. Thus, as might be expected, the law firms most experienced in these matters charge significant fees for both the creation and maintenance of SMICs. Set-up costs are typically $75,000-plus and annual maintenance costs can be around $5,000 per month. While these fees are significant, they can be shared among a number of SMIC owners. The SMIC’s potential risk management, tax, practice, estate planning, and asset protection benefits often combine to make it a very attractive option for very successful attorneys. There is no better way for successful law practice owners to leverage their advisors than to work with them to create such a flexible and efficient planning tool as a small insurance company.
Because successful attorneys have significant risks, are interested in better management of these risks, desire asset protection, want to build tax-favored wealth over the long term, and might enjoy learning new ways to fund practice buy-out and estate planning opportunities, there is a good reason to spend a little time reviewing the benefits of the SMIC as an important planning tool.
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