As medical reimbursements continue to shrink and threats of continued health care reform loom, a very popular question we receive at conferences and in consults with high-income practices is, “Would owning part of a Small Insurance Company help me and my practice become more financially efficient?”
If your practice currently generates over $3 million of revenues and you would like to take advantage of opportunities to improve the financial success you realize from your hard work without having to see any more patients, then this article may prove to be very valuable information for you.
Small Insurance Companies (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 if 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.
What is a SMIC?
The SMIC we will discuss here is a properly-licensed, U.S.-based insurance company — domiciled in one of the states that has 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.
SMIC as a risk management tool
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. Your particular situation determines how risk is managed and how much risk can be insured in a captive. 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 doctors are acutely aware of medical malpractice, but there are many other risks to doctors as employers and recipients of insurance (and Medicare). The SMIC can be used to protect the doctor and practice from employment liability, insurance audits, HIPAA defense and a variety of other risks that will vary based on your practice size, revenue, number of employees and other risks. 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 doctors 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). Avoiding this appearance is a valuable asset protection strategy that is stressed in our book, For Doctors Only: A Guide to Working Less and Building More.
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.
Case Study: Justin and Harry
Justin and Harry are doctors who each own successful practices and surgery centers. Justin feels like he is paying too much for his group’s medical 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 medical malpractice and commercial liability claims (under $100,000 per occurrence). This significantly reduced his existing insurance premiums because then he 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 center and reduce his over payments and costs. Ultimately, he hoped that the SMIC would help him increase the profits of the center. 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. Justin also had the SMIC owned by a Trust for his family, so he was able to build the wealth created by the SMIC out of his taxable estate.
Harry had a different approach. He established an SMIC to insure lesser risks that were not covered under commercial insurance. These policies included Medicare fraud defense, HIPAA litigation expense and malpractice defense policies (which is available only to pay for the company’s legal fees, but not to pay claimants). 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 on 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.
The “rainy day fund”
Because our society has become so litigious, many doctors have been “self-insuring” against potential losses like the ones named above. These clients 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 any 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, estate, practice 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% 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 $3,000 to $4,000 per month. These fees are significant (and often fully tax-deductible), but 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 doctors. There is no better way for successful 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.
SMICs can be great tools for certain physicians
Because successful doctors 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.
The interest level in the SMIC is even more pronounced with high-liability and high-income specialists. If you are a successful physician or you work in a high-liability specialty, you may want to review how an SMIC could seriously improve your overall planning.
David Mandell, JD, MBA, is an attorney, co-author of seven books for doctors, and principal of the financial consulting firm OJM Group. He can be reached at email@example.com or (877) 656-4362. Carole C. Foos, CPA, is director of tax planning at OJM Group and can be reached at (877) 656-4362 or firstname.lastname@example.org. For questions about this article or to receive a free (plus $5 S&H) copy of For Doctors Only: A Guide to Working Less and Building More call (877) 656-4362.
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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.