Nursing homes, hospitals, and other long-term care facilities throughout the country continue to face increased pricing and coverage limitations on much of their insurance, while insurance companies are reporting record profits. Operators today often decide to self-insure more and more of their business risks, often because of higher deductibles or even policy cancellations. Facilities in Florida and along the Gulf Coast are being forced to carry larger amounts of risk from potential hurricane losses because of capacity limitations of the insurance industry.
These trends open the door for nursing home owners to form their own private insurance company to better manage a variety of these self-insured risks. Moreover, with recent clarification of the tax rules regarding such insurance companies, owners and operators can now also enjoy significant tax and financial benefits from forming their own private insurance company.
A Growing Trend
Private insurance companies are not new—the first such companies were formed in the late 1800s. But until recently, only the largest companies in the world could justify forming and operating an insurance company. The situation has changed and, as a result, midsize organizations have the opportunity to reap the tremendous benefits that were previously unavailable to them.
There are many different types of private, or “captive,” insurance companies. Fortune 1000 companies typically form their own “large” insurance companies, often to obtain better coverage terms and pricing. Another approach is for a number of companies in the same industry to form a “group captive,” which is designed to replace coverages that are not offered at competitive prices by the standard insurance market.
But today, profitable nursing home owners and other long-term care operators can form a “pure captive” insurance company that only insures its affiliated companies against risks that are not currently covered by their third-party insurance. These types of insurance companies are truly “private,” in that the owners of the insured (the nursing home, for example) can control their own risks and can create a potential “upside” or profit on the insurance transaction. Organizations realizing $3–5 million in pretax profits are viable candidates for this option.
A pure captive insurance company creates a reserve against potential losses nursing homes may face in the future. In Florida and along the Gulf Coast, how might companies plan for the next hurricane? Simply setting aside funds on the balance sheet is one way, but there are no tax benefits in doing so. A properly formed and operated private insurance company, however, generates special tax benefits that change the economics of such planning enormously.
Recently updated tax rules based on more than 20 years of case history now allow a nursing home to fully deduct the premiums paid to its own private insurance company, yet that insurance company will not pay any taxes on those same premiums. In effect, an owner can transfer funds to another affiliated company for the purpose of setting aside a pretax reserve against future losses and at the same time reducing the nursing home's income tax bill.
These premiums can be as much as $1.2 million per year. And if the insurance company is ultimately profitable, the owners of the insurance company can later access those funds at capital gains rates.
Forming a Private Insurance Company
What is new about all this? First, the Internal Revenue Service has finally issued “safe harbor” revenue rulings that quantify the acceptable structure of a private insurance company in order to qualify for the tax benefits described above. These rulings seem simple on their face but require an experienced practitioner to ensure that the new insurance company qualifies.
Second, more and more states have enacted special legislation allowing the formation of private insurance companies. As a result, owners and operators no longer have to go “offshore” to form these types of companies. In addition, the domestic requirements for licensing are thorough, guaranteeing that the new company is truly an insurance company in every sense of the word.
This concept is predicated, of course, on three important factors: (1) the new insurance company must be formed as a real risk management tool, which means it is actuarially sound; (2) the risks transferred must be carefully structured so the new insurance company has a good chance of being ultimately profitable (i.e., insured losses are significantly less than premiums contributed); and (3) the insurance com-pany must comply with the clarified tax rules so that all tax benefits are captured.
Structuring the risks transferred to the new insurance company is critical. Risk portfolios must be diversified just as much as investment portfolios. It is extremely important that the new insurance company not assume too much risk. A risk management tool like a captive insurance company is sensible only if it is profitable and adequately prices its risks. The new insurance company will insure a variety of risks, including professional liability, property, employment practices liability, directors' and officers' liability, and other unique risks relevant to the organization.
Typically, a pure captive insurance company supplements existing insurance programs rather than replaces them. This is important because if an owner uses government financing to build the facilities, the government will not recognize “private insurance” from a captive as satisfying certain coverage requirements. If, however, the nursing home owner purchases such coverages in the standard market with high deductibles, the self-insured portion of the risk can transfer to the new private insurance company.