The asset management industry and captive insurance would facially seem worlds apart. However, there is a potentially powerful intersection. At the management company level of most hedge funds, private equity funds and even mutual funds, you will often find a limited partnership that collects fee income on an annual basis and distributes it to its partners. A typical fact pattern is that the partnership bears operational risk for the underlying activities and the income is ordinary income taxable at the highest rates, perhaps subject to self-employment tax in whole or in part, and the partners don’t need most of the money. An effective but often overlooked method of managing risk and, secondarily, reducing the effective tax rate of the management company principals is the use of a captive insurance company.
The management company of a fund experiences myriad business risks during its operation, the same as any other business venture. For many of these risks the company typically purchases commercial insurance at market rates. There are many risks however that are left uninsured. For example, the existing commercial insurance has deductibles, exclusions and limitations for which the management company simply bears the economic risk. There are also uninsurable risks associated with key personnel, business interruption, fraud, etc… These risks are the bailiwick of the captive insurance company.
Captive insurance companies also offer a unique tax planning opportunity. The management company is permitted a deduction for premiums paid to the captive while the captive is permitted to exclude the premium receipt from income, provided the total premium income does not exceed $1.2mm per annum. This tax asymmetry is unprecedented in the tax world. Perhaps the only other area that permits an income deduction by one entity without inclusion somewhere else are qualified retirement plans, which management companies should also have in place.
In practice, the way captives are utilized, the principals of the management company (individually or as a group) will form a captive or multiple captives. The individuals or their family (directly or indirectly though trusts or family limited partnerships) will own the stock of the captive insurance company. The captive will write insurance to the fund management company at market rates. The management company will deduct the premiums paid as a business expense which will reduce the amount of taxable income passed through to the principals on their K-1s. The captive will exclude up to $1.2mm of premium income from taxable income. Note, if the management company principal has placed ownership of the captive in the hands of his children or grandchildren then he is not only reducing his current year tax bill but he is making tax free gifts to his heirs. When the shareholders of the captive require liquidity, they can borrow from the captive or take distributions. Distributions are taxed as dividends which are permitted capital gains tax rates for U.S. individuals.
Why doesn’t everyone have a captive insurance company? Two main reasons exist. First, there has to be real insurance risk covered. This risk is verified through an independent third-party feasibility study. Second, the captive must insure unrelated third-party risks as well as those of the management company. Captives typically dedicate 30% – 51% of their assets to third-party risks. This is normally where the wheels come off for many potential users. However, if you take the time to understand how the third-party risk is acquired, you would not be so flummoxed. Captives participate in “risk pools” maintained by large, national insurers. Within these risk pools, the risk is spread among unrelated coverage pools and each of those pools is segregated and protected from the other. The structure is very similar to an umbrella policy which insures risks not covered by traditional insurance. In short, the risk of loss to third-party risks is minimized to the greatest extent possible using sound actuarial principles. And, of course, these other risk pools are available to absorb a portion of your company’s loss should one arise.
Asset managers with large amounts of ordinary income should consider instituting captive insurance companies as well as qualified retirement plans at the management company level as a safe and secure way of reducing current tax costs. For more information regarding captive insurance or other tax efficiencies within asset management please contact your regular WithumSmith+Brown partner.