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15 November 2016Accounting & tax analysis

A beginner’s guide to physician group captives

Three things are inevitable in the life of a physician: death, taxes, and the threat of professional liability. While there currently is no strategy for escaping death, there is a cadre of tax professionals working to minimise tax liabilities. A captive insurance vehicle can also help physician practices to combat the inevitable, as it provides the triple benefit of improved coverage, asset protection, and potential tax advantages

A captive insurance company is, in its simplest form, a closely held insurance company that insures the risks of its owner or owners and any affiliates. The captive insurance company insureds have direct involvement and influence over the captive’s operations, including underwriting, claims management, policy coverage and form, risk management and investments, as well as controlling governance documents. The capital requirements of the captive must meet thresholds based on the risks insured by the captive and to satisfy regulatory requirements.

While there are several different forms of captive insurers, including single parent captives, agency captives and risk retention groups, this article focuses primarily on protected cell captives available to medical practices which are often offered through insurer-sponsors.

A protected cell captive is an increasingly popular vehicle for physician groups to participate in a captive without having to incur the full expense and capital outlay of forming and maintaining a standalone captive. Protected cell captives are often sponsor-owned facilities that permit the medical practice owners to retain their own insurable risks in a formal insurance environment. The assets of each individual cell are protected from other cells and from the core captive entity. Each cell in the captive operates much like an independent insurer, but often with common management and service agreements that can provide operational efficiencies.

“After the individual assessments have been completed, the members, as a whole, need to determine which goals will be included in the strategic plan.”

Each protected cell is responsible for satisfying the medical malpractice claims of its policyholder-owners, but may also benefit from any underwriting profits that arise from having a favourable claims experience. In other words, the policyholder-owners pay the captive the insurance premiums for protection that they may have otherwise purchased from a traditional insurance company. When a claim is covered under the captive’s insuring agreement, the protected cell satisfies the claim.

At the end of each period, before taxes, the captive then declares a profit or loss based upon the premiums paid in, less the estimated incurred claims under the policies and operating expenses, plus investment income earned throughout the period. Like any company, net after-tax profits, if any, help build the capital base to strengthen the captive and create equity for its owners.

As with any new business opportunity, due diligence must be performed in order to ensure that there is a sufficient risk profile that supports the use of a protected cell captive for the organisation. Cell captives are not for every business enterprise. The medical group must be comfortable with retaining risk and have a good claims track record. Although the risk elements and capital resources will be unique to each situation, the following steps are commonly performed by medical practices when they are considering moving to a protected cell captive model as part of their risk management solution.

Know your practice

Develop a shared vision for your medical practice including your current structure, practice composition, as well as a comprehensive strategic plan specifying where the key stakeholders would like to be in the future. This is an opportunity for each member of the practice to self-reflect on the business and what their individual goals are for its future.

After the individual assessments have been completed, the members, as a whole, need to determine which goals will be included in the strategic plan. At a minimum, this should determine the following:

a. An increase or decrease in the size of the practice;
b. An expansion or reduction in the procedures, specialties, locations, etc;
c. Any potential mergers or acquisitions;
d. Capital investments required for technological advancements;
e. Capital available for captive formation and other initiatives; and
f. Any regulatory actions requiring capital investment.

Know your insurance needs

This includes not only an assessment of your medical professional liability insurance requirements and a five-year review of losses, including defence costs, but also a determination of the services currently provided to your practice by your insurance carrier. In order to successfully complete this step, the following are needed:

a. The practice’s historic loss and defence costs ratio. This includes the ratio of paid loss and defence costs to the insurance premiums paid under the policies issued;
b. The practice’s incurred loss and defence costs ratio. This includes both the paid losses as well as the estimated reserves for future losses covered under the policies issued;
c. Any additional coverage your insurance carrier provides at no cost, for example, cyber liability coverage, defence coverage for medical board complaints, etc; and
d. The customary operating costs such as underwriting and pricing functions, policy issuance, claims handling and risk management services along with actuarial services, investment management, banking, tax counsel, accounting and auditing fees.

Know your options

As mentioned earlier, there are several different types of captives, including a single-parent captive, group captives, and protected cell captives. The single-parent captive insures only the risks of the owner and the owner’s subsidiaries, if any. The group captive is owned by members of a common industry in order to share the risks of that industry among its members.

A group captive is often owned by multiple, non-related organisations and is designed to insure the risks of these different entities. Finally, there is the protected cell captive. A sponsoring insurer provides a core, and typically each cell is owned and capitalised at a segregated cell level whose insureds are the principal beneficiaries of the cell.

Obtain professional services

Once the first three steps are completed, it is time to engage the services of specialised professionals. Steps one through three are designed to help gather the necessary practice information to provide to the captive professionals to determine if a captive option is feasible for your business by preparing a feasibility study. A feasibility study will look at three core items: risk control, cost, and capacity.

a. Risk control
The feasibility study should determine the types of insurance coverage your captive will provide (ie, professional liability and others) and how the captive can reasonably help to improve your current risk structure. This will help to determine the fundamental design of your captive as well as identifying suitable risk appetites.

b. Costs
This portion of the process should assess the costs associated with your current insurance program (such as a high-deductible medical professional liability programme) and evaluate various risk and tolerance levels. The revenues and expenses associated with the captive should include the premiums that would be paid, the expected loss and claim defence costs as well as how much it will cost to form and operate the captive.

It is important to recognise that actual loss costs could significantly vary from expected projections. Evaluating tax implications for the various forms of captive structures, the financial implications due to where the captive is domiciled, and the long-term effects to the group entity. The financial feasibility is generally performed by a qualified actuary who has expertise in estimating premiums and loss costs. It is often laid out in a five-year financial pro forma with expected, favourable and adverse scenarios.

There are advantageous federal tax elections that may be available to the protected cell captive depending on its structure, size, ownership and purpose. Involving specialised tax professionals early in the process is important when structuring the captive.

c. Capacity
The final portion of the report should discuss the pros and cons of creating the captive and what levels of capital will be required at various risk levels. It will also discuss how to build future capacity as the captive matures and is operating effectively.

Once these areas have been addressed, choosing a state of domicile is a strategic decision to be made by the medical practice. Captive specialists can assist in navigating the regulatory decisions and help with the application process for licensing. Typically, the captive insurer application to become licensed by state insurance regulators must include a business plan, an actuarial feasibility study, identification of service providers and sample insuring agreements. Corporate governance is also key to starting and maintaining a healthy captive to ensure proper and transparent decision making.

Always choose consulting and advisory partners you can trust. These are often the insurers and advisors that already know your professional liability needs and have a proven track record of service to your medical group and to the niche captive insurance market. Using qualified resources in designing and forming a cell captive pays dividends in the long run!

Ed Marley is chief financial officer of the Mutual Insurance Company of Arizona and treasurer of MICA Specialty PCC.
Julie Ritzman is vice president of risk management, Mutual Insurance Company of Arizona.