Captive Insurance

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In this Growers Spotlight, we spoke with Jeff Blankinship and Elizabeth Becker of Cannabis Captive Insurance about how a captive insurance model may be well-suited to fit the needs of the cannabis industry and its unique challenges.

The following is an interview with industry experts. Growers Network does not endorse nor evaluate the claims of our interviewees, nor do they influence our editorial process. We thank our interviewees for their time and effort so we can continue our exclusive Growers Spotlight service.

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Risk Mitigation

Asset Protection

Wealth Accumulation

About Cannabis Captive Insurance

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Abbreviated Article

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5-Minute Snapshot

Risk Mitigation

What’s the difference between captive insurance and regular insurance?

For standard insurance, typically you pay a premium and in return you get a policy covering you up to a certain amount. Most insurance companies will then take some of that premium and invest it into the stock market, and keep some of it liquid in case an event occurs. Captive insurance is fundamentally summed up in two words: “self insurance.” The idea is that your company creates a “captive” company to insure itself. This is a simple idea, but it has a lot of serious ramifications. It’s also rare, for two reasons:

Not many people know about it.
It generally isn’t worth setting one up for coverage less than half a million dollars.

Why would you want a captive insurance program over a normal insurance company?

Three primary reasons:

Risk Mitigation

Captive insurance is still insurance! You can cover yourself for almost everything that a normal insurance company could, but you can also insure against liabilities that most insurers would not cover. For example, you could insure against key employee loss, product loss, government interference, poor harvest, and more.

Asset Protection

During the period in which your captive insurance policy is effective, the premium you pay is asset-protected by law. Creditors and debt collectors cannot touch that money. And once the policy period is over, the premium becomes a surplus, which is also asset protected.

Wealth Accumulation

Businesses can write-off what they pay in premiums to insurance. The premiums paid are written off by the company as a necessary business expense. With a captive insurance policy in effect for 12 months, the premium turns into a surplus. During that 12 months, that premium is not taxed, because it must remain liquid by law. After the 12 months is over, any remaining surplus from the premium becomes taxable as capital gains, which is often a much lower tax rate than ordinary income. Additionally, because you own the captive program, your premium does not disappear into a black hole like it might for a standard insurance company. You still have it at the end of this process, and it’s being taxed at a lower rate.

What are the limits of a captive insurance program?

One of the most important things to consider is where you the captive is domiciled. The rules governing captive insurance can differ based on location. If you compare Puerto Rico and California, there are very different rules regarding captive insurance companies. The second limitation is imposed by the IRS in section 831. Captive insurance programs can accept premiums up to $2.3 million, but no more. You can have multiple captive insurance programs though, with a limit of one captive insurance program per business entity. As a matter of personal opinion, I also wouldn’t recommend starting a captive insurance program for any less than $600,000 of premium. The simple fact is that for any less money, it isn’t worth the effort to set up and run.

Asset Protection

What are the pros and cons of a captive insurance company?

Pros:

You control and own the insurance company.
You can cover events that might not be otherwise coverable.
Your assets are protected.
Insurance companies pay capital gains taxes, rather than ordinary income taxes.

Cons:

There is more administrative and legal work to operate the captive.
Captives are not short-term propositions. Most people generally establish captives with the intent of using them at least 5 years.

What is preventing this system from abuse?

The IRS. The IRS is extremely diligent and they are very much aware that there are always people who are trying to bend the rules. If the IRS catches wind of you setting up policy coverages for bogus risks, you will very likely be audited. If you try to use captive insurance as a loophole, you will probably get caught.

What about a group captive?

You can make what’s called an “association captive.” Essentially a group of individuals or companies can pool together. Ideally you want people in similar situations as yourself. Say you’re a grow operation in a greenhouse and prefer to use organics, it would make sense to pool with other organic greenhouse growers, because you’ll generally face similar risks.

How do you start a captive insurance company?

That depends. Generally, the first step is to start a holding company that can claim ownership over several other companies. Money would flow into the management company, which could then establish a captive insurance company to insure its holdings.

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Risk Mitigation

What’s the difference between captive insurance and regular insurance?

That’s a great question, and there’s a lot of nuance involved in the answer. For a standard insurance company, typically you pay the company a premium and in return you get a policy covering you up to a certain amount, depending on what coverages you wanted and how much you wanted them covered. Most insurance companies will then take some of that premium and invest it into the stock market, and keep some of it liquid in case an event occurs. In order to reduce the risk of a “feast or famine” situation, these insurance companies try to have as many policyholders as possible to reduce the chance of high-value claims causing the company to go under. This group of clients is sometimes referred to as a “pool.”

Captive insurance is a fundamentally different idea from typical insurance companies. If you were to sum it up in two words, it would be “self insurance.” The idea is that your company (or your holding company) creates a “captive” company that insures the original company or a group of companies who have signed on. This is a simple idea, but it has a lot of serious ramifications. It’s also rare, for two reasons:

Not many people know about it.
It generally isn’t worth setting one up for coverage less than half a million dollars.

Captive insurance is not strictly limited to businesses. Often professional athletes or high-risk individuals may establish captive insurances to protect themselves in the event of something happening. In fact, some of the earliest captive insurance programs were actually formed by groups of sailors who would take perilous voyages and established a pool in the event that misfortune should befall one (or all) of them.

Why would you want a captive insurance program over a normal insurance company?

So there’s three primary reasons for a captive insurance program, which I’ll go over in some detail:

Risk Mitigation

Captive insurance is just that… insurance! You can cover yourself for almost everything that a normal insurance company could, if you wanted to. However, it differs from typical insurance because you can also insure against liabilities that most insurers would not cover. For example, standard insurance policies cover things like accidental death and dismemberment (AD&D), property, health, life, etc. But most insurance companies won’t provide coverage for events such as key employee loss, product loss, government interference, poor harvest, and more. Captive insurance can cover incidents that most typical insurance policies wouldn’t.

Now of course, you’re probably wondering how this differs from just keeping a rainy day fund. That’s where the next two reasons come into play.

Asset Protection

During the period in which your captive insurance policy is effective (typically 12 months from January 1st to December 31st), the premium you pay to the captive insurer is asset-protected. Under federal law, creditors and debt collectors cannot touch that money. And once the policy period is over, the premium becomes a surplus, which is also asset protected. If we boil this down into simpler language, you’re insuring yourself with money that creditors cannot touch. The captive can store this money, and lenders can’t do anything about it. I should note that there is a limitation to this -- Section 831(b) of the IRS tax code explicitly states that a captive insurance company cannot receive over $2.3 million in premiums, so you can’t just exploit this system to keep your creditors away. The IRS will also audit any policies that seem fishy -- if they see that you’re buying earthquake insurance in Texas, for instance, they will definitely notice and you could get in a lot of trouble for fraud. Captive insurance offers one other unique advantage, and that is...

Wealth Accumulation

Depending on where you live, taxes can be pretty high if we’re talking revenue in the millions. It’s not uncommon to see tax rates of 40% on $1 million of revenue, or higher depending on your state. However, businesses can write-off what they pay in premiums to insurance. And that’s where the captive insurance comes in. The premium money is written off by the original company as a necessary business expense. Then, your captive insurance policy is in effect for 12 months, at which point the premium turns into a surplus. During that 12 months, that premium is not taxed, because it must remain liquid by law. After the 12 months is over, any remaining surplus from the premium becomes taxable as capital gains, which is often a much lower tax rate than ordinary income. Because you own the captive program, your premium does not disappear into a black hole like it might for a standard insurance company. You still have it at the end of this process, and it’s being taxed at a lower rate. The captive program can also do a variety of things with the surplus money, depending on your state’s laws.

A diagram demonstrating how captive insurance works.

What are the limits of a captive insurance program?

Great question, and there’s always a tradeoff when you make a decision to implement a program like this. One of the most important things to consider is where you “domicile.” This is a legal term indicating where you live for a majority of the year, or six months plus one day. Depending on where you domicile, the rules governing captive insurance can differ. For instance, compare Puerto Rico and California. Puerto Rico is a US territory, so it’s not taxed like an offshore account, but it also has extremely relaxed tax policies to encourage businesses to invest in Puerto Rico. In contrast, California has very restrictive rules and taxes governing captive insurance programs, which could tie your hands. Whenever we consult with a company to establish a captive insurance program, this is a major factor for consideration.

Where do you domicile? The second limitation is imposed by the IRS in section 831. Captive insurance programs can accept premiums up to $2.3 million, but no more. The limit used to be $1.2 million until Obama signed a 2016 law into place which effectively doubled the limit. This rule can be worked around if you have multiple business entities with different federal IDs (IE a dispensary and a grow). You can have multiple captive insurance programs with a limit of one captive insurance program per business entity. Editor’s Note: The link I provided above says a limit of $2.2 million, but the law itself is designed to adjust for inflation, which raises that limit to about $2.3 million. As a matter of personal opinion, I also wouldn’t recommend starting a captive insurance program for any less than $600,000 of premium. The simple fact is that for any less money, it isn’t worth the effort to set up and run.

Asset Protection

What are the pros and cons of a captive insurance company?

Pros:

You control and own the insurance company.
You can cover events that might not be otherwise coverable.
Your assets are protected.
Insurance companies pay capital gains taxes, rather than ordinary income taxes.

Cons:

Your pool of “riskholders” is much smaller, and significant claims against your policy can result in a bankruptcy of the captive. Captives are best used as supplementals to your primary policies.
There is paperwork and legal work that must be resolved in order to set up the captive.
1. As I said before, I wouldn’t create a captive for less than $600,000 of premium for this reason.
You must domicile in the place that you would like to set up your captive insurance program.
The premium you pay must remain liquid for the period of the policy, or you will be breaking federal law.
If you want to establish a coverage in the event of a lawsuit (IE Malpractice for doctors), you could end up on the hook for significantly more money than you might have to pay with an ordinary insurance policy.
Captives are not short-term propositions. Most people generally establish captives with the intent of using them at least 5 years, if not longer.

What is preventing this system from being abused?

The IRS. The IRS is extremely diligent and they are very much aware that there are always people who are trying to bend the rules. I mentioned earthquake coverage in Texas as an example before -- if the IRS catches wind of you setting up policy coverages for bogus events or events that generally aren’t risks, you will very likely be audited and get into a whole heck of a lot of trouble. This is a big no-no, as you can probably guess. If you try to use captive insurance as a tax loophole, you will probably get caught.

The IRS finds this stuff exciting. This is why we at Cannabis Captive Insurance use a third party actuary to verify that any captive insurance company we set up remains within appropriate legal parameters. We’ll discuss your current coverages, review them, and go over any other potential coverages you might want. The third party actuary then sets your policy limits based on where you live and the amount of coverage you would like. This helps keep the whole process above board. As a side note, many of the limitations on captive insurance were established because wealthy parents were using captive insurance programs to pass on their wealth to their children and avoid the estate tax. The IRS caught onto that and implemented the current limitations in response.

How are the premiums determined?

The third party actuary determines your premium based on two things:

Your revenue.
The coverages and policies you want.

If your revenue is $1 million, for example, it would make no sense to have a $2 million premium. That just doesn’t compute in any way whatsoever. So your revenue is an obvious consideration. And then the things you want to cover also matter. If you’re trying to protect for product loss or a key employee loss, you’ll need to consider how much those events might cost you.

You mentioned that you can have multiple captives? And what about a group captive?

Yeah, so if you have a dispensary and a grow operation that are listed under different federal IDs, you can open a captive insurance company for each business. Additionally, if you’re bumping against the $2.3 million premium cap, and you have two different entities under your ownership, this is a relatively logical choice to make. To your second question, you can make what’s called an “association captive.” Essentially a group of individuals or companies can pool together to make a captive insurance company for the whole lot. Ideally you want people in similar situations as yourself, and like-minded individuals. Say you’re a grow operation in a greenhouse and prefer to use organics, it would make sense to pool with other organic greenhouse growers, because you’ll generally face similar risks. If you have individuals that are too disparate in their risks, it is likely one will make significantly more claims against their policy than others in the pool and will make the payout lopsided.

Wealth Accumulation

How do you start a captive insurance company?

Well, that depends on your situation. Generally, the first step is to start a management company or holding company that can claim ownership over several other companies. This allows you to separate HR, payroll, and other administrative work from the day-to-day functioning of an individual business. A management company could provide administrative services to a grow op, a dispensary, a processor, and more, all under the same umbrella. Money would flow into the management company, which could then establish a captive insurance company to insure its holdings. In the process, it would take the write off of whatever the premium is, and would be covered for 12 months by the captive, all while asset protected. After 12 months, that money would turn into a surplus and could be stored in a bank, invested, or returned to the shareholders.

Tell me about the investment side of captive insurance

So one of the critical things about the functionality of a management company and captive insurance company is that they open the door to potential banking (and investment) solutions. These companies do not directly touch cannabis and will generally face fewer issues. Depending on where you domicile, different options are available for any surplus that the captive insurance company has. State law will govern what you can and cannot do with the surplus. However, bear in mind that the cannabis is still on the legal fringes of federal law, so you should always be absolutely clear about what you’re doing. There is no magic bullet to get around all of the problems the industry faces, but you can take steps to reduce the impact this has on your business.

About Cannabis Captive Insurance

How did you get into captive insurance?

I own a large medical records and service company that has partnered with a large number of surgery centers in almost all US States. I’ve been involved in the healthcare industry for most of my career as a service provider. I was approached about 8 years ago by a company that was interested in establishing an 831(b) captive insurance company, which I had never heard of before at the time. So I asked my accountant about it, and he told me not to do it because he didn’t know anything about it either. 4 years goes by, and then I get approached again by a few other individuals interested in setting up an 831(b) captive insurance program, so I decided to do some more research. After reading up about it, I decided to give it a go and try it out. Within 12 months, that decision turned out to be the best business decision I’ve ever made. Since then I’ve helped form over 300 captive insurance programs, with only 5 or so claims ever made against their policies.

What brought cannabis to your attention?

Prior to Cannabis Captive Insurance, I had (and still have) ownership in a company called Evergreen Farms, which is based in San Luis Valley in Colorado. I already had some involvement with the cannabis industry when I was introduced to Elizabeth. After consulting with Elizabeth, I realized that the cannabis industry has quite a few unique challenges that make it well-suited for captive insurance. I primarily refer to three problems in the cannabis industry:

Any business that touches the plant is unable to use an FDIC-insured bank due to federal prohibition.
The insurance market in cannabis is relatively limited and rarely covers cannabis-specific problems.
Section 280e of the IRS tax code prohibits any business involved in the production, distribution, or sale of federally-prohibited substances (aka Cannabis) from taking tax deductions or tax credits on their tax returns.

Because of these unique challenges, I realized that the best course of action would be to start informing the industry about how captive insurance can really solve a lot of underlying issues they’re facing while also staying within the bounds of the law. Elizabeth and I both started Cannabis Captive Insurance with that express purpose.

Tell me about your company

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Website: http://www.cannabiscaptiveinsurance.com/
Phone: 833-322-7848

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About the Author

Hunter Wilson is a community builder with Growers Network. He graduated from the University of Arizona in 2011 with a Masters in Teaching and in 2007 with a Bachelors in Biology.

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