Captive Insurance Companies

In Brief

A captive insurance company is organized for the purpose of insuring or reinsuring liabilities of the owner, and is an effective risk-mitigation vehicle for its parent company. Advantages include:

  • Advantageous risk management and asset protection
  • Favorable insurance cost minimization and underwriting gains
  • Greater autonomy and control

A captive insurance company, or “captive,” is generally defined as an insurance company that has been organized primarily for the purpose of insuring or reinsuring the liabilities of the owner.

As a result, the owners/insureds participate in controlling the underwriting, claims, and investment decisions of the insurance company, ultimately profiting from the experience gains of the company, and realizing any reduced risk management cost savings.

Below is a common, simple structure often used by privately held business owners to create a captive insurance company, which then serves as remote risk insurer or reinsurer of insurable risks associated with company activities.

There are many types of risks that individuals and businesses do not insure for, primarily because those risks are viewed as either too expensive or too remote to occur.

In most instances, however, business risks that might in fact be remote risks to an operating business are nonetheless properly insurable through a captive insurance structure.

In a captive structure premiums paid are tax deductible (to the extent such premiums are not subject to claims while the various insurance policies are in effect), and are returned to the captive in full.  This function makes the use of captives a sound risk mitigation strategy.

There are many reasons for starting or continuing to use a captive. These reasons tend to change in priority as the needs of the owners evolve over time; therefore, it is essential to establish the right structure from the beginning.

A properly structured captive in the correct jurisdiction will provide the flexibility required to maximize its long-term utility for the owners. Corporations and business owners have started or continue to use captive subsidiaries in order to:

Retain Favorable Underwriting

In general, any profits resulting from a company’s positive loss history belong to the external insurance companies underwriting the risk. With a captive, those profits stay within the owner’s control. This is particularly valuable when a company has a claims history that is better than the overall class, or business block, for a particular commercial insurer.

Maximize the Benefit of Self-Insured Retention

Coverage to insure many business exposures can often be highly restrictive and cost-prohibitive, or otherwise unavailable in the marketplace. As a result, companies simply self-insure on these genuine exposures and lose the ability to deduct them for U.S. income tax purposes.

The Establishment of a viable captive will mitigate the lost deductible opportunity. All premiums up to the safe harbor amount ($1.2M) permit-ted under the Internal Revenue Code paid into the captive for these otherwise non-insured expenses will be fully deductible in the year of payment.

Moreover, if structured properly, the profits in the captive will be excluded or tax-deferred for U.S. Federal income tax purposes.

Lower Insurance Cost

Commonly, the overhead and profits of third party insurance companies account for 35-40% of premium payments. Writing insurance directly through a captive can significantly reduce the payment by not paying for these unnecessary expenses. In addition, a captive can offer direct access to the third party reinsurance market and the related wholesale pricing, which is often considerably less than what is otherwise available.

Writing Unrelated Parties for Profit

Often, a company’s direct knowledge of their business can give certain exposures within the industry.

This knowledge can help serve as a platform to generate a new profit center by offering coverage to unrelated parties as an alternative to the commercial marketplace.

Cash Flow and Investment Income

One of the most attractive features of the insurance business is the positive cash flow and related time value of money. Premiums are paid up front to the carrier with the agreement that they will cover certain exposures over a designated period of time (typically a year to fourteen months).

At the end of the premium risk period, the premiums are no longer subject to claims associated with the underlying risk pools to which the premiums were allocated.

Consequently, such premiums are effectively “returned” to the captive and thereafter invested by the captive in traditional investment vehicles.

This benefit is significant, as the return of premiums does not constitute income to the captive; rather, only the investment income earned on returned premiums from that point forward is taxable.

Coordination with Estate Planning

A captive can be owned by the same individuals that own the operating company or in some instances, captives can be owned by trusts established by the business owners themselves for the benefit of their descendants.

If, at inception, the captive is properly established by one or more irrevocable multi-generational trusts which are considered tax-exempt, as the value of the captive grows each year (return of premiums), said value passes to the business owners’ descendants free of estate and gift taxes.

Properly structured captives can provide the following:

  • Favorable risk management and asset protection
  • Favorable insurance cost minimization and underwriting gains
  • Favorable control

Since tax benefits are a fundamental advantage of establishing a captive, it is important to note that captives have been statutorily prescribed under the Internal Revenue Code, and have a significant body of case law and IRS pronouncements governing their use.

Captives, in essence, have been around in various formats for decades, and there is no considerable guidance that provides a framework on how to establish a viable structure.

First and foremost, it is essential that the entity have some business substance beyond the underlying tax benefits.  In order to determine whether a captive is appropriate, individuals typically have a preliminary feasibility study performed by qualified actuaries to determine what business risks might be suitable for a captive.

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