For years, large corporations have used captive insurance companies to control insurance costs. Today, even small, closely held businesses are taking advantage of the many financial and tax planning benefits captives have to offer.
What is captive insurance?
A captive insurance company is a private insurer owned and controlled by the business or businesses (or the owners of such entities) it insures. Captives may be structured in several ways.
For example, a corporation may set up a captive as a wholly owned subsidiary to insure the parent. Alternatively, a group of related companies with a common parent may set up a captive to cover its members. Or, a group of unaffiliated companies (such as members of an association) may use a captive to pool their risks and share in cost savings and other benefits.
Insurance benefits of captives
The most significant benefit of a captive may be that the owners participate in the captive’s underwriting profits and investment income. For example, let’s say a business pays a commercial insurer a premium of $1.5 million per year. If the company’s claims average $1 million, it’s essentially “losing” $500,000 each year.
Suppose instead that the business sets up a captive insurance company and pays that same premium to the captive for comparable coverage. Instead of losing $500,000 per year, the underwriting profit is captured by the captive and retained by the business owners who formed the affiliated captive program.
What happens if the business experiences $3 million in claims in a given year? Depending on how long the captive has been in operation, it may have sufficient reserves to cover them. But a better approach is to purchase reinsurance for protection against catastrophic losses.
There are other benefits to a captive from an insurance perspective. For example, because the insured parties have control of the captive, they can design customized coverage to meet their needs best. Rather than covering all a business’s insurance needs, for example, a captive might simply cover deductibles or exclusions under commercial policies.
In addition, the owners have control over the claims process and the investment of the captive’s assets — two big advantages over conventional policies. Plus, a captive provides its owners with direct access to the wholesale reinsurance markets.
Captives can also offer more stable premiums and lower fixed costs than traditional commercial insurers. But that doesn’t mean their owners can set premiums at their desired level. A captive must charge reasonable, actuarially supported premiums to obtain certain tax benefits.
Income tax benefits
Captive insurance is a form of self-insurance, but it offers considerable tax advantages over self-insurance. Ordinarily, commercial insurance premiums are deductible business expenses, while self-insurance reserves are not. But you can deduct premiums paid to a captive insurance company, so long as it qualifies as an “insurance arrangement” for federal income tax purposes. (See the section “What is an ‘insurance arrangement’?”)
As an insurance company, a captive can deduct most of its loss reserves, allowing funds to grow on a tax-deferred basis. Even greater benefits are available for a “micro-captive” — one that receives premiums of $2.8 million or less for tax year 2024.
A micro-captive may exclude underwriting from taxable income and pay tax on only its net investment income. This allows it to accumulate surplus from underwriting profits on a tax-free basis.
Once a captive has accumulated sufficient reserves, it can pay out dividends to its owners. Because qualified dividends are taxed at favorable long-term capital gains rates, a captive effectively allows business owners to maximize the savings on their risk management programs.
Do your homework to find the best solution
Captive insurance companies offer many benefits, but they’re not for everyone. To make this strategy work, you must prepare for the operational and compliance issues the insurance business entails, including licensing, capitalization requirements, investment management, claims management, actuarial reviews, financial statement audits and IRS oversight.
MarksNelson recommends the engagement of a qualified professional to assist prospective captive owners in assisting with ascertaining whether a captive program is a viable option for their risk management needs.
What is an "insurance arrangement"?
To provide the benefits discussed above, a captive must qualify as an "insurance arrangement" for federal income tax purposes. Among other things, the captive must receive more than 50% of its revenue from issuing insurance or annuity policies. And the arrangement must involve elements of risk shifting and risk distribution.
Risk shifting means that the business transfers certain risks to the captive in exchange for a reasonable premium. Risk distribution means that risks are pooled with enough other, independently insured risks to minimize the possibility that actual losses will exceed expected losses.
The IRS evaluates captive insurance arrangements on a case-by-case basis, but it has established several safe harbors through revenue rulings. In one ruling, for example, risk distribution existed when a corporation established a wholly owned captive to insure each of 12 operating subsidiaries, none of which paid more than 15% of the premiums.
In another ruling, the IRS found that a wholly owned captive that insures only the risks of the parent doesn't distribute risk. But risk distribution exists if the captive receives less than 50% of its premiums from the parent and the balance from unrelated third parties.
One way to satisfy this requirement is to participate in a risk distribution pool. Such a pool facilitates the exchange of insurance business among multiple captives, allowing them to spread the risk among many insured parties.
Importantly, the captive must also conduct its operations in a manner substantially similar to those common within the general insurance industry. This means the engagement of qualified actuaries to price policies appropriately, timely policy issuance and renewals, stringent claims adjudication processes, and arms-length and commercially reasonable investing of a captive’s assets.
For more information contact your MarksNelson professional at 816-743-7700.
