Captive Insurance
What is a Captive Insurance Company?
A Captive Insurance Company is a privately owned insurance company—not an insurance product. A Captive only insures the risks its owners want it to accept, insuring other risks through commercial insurers. A Captive can provide an opportunity for a corporation or its owners/shareholders to retain profits that might otherwise be earned by a third-party insurance company. Annual insurance premiums paid to the Captive are fully deductible by the payer as "ordinary and reasonable business expenses," pursuant to IRC Section 162(a).
Captive Benefits
Captive Insurance Companies are often overlooked as a strategic initiative by finance and tax professionals, as the benefits are not easily understood or explained. With the proper guidance, the economic advantages of a Captive program become readily apparent. Such benefits include:
Tax Savings – 831(b) of the Internal Revenue Service (IRS) Code permits the Captive to receive a certain amount of annual insurance premiums completely income tax free. Tax savings start immediately and allow for flexible participation. Annual insurance premiums paid to the Captive are fully deductible by the payer as "ordinary and reasonable business expenses," pursuant to Internal Revenue Code (IRC) Section 162(a). The business owner decides when, how much, and for how long the existing businesses will pay premiums to the Captive. There are no restrictions regarding the amount of time the Captive is in operation.
Improved Cash Flow – With a Captive, the business can retain insurance premium dollars, which would have otherwise been paid to third-party insurers, within the business enterprise or same "economic family," thereby increasing investment income on its unpaid loss reserves, capital, and surplus.
Ownership and Control – The business owner will be in complete control of the Captive. The owner or assigners will own all the stock of the Captive and will control all of its bank and investment accounts. Owning a Captive will also improve control over loss costs by providing the business owner with a vehicle and the resources to categorize, measure, and manage these costs. In addition, a Captive enables its management to regularly reassess its risk appetite, deciding the type and amount of economic risks to transfer to the reinsurance markets and those to retain within its Captive.
Insurance Coverage Flexibility – The business can obtain insurance for risks not often covered by conventional insurance policies (i.e., administrative actions, product recalls, and other operating risks). Owners can tailor coverage and policy language to insure risks and obtain access to the reinsurance markets that may have a greater ability and willingness to handle such risks. The Captive will also provide better availability, stability, and affordability on a wide range of commercial coverages compared to conventional commercial insurers.
Reduced Insurance Costs – A Captive can provide an opportunity for a corporation or its owners/shareholders to retain profits that might otherwise be earned by a third-party insurance company. By establishing a Captive, insurance costs are reduced, and those savings and profits are subject to control within the same economic family. A Captive allows management to adapt to changes in the pricing structure of the commercial insurance market and to changes in the company’s business, risk tolerance, low history, cash flow, etc. A Captive only insures the risks its owners want it to accept, insuring other risks through commercial insurers. A Captive is less vulnerable to "hard" and "soft" pricing cycles and can help a business maintain accurate financial projections. While reinsurance is only available to insurance markets, a Captive can directly access the reinsurance markets providing such benefits as increased potential capacity, lower pricing, coverage benefits, and reduced exclusions. Access to the reinsurance market also permits the Captive to create a "cap" on the internal economic exposure of the Captive itself.
Captive Feasibility
When forming and operating a Captive, management must understand how the Captive will work and fit into the company’s planning and economics as well as the benefits and issues it will resolve. Ultimately, other corporate functions such as accounting, finance, and operations also become fully involved in Captive projects.
A Captive Feasibility Study must be undertaken. They base assessments on client data, and all of the recommendations are tailored to meet the client’s unique business goals. This study provides an in-depth overview of the costs and benefits of owning a Captive, including an adaptive business purpose and multi year cost benefit analysis; tax analysis; identification of the lines, limits, rules, rates and policy forms; and domicile selection and Captive structure selection.
Conclusion
A Captive insurance company is a regulated entity that allows an owner to more efficiently manage business risk. Structured properly, the Captive may also provide its owner with substantial federal and state income tax savings. The resulting tax savings may be utilized to fund other business risks and increase shareholder distributions.