Why use insurance captives

There are a couple of crucial introductory distinctions to make with the member-owned group captive model:. There is much more to cover in understanding group captives, but that brief introduction should suffice in helping us answer the question, "what is a captive insurance company? Captives are usually formed to supplement other commercial insurance coverage and allow the parent company to retain some risks at a lower cost.

The captive can provide coverage that is unattainable or inadequate in the private market. In addition to the opportunity to obtain more comprehensive or specialized coverage for the company's risks, the parent company can achieve cost savings, tax savings, and better control over claims decisions. The captive can be especially cost-efficient because the parent company retains what it would otherwise pay a third-party insurer.

The bolded text here is a critical motivator behind forming a captive insurance company. Conventional insurers have significant overhead costs — e. By circumventing conventional insurers, companies that form captives can enjoy more control over these costs or eliminate certain costs entirely.

Captives must be capitalized and domiciled in a jurisdiction that legally allows captives to operate as licensed insurers. The captive insurer is an unlicensed, non-admitted insurer except in its own domicile. Because it is generally illegal for an unlicensed insurer to issue policies, captive insurers typically contract with a licensed insurer to issue policies.

However, the captive does not transfer the risk. These fronting arrangements allow captives to comply with various state financial responsibility laws that require evidence of coverage for certain lines, such as workers' compensation, to be written by an admitted insurer. The captive determines the types of risks that will be covered and establishes premiums that are paid to the captive by the business owner s. If claims exceed premiums in the captive, the company, or group of member companies, is liable for the excess cost.

On the other hand, if losses for the coverage are less than expected, the excess premium can be distributed back to the business owner s. The point of a captive is not to retain all risks. Group captive members still transfer some risk to conventional commercial insurers. While captive insurance allows companies a means for managing risks that traditional insurers don't cover, the risks that group captives most commonly retain share some distinctive characteristics:. Given these characteristics, group captive insurance is most often used for standard casualty lines like:.

In its modern format, captive insurance dates back to the late s, when poor market conditions led to increasing premiums, higher deductibles, and tighter policy conditions, prompting several large companies to form single-parent captives. At the time, the captive insurance model was only financially viable for larger companies with significant capital.

Today, captive insurance has become commonplace among larger corporations as approximately 90 percent of Fortune companies have captive subsidiaries, according to the National Association of Insurance Commissioners NAIC.

While originally a formal vehicle for large companies to self-insure, captive insurance became accessible to mid-size companies thanks to group captives. At the time, business owners were paying exorbitant premiums for traditional insurance coverage or struggling to obtain coverage at all. The model has since become an accepted standard in the group captive industry and is widely used today.

Overall, captive insurance has enjoyed steady growth over the years. Thus, the captive must be accepting risks from multiple separate entities to satisfy this requirement. The IRS has issued a number of revenue rulings that provide guidance to captives to ensure compliance with these factors see, e.

In addition, in Rev. There is one additional requirement for the captive to be considered an insurance company for federal purposes. The formation of a captive insurance company is a lengthy process including feasibility studies, financial projections, determining domicile, and, finally, preparing and submitting the application for an insurance license.

The need for a qualified insurance manager on the planning team is very important, particularly in the formative stages. The requirement for adequate initial capitalization of the captive is dependent in part on the level of risk projected to be assumed by the captive and the requirements of the particular domicile chosen.

In some cases, this initial capitalization can be accomplished through the use of irrevocable letters of credit. The irrevocable letter of credit would be obtained by the sponsor applying to the bank for this letter of credit.

One critical function to be performed during the formative stages is the identification of the risks to be insured by the captive. The operating company is presently paying premiums to one or more commercial insurance companies to protect it from specific risks, some of which could be catastrophic if they were to occur without such insurance.

Should the captive see a need to protect itself in the case of a higher-risk policy, it may be able to buy reinsurance at premiums that are less than the premiums that it has charged the parent company. On an annual basis, the premiums paid to the captive in excess of its claims and operating expenses will transfer to the earned surplus account and be available for more aggressive investment activities.

As was pointed out in Rev. In that case, payments into the captive would take on the aspects of deposits into a sinking fund to help liquidate an existing liability. One of the risk management benefits that the captive may provide is the flexibility to opt for higher deductible levels on the existing property and casualty insurance policies.

In keeping with the above desire to minimize, but not eliminate, claims experience, the selection of the risks that the captive is willing to assume should be prudent. The attractive tax benefits associated with the smaller captives can sometimes cause business owners to forget that the captive must operate as a true insurance company.

The use of an experienced and capable captive management company is an essential element of the normal operations of such an entity. The need for annual actuarial reviews, annual financial statement audits, continuing tax compliance oversight, claims management, and other regulatory compliance needs puts the day-to-day management of a captive insurance company beyond the skills of most general business people.

In , Congress inserted a provision into Sec. Under Sec. In general terms, an insurance company must be taxed as a C corporation and must file its return on a calendar-year basis, unless it is being included in a consolidated tax return.

If an insurance company is established as an LLC or a partnership, it must elect to be taxed as a corporation under the check-the-box regulations of Sec.

Unfortunately, upon liquidation, the corporation and its shareholders could be subject to double taxation because the entity is a C corporation. If the shareholders of the captive are family members of the owners of the parent company or trusts with family member beneficiaries, any income of the captive would inure to their benefit. Since this is a transaction in the ordinary course of business, no gift or estate tax would attach to the intrafamily transfer of wealth.

Likewise, some shares of preferred stock of the captive might be distributed to key employees of the operating company and then redeemed upon retirement. The capital gains tax on the redeemed shares should be less than the tax on any other form of deferred compensation. The possible use of multiple captives also should not be ignored.

Care should be taken to avoid the attribution rules under Sec. Using multiple captives, or cells discussed below , could also accommodate shareholders with different retirement goals and investment philosophies. As a result, the benefits of operating a captive insurance company may be slightly reduced, but they are not eliminated. The state taxation of the captive depends on the state in which the captive is domiciled, which need not be the state in which the operating company is located.

Selecting a domicile depends on a number of factors, including taxation. Recent legislation in a number of states has created a new form of entity that is viewed as an attractive structure for captive insurance operations.

Proposed regulations under Sec. A captive insurance company should not be confused with a captive insurance agent , who is an insurance agent who only works for one insurance company and who is restricted from selling competitors' products. A captive insurance company is a form of corporate " self-insurance. There are also complex compliance issues to consider. As a result, larger corporations predominantly form captive insurance companies, but may also rely on third-party insurers to insure against certain hazards.

The tax concept of a captive insurance company is relatively simple. The parent company pays insurance premiums to its captive insurance company and seeks to deduct these premiums in its home country, often a high-tax jurisdiction. A parent company will locate the captive insurance company in tax havens , such as Bermuda and the Cayman Islands, to avoid adverse tax implications. Today, several states in the US allow the formation of captive companies.

The protection from tax assessment is a sought-after benefit for the parent company. Whether the parent company realizes a tax break from the creation of a captive insurance company will depend on the classification of insurance the company transacts.

In the United States, the Internal Revenue Service IRS requires risk distribution and risk shifting to be present for a transaction to fall into the category of "insurance. Some risks could result in substantial expenses for the captive insurance company that are unaffordable. These sizable risks could lead to bankruptcy. Single events are less likely to bankrupt a large private insurer because of a diversified pool of risk they hold.

A well-known captive insurance company made headlines in the wake of the British Petroleum oil spill in the Gulf of Mexico. British Petroleum is not alone in this practice, and indeed many Fortune companies have captive insurance subsidiaries.

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