Insurance is something needed by all businesses to protect against the risk of loss. With captive insurance, a business can create its own coverage to achieve two goals: protection for the businesses and financial advantages for their owners. Captive insurance is also sometimes promoted chiefly as a tax shelter, but using it this way has its hazards. (More on that later.)
How Captive Insurance Works
Captive insurance is an insurance company owned by the people it insures. Unlike mutual insurance companies, which are also owned by policyholders, captive insurance companies are both owned and controlled by policyholders. In a nutshell, captive insurance is a form of self-insurance. However, the captive insurance company is subject to state regulations on insurers just like other insurance companies.
While policyholders own the captive insurer, the policyholder’s ownership is not an investment in the true sense of the word. No capital or property is contributed to the company, other than premium payments. And ownership ceases when insurance lapses, such as when the owner no longer needs coverage and stops paying for it. The policyholder cannot sell, gift or bequeath anything.
Captive insurance companies can be set up in a variety of ways. “Pure captives” insure only its owners. “Single parent captives” have a single owner (such as a Fortune 500 company); “group captives” have multiple owners. For example, companies in a single industry may form a captive insurance company (a group captive) to meet their special risk needs.
Captive insurers can be formed in the U.S. or in numerous jurisdictions worldwide. Each country has its own limits on capitalization and how much surplus must be retained. According to the National Association of Insurance Commissioners (NAIC), there are more than 6,000 captive insurers worldwide.
Protection for the Business
Traditional insurance products may not meet a business’s needs, at least not at an affordable price. Captive insurance can provide broader coverage than available through existing products. This coverage can be tailored to protect against difficult risks. Professional services businesses and construction companies, for example, may find captive insurance appealing. Trade associations may also offer captive insurance for members. The Coin Laundry Association, for example, used captive insurance for many years because its members could not obtain traditional coverage for their 24-hour businesses.
But the extent of this special type of coverage is quite limited. According to the International Risk Management Institute (IRMI), the typical captive insurance limit is $250,000 per occurrence. Losses in excess of this limit are not protected by the captive insurance. Those with captive insurance use reinsurance for losses in excess of the limit.
Businesses also have better control over their cost of protection. Because captive insurance is limited in scope, it can better manage risk and avoid price hikes inherent in the commercial insurance market.
Financial Advantages for Owners
While the main reason for captive insurance is risk management, an ancillary benefit for businesses that use captive insurance is that they stand to profit if the company’s underwritings are sound. Captive insurers generally distribute dividends to owners.
One way to increase these returns is to reduce claims. This can be done by better business practices aimed at safety so that claims are minimized or avoided. Another way is to have greater review of claims through a better understanding of occurrences than traditional insurers have.
Yet another way that captive insurers generate profits is by controlling expenses. According to Captive.com, premium allocations in the commercial market toward administrative costs are about 40%, but only 30% for captive insurance.
Captive insurance is a legitimate tax structure for small-business owners. Premiums paid to a captive insurer can be tax deductible if the arrangement meets certain risk-distribution standards. Thus, the business gets a current year write-off even though losses may never occur. The IRS, in Rev. Rul. 2002-89 and Rev. Rul. 2002-90, has laid out the rules under which captive insurance constitutes insurance for federal income tax purposes so that premiums are deductible. There are two safe harbors under which captive insurance is viewed as real insurance (i.e., premiums are deductible):
- 50% third party insurance safe harbor. If the captive insurance company gets at least 50% of its premiums from unrelated third-party insureds, there is sufficient risk distribution.
- 12 insured safe harbor. If the captive insurance company has at least 12 insured, each having between 5% and 15% of the total risk, then there is sufficient risk distribution, too.
However, the IRS may still challenge premium deductions where it believes there are stopgaps that thwart risk distribution, such as reinsurance or tax-shelter like arrangements. In fact, captive insurance was one of the “abusive tax shelters” on the 2015 IRS “dirty dozen” list of tax scams. The problem arises, according to the IRS, when promoters of small captive insurance companies “assist with creating and ‘selling’ to [business owners] oftentimes poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums,’ while maintaining their economical commercial coverage with traditional insurers.” Total amounts of annual premiums in these so-called micro captives “often equal the amount of deductions business entities need to reduce income for the year; or, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the Tax Code provision.” These captives are being targeted by the IRS for audit.
The Bottom Line
Captive insurance can meet risk-management needs for a small company while providing financial rewards for it, but this type of insurance is not for everyone. Typically, initial premiums can run hundreds of thousands of dollars or into the millions. And there are considerable costs – more than a quarter of a million dollars – to create a captive insurance company and cover fees to actuaries, attorneys and an insurance expert (consultant or broker).