Captive insurance is a tool to manage the insurance risks of operating a business, while providing the business owners substantial benefits beyond the purchase of commercial insurance. Captive insurance is obtained through a captive insurance company (“captive”), which is an insurance company, created for the primary purpose of insuring the risks of an operating business and its affiliated companies. Establishing a captive allows the operating business to take control of its risk management by allowing it to insure risks for which coverage may not be available in the commercial market or may be prohibitively expensive. Captive insurance is often less expensive than commercial insurance, because it can be tailored to the needs of the operating business. In addition, because the captive and the operating business generally share the same or a related owner, the captive can be a profit center, instead of a drain on resources.
Captive insurance is a proven strategy for risk management that large corporations have employed for years. Most Fortune 500 companies have captives, and several wellknown insurance companies got their start as captives. Because of recent developments in the law, captive insurance has become a strategy that small to mid-sized businesses can employ. RMC’s captive insurance consulting services are designed to guide businesses through the process of establishing and managing a captive.
Benefits of Captive Insurance
Filling the Gaps
Captive insurance can replace or supplement insurance available in the commercial market. Commercial insurance may not provide adequate coverage for certain types of risks. In fact, the commercial market may not offer the types of insurance that a particular business requires. In addition, a captive can fill gaps that are built into commercial insurance, such as deductibles, policy exclusions and policy limits. A captive can bring peace of mind to a business owner, who would not otherwise have adequate coverage.
A captive is an insurance company, and, like any insurance company, it provides protection against insurance risks that a business faces on a daily basis. While some of these risks may be remote, they could have catastrophic consequences if they were to occur. Forming a captive allows a business to transfer the risk of loss to an insurance company, instead of having to absorb the loss on its own.
Captive insurance may be more cost-effective than commercial insurance. Because the primary purpose of a captive is to insure the risks of related businesses, a captive can tailor its coverage to the needs of its insureds. The captive will have greater knowledge about the business operations of its insureds and should be better able to forecast the nature, magnitude and frequency of the risks faced by its insureds than a commercial insurance company. This should result in reduced costs, as the captive is able to develop a premium structure that reflects the risk exposures of its insureds, instead of the industry as a whole. Costs may be further reduced, because a captive does not have many of the expenses faced by a commercial insurance company. While a captive must accept unrelated risk, its primary customer is its related operating business. As a result, it will not have the same marketing expenses as a commercial insurance company, and its premiums may not have to reflect these costs. In addition, because the captive and the operating business will share the same or a related owner, the captive does not generally need a separate physical presence and will not have the overhead expenses of a commercial insurance company. The captive’s reduced expenses are passed on to the operating business in the form of lower premiums.
Another cost-efficiency may be reinsurance. Reinsurance is insurance for insurance companies and is generally not available to the general public. An insurance company can reduce its risk exposure through reinsurance, thereby lowering its costs. Because a captive may have access to the reinsurance market, it can reduce its risk exposure and pass on the savings to the operating business. In addition, the ability of the captive to obtain reinsurance for certain risks may give the operating company greater leverage in negotiating premium rates with commercial insurance companies.
To the extent that premiums paid to the captive exceed claims paid by the captive, the premiums paid by the operating business go to the bottom line of the captive. Since the captive and the operating business may have the same or related owners, this means that insurance premiums paid by the operating business to the captive may generate a profit for the owners. Compare this to premiums paid to commercial insurer, which, in the absence of claims, are gone forever.
Insurance companies are taxed differently than other companies under the Internal Revenue Code (the “Code”). It is important that a captive be properly structured and managed in order to take advantage of tax benefits available to insurance companies and to avoid the pitfalls that are contained in the Code. That is why a client contemplating the formation of a captive must consult with its independent legal, tax and accounting advisors. RMC does not provide legal, tax or accounting advice.
Property and casualty insurance premiums may be deductible under section 162(a) of the Code if they constitute ordinary and necessary business expenses. Accordingly, it is imperative that payments from the operating business to the captive constitute insurance premiums. Otherwise, the operating business will not be able to deduct its payments to the captive.
Under normal circumstances, premiums paid to an insurance company would constitute the taxable income of the insurance company. However, insurance companies are required to maintain reserves to protect against future claims. The Code defers taxing these reserves by providing a deduction from taxable income for such reserves. Only income in excess of the company’s reserves is immediately taxable.
Election of 831(b)
The Code provides an additional benefit to small insurance companies. Effective January 1, 2017, section 831(b) of the Code permits an insurance company with annual premiums that do not exceed $2.2 million to be taxed on its investment income only. An insurance company must make an affirmative election to be taxed under section 831(b). The election permits a small insurance company to retain more of its premiums to pay claims.
Because the taxation of a captive is so complicated, there is a potential for abuse. The Internal Revenue Service is aware of these abuses and will challenge arrangements that do not constitute insurance. You may want to obtain a private letter ruling from the IRS.
Implementation and Administration
The first step in implementing a captive is the feasibility study. The feasibility study reviews the nature of the client’s business to determine whether the business has risks that can be insured through a captive. The feasibility study will also explore alternate options for risk management. An analysis is prepared to illustrate the benefits of providing insurance through a captive as opposed to a commercial insurance company. In most cases, the captive will provide significant advantages to the client. RMC will work closely with the client and the client’s advisors to ensure that business goals and insurance needs are met.
Establishment and Administration
Once the client decides that a captive is a viable solution to the client’s insurance needs, RMC will work with the client to establish the captive. The client needs to select a domicile, and RMC will file the incorporation documentation with the appropriate authority in the domicile. RMC will also prepare and file the application for an insurance license and will work with the insurance department of the captive’s domicile to get the license issued. The client will select the types of coverage to be provided by the captive, and RMC will prepare the insurance contracts for filing with the insurance department. The captive will establish premiums based upon the actuarial study obtained in connection with the feasibility study. The captive will be required to invest premiums in order to maintain its solvency, and RMC will execute those investments at the direction of the captive’s owner. RMC will facilitate reinsurance, where necessary, and will administer the insurance, collect premiums and resolve claims, on behalf of the captive. RMC will meet with the client on an annual basis to review the operation of the captive and to make necessary adjustments in order to comply with laws and the client’s business needs.