By: Randall A. Denha, J.D., LL.M.
First, what is a captive insurance company? The National Association of Insurance Commissioners defines a captive as an insurance company that is created and wholly owned by one or more non-insurance companies to insure the risks of its owner or owners—essentially a form of self-insurance whereby the insurer is owned wholly by the insured. Once established, the captive operates like any commercial insurance company and is subject to state regulatory requirements including reporting, capital and reserve requirements. By establishing one’s own insurance vehicle, costs for overhead, marketing, agent commissions, advertising, etc., may result in significant savings in the form of underwriting profits, which can be retained by the owner of the captive company.
The way it works is a business pays the wholly owned captive’s annual premiums, and profits left at the end of the year after paying claims are the business owner’s to keep. The captive premium expense is tax deductible as an “ordinary and necessary business expense.” There are an estimated 5,000 captive insurers worldwide, according to The Center for Insurance and Policy Research’s data from A.M. Best.
Captive insurance companies, self-insurers for businesses, provide owners with substantial tax advantages, the most attractive of which is an annual deduction of up to $2,200,000 based on an actuarial assessment of your business. In effect, this creates an opportunity shift or tax arbitrage-moving business income from the top marginal tax rate of 39.6%, towards a more preferred dividend tax rate of 20%. In its simplest expression, the dividend received deduction allows a company that receives a dividend from another company to deduct that dividend from its income and reduce its income tax accordingly. Additionally, the realized savings from the reduced tax can further benefit from the dividends-received deduction, which allows the captive to deduct 70% of the dividends that it receives from its stock portfolio investments. Over time, as these premiums accumulate, they can be invested to generate additional income which can then be distributed back to the shareholder. Owning an insurance company gives a business the opportunity to retain favorable, (i.e. profitable) risks within the captive, and transfer the less favorable risks to the traditional insurance marketplace.
To put this in perspective, a business owner that deducts $650,000 per year to fund a captive, can reasonably expect to accumulate over $7.8 million over 10 years, versus $3.8 million had they not used such a vehicle, for net savings of $4 million. Sounds too good to be true? It’s not. If properly established and set up with the primary intent of filling a legitimate business need, these tax savings can be a welcomed benefit to the owner. It’s no wonder this strategy is being incorporated into the tax and estate planning of high net worth business owners.
There are numerous other potential advantages to forming a captive insurance company. Captive insurance companies are formed for both economic and risk management purposes. For example, by forming a captive insurance company, a business can dramatically lower insurance costs in comparison to premiums paid to a conventional property and casualty insurance company. The risk management benefits of these captives were primary, but their tax advantages were also important. In recent years, smaller, closely held businesses have also learned that the captive insurance entities can provide them significant benefits.
Additionally, a captive insurance company can provide protection against risks which prove to be too costly in commercial markets or may be generally unavailable. The inability to obtain specialized types of coverage from commercial third-party insurers is another reason why clients may choose to establish a captive insurance company. With a captive insurance company, a business owner can address their self-insured risks by paying tax deductible premium payments to their captive insurance company. To the extent the captive generates profits, those dollars belong to the owner of the captive.
In most cases, to the extent existing P&C coverage is reasonably priced, business owners will continue to maintain existing policies for their traditional coverage and supplement existing coverage by addressing their self-insured risks with their own captive insurance company. Policy features, coverage and limits can be drafted to meet specific enterprise exposures. This allows for many risk-management advantages, including, but not limited to the following:
- Greater Control over Claims
- Increased Coverage
- Increased Capacity
- Flexibility as to form and rates
- Investment Income
- Access to the Reinsurance Market
- Enhanced Loss Prevention
- Incentive for Loss Control
- Premium and Loss Allocation
- Reduced Insurance Costs
- Capture Underwriting Profit
- Pricing Stability
- Improved Claims Review and Processing
- Defensive Strategies
- Tax Benefits
- Investment Income
- Additional Profit Center
In general, your captive insurance company will be capable of delivering better service to your operating company than a commercial insurance company can. Ultimately, an analysis is undertaken by a consultant that will help you to determine the best balance between coverage retained from commercial carriers and your captive insurance carrier as well as the premium to be charged.
Premium payments made by the operating company to the captive insurance company for property and casualty insurance coverage should be tax-deductible as an ordinary and necessary business expense, just as they would be treated had they been made to a traditional insurance company.
Internal Revenue Code Section 831(b) provides that captive insurance companies are taxed only on their investment income, and do not pay income taxes on the premiums they collect, providing premiums to the captive do not exceed $2,200,000 per year (indexed for inflation annually.)
Further, the captive may retain surplus from underwriting profits within reserve accounts, free from income tax. It can also generate profits by controlling or eliminating costs for overhead, marketing, advertising, agent commissions, profits, etc., items normally built into the premiums charged by traditional insurance companies. After adjustment for expenses and claim payments, net underwriting profits are retained within the captive insurance company. Over the years, profits and surplus may accumulate to sizeable amounts, and may be distributed to the owner(s) of the captive company, under favorable income tax rates as either dividends or long-term capital gains.
Amounts set aside as reserves for potential claims payments, plus capital surplus, should be maintained in safe, liquid asset classes so that the captive has adequate solvency to pay claims when called upon. The formation of your Captive Insurance Company and eventual issuance of a certificate of authority to do business, are subject to approval by the insurance regulators in the jurisdiction where the insurance captive is formed. The insurance regulators will also oversee the organization and ongoing operation of the captive insurance company to assure ongoing compliance with the rules for that jurisdiction.