Risk management is part of every business, and most owners have a good understanding of traditional property and casualty policies. But what do you do when you have exposure to risks for which your company has no coverage?
Risk management is part of every business, and most owners have a good understanding of traditional property and casualty policies. But what about exposure to risks for which your company has no coverage? Perhaps a captive insurance company can help you manage those risks more effectively.
What is a captive insurance company?
A captive insurance company (captive) is a special purpose insurance company established to provide risk management for a parent company. It offers an alternative to the traditional commercial insurance and reinsurance markets. The business of the captive is usually controlled by its owners, who are also normally the principal insureds. In many cases, the owner of the parent company is also the owner of the captive, though the arrangement can be structured in another way. Think of a captive as a form of self-insurance.
A captive is organized for the main purpose of funding the owner’s risk while allowing the owners to actively participate in decisions influencing underwriting, operations, and investments. The captive must act as a legitimate business entity and remain in compliance with all insurance regulatory provisions and IRS requirements. One of the main ways to do this is to insure a risk that will pay out claims as a standard insurance company would.
There are many different types of captives. The most common are:
Single parent captive — This is often referred to as a “pure” captive. The captive continues to be a subsidiary of a single parent that underwrites only the risks of its parent and related affiliated companies.
Group captive — Formed by members of an industry or trade association for the members to share the risks of the industry or association.
Rent-a-captive — Owned by unrelated sponsors that provide insurance for a fee. The insured will be required to provide some capital to supplement the risk of the captive. This type is often used by a company for a program that is too small to justify incorporating its own captive.
Protected cell companies (PCC) — Also referred to as segregated accounts companies and segregated portfolio companies, these are similar to a rent-a-captive with a special difference. A PCC guarantees each “cell” within the company will be shielded from sharing capital and surplus with other cell owners, but also from any legal action against the cell’s assets.
Risk retention groups — Created by the federal Liability Risk Retention Act (LRRA), this is a pool of individual insureds that are similar and have agreed to share risk among the group as a third party.
Agency captive — This is typically a reinsurance company owned by an agent or group of agents. These are formed by brokers or intermediaries for their clients.
A captive can be strategic
Captives are created for both risk management and economic purposes. A captive can be a tool for a company that has had difficulty finding coverage at affordable premiums. Captives can also help companies control their insurance costs by lowering the premiums for various insurance programs. The price of insurance purchased in the conventional market typically will reflect a significant markup to pay for the expenses of the insurer as well as profit. There is also a lost investment opportunity by having to pay the premiums in advance. A captive will not eliminate these costs, but it can reduce them significantly. By forming a captive, the business owner can address the company’s self-insured risks by paying a tax-deductible premium to the captive. Any profit generated from the captive belongs to the owner of the captive.
What are the benefits and disadvantages of a captive?
There are many pros and cons to captives, so deciding on whether a captive is right for you will take some thought and discussion with the enterprise leaders and other professionals.
Benefits:
Greater control over claims — The insured controls the claims review process and has direct control over how the claims are handled. The insured can implement best practices for claims processing.
Increased coverage and capacity — The captive policy can provide coverage for exposures and limits that may be unavailable from conventional carriers.
Underwriting flexibility — The captive policy can be customized, and the insured decides the limitations and exclusions, which are subject to insurance regulatory approval.
Access to the reinsurance market — A captive offers direct access to the reinsurance market.
Incentive for loss control — Underwriting profits belong to the owner of the captive (often the insured). This provides an incentive to implement loss control measures and reduce claims.
Pricing stability — Due to sound loss control efforts and reduced claims, the insured has the ability to price the insurance coverage accordingly.
Purchase based on need — Coverage is designed to provide coverage that is actually needed, rather than as a pre-established policy, and it can be updated as needs change.
Tax benefits — Underwriting profits are tax-exempt under IRC 831(b) and only taxed when distributed to the owner of the captive.
Investment income — Reserves and surplus are invested, which allows investment income to benefit the insured.
Disadvantages:
Of course, every rose has its thorn.
Increased administration burden — The captive owner is responsible for claim administration, loss control, and underwriting. That is a lot of work.
Acquisition of expertise — The captive owner must acquire relevant expertise for all insurance-related disciplines.
Merger or acquisition — The captive could complicate a merger or acquisition activity.
Volatility of reinsurance market — A reinsured risk of a captive might face premium increases sooner than a commercially insured risk.
Capital commitment — Funding of the initial set-up and capitalization may tie up some cash.
Run-off — A change in the parent company’s business plan or a merger could cause the captive to be placed in a run-off mode, during which it stops actively trading, ends its underwriting operations, and produces no economic benefit.
Tax opportunities
Insurance companies are generally taxed more favorably than other entities and are afforded tax benefits such as:
- Deferred recognition of a portion of the company’s unearned premiums
- A discounted reserve for unpaid losses, including incurred but not reported (IBNR) losses and case development
The largest tax issue related to captive insurance companies is whether the captive’s primary and predominant business activity is the issuance of insurance contracts. This is significant to the policy holders because the deductibility of payments to the captive depends on whether its payments are made as part of an insurance contract. This is important to the parent company because such payments are characterized as ordinary and necessary business expenses and currently deductible under IRC § 162. If the payments were made as a risk financing arrangement that does not constitute insurance, the payments would not be deductible. The deduction would be deferred until payments were made to claimants. Neither the IRC nor the U.S. Treasury regulations provide definitions of the terms “insurance contract” or “insurance,” so the Supreme Court has established that the presence of two elements constitute insurance status: risk shifting and risk distribution. The court agrees with the IRS that risk is not shifted or distributed when a parent corporation makes premium payments on its own behalf to a wholly owned insurance subsidiary.
However, two alternative approaches for finding risk shifting and risk distribution were established in the context of captive structures:
- Including a substantial level of risk exposure of parties legally unrelated to the insurance subsidiary and its parent in the risk pool. This is the unrelated party risk approach.
- Including the risk exposure of numerous corporate affiliates of the insurance subsidiary in the risk pool. This is the brother-sister approach.
If the arrangement satisfies either approach, the payments to the captive may constitute deductible insurance premiums, and the captive may qualify as an insurance company under the IRC.
State premium taxes are due when premiums are paid to an insurance company, and these taxes ranges from 3 – 4 percent of premiums.
Micro-captives
Micro-captives allow earned insurance premiums received by the captive to be tax-exempt, as long as the paid-in premium does not exceed $2.3 million annually. The captive is only taxed on the investment income generated during the year. This allows the captive to build surplus from underwriting profits free from income tax. This surplus can be distributed out to the owner under favorable income tax rates, either as dividend or long-term capital gains. Micro-captives have been scrutinized by the IRS and placed on the agency’s “Dirty Dozen” tax scams list for several years because micro-captive insurance transactions have the potential for tax avoidance or evasion. Taxpayers who have entered into a reportable micro-captive transaction must disclose the transaction to the IRS.
Offshore captives
The taxation of an offshore captive depends on if it is engaged in a U.S. trade or business. If related to a trade or business within the United States, income attributable to the business is generally subject to U.S. federal corporate income taxes.
If the captive is not engaged in a U.S. trade or business, it would be subject to indirect U.S. taxation under subpart F of the IRC. This imposes a tax on U.S. citizens owning stock in certain off-shore captives. There are also other foreign filing requirements as well as a federal excise tax based on the gross premiums of the captive. It will be necessary to work with a tax advisor who is experienced with offshore captives if this is an option you are interested in.
Why might a captive be right for my company?
Captives are created for both risk management and economic purposes. Captives allow the business owner to control many aspects that are generally not available to the owner when using conventional insurance companies. Consider the following when determining if a captive is right for your company:
- Could the parent company pay premiums that are sufficient to achieve savings and cover expenses?
- Are the current loss ratios for coverage low enough to generate surplus and offer cash flow if the captive were to sustain an adverse loss?
- Does the parent company have enough resources to provide the initial funding to the captive?
- What insurable needs will the captive address?
- Who will own the captive?
- Does the concept of a captive complement the overall corporate strategy?
While a captive can be used to replace your existing coverage, it may be better to maintain the current coverage and supplement that coverage with a captive, particularly if the current coverage protects against risks that may result in catastrophic losses. While there are many risks with insuring as a captive, if carefully considered and formed properly, captive insurance companies can offer unique benefits that are hard to match in the traditional insurance marketplace.
How we can help
Depending on the size and complexity of your company, using conventional insurance companies may be simple and more cost effective. However, if your risk management situation demands a more tailored approach, CLA has many tax and audit professionals who can help you find the right fit for your company.