This is the first installment in a two-part series on the potential benefits of forming a captive insurance company, or captive.
Whether you are the CFO of a large corporation or the owner of a private company, you may be looking to have more flexibility with your business insurance solutions, while managing your business risks with less cost and potentially gaining some tax savings.
If this sounds like your situation, you may be interested in the alternative risk management strategy of using the self-insurance concept of “captive insurance.”
What Is a Captive and How Does It Work?
A captive insurance company, or captive, is an entity that is formed to supplement a business’s commercial insurance coverage. It is typically owned by the corporation and acts as the in-house insurance agent for the enterprise.
The simplest example of how a captive works would be to compare it to an HSA (health savings account) for individuals, that is, the sponsoring insured business is taking pre-tax income and setting it aside in a new financial entity (the captive). This income is in the form of tax-deductible premiums paid for an insurance policy to cover a future potential claim(s) against the policy for specific risks.
If a claim or claims against the policy do not exceed earned premiums within the policy period, then the captive has an underwriting profit, or reserve, that is still owned by the captive and still available to cover future claims against the insured’s risks.
Companies form captives to save money. An example of how a captive program saves on insurance costs is where the insured business directs its captive to take the first layer of coverage for a particular risk, say the first $100,000 of annual claims. Then the insured business increases its commercial policy deductible for that specific risk to $100,000 and uses the difference in premiums that they would have paid their commercial agent as the funding source for the premiums paid into the captive for that policy year.
Types of Insurance Captives Can Cover
Captives can provide a wide variety of insurance coverage types against insurable risks in your business, including but not limited to:
- Property and Casualty
- Product Liability
- Cyber Risk
- General Liability
- Directors and Officers Liability, Professional Errors and Omissions Liability
- Workers Compensation
- Medical Stop-loss
- Medical Malpractice
- Extended Warranty Programs for clients
Potential Tax Implications of Captives and Other Considerations
Since the late 1970s, the IRS code has allowed small captives called “Micro Captives” to have an exemption against paying any income taxes on underwriting profits, so long as the captive meets some strict guidelines for eligibility to make what is called an 831(b) tax election. This tax-free election is currently limited to a maximum of annual paid-in premiums of $2.2 million dollars. All other captives are taxed as C corporations.
While the tax implications of using a captive as an alternative risk strategy are attractive, they are by no means the principal reason for participating in captives. As stated above, the use of captives is designed to be a supplement to a business’s commercial insurance program. You would consider forming a captive where the commercial insurance market either does not provide adequate coverage or any coverage at all for certain risks.
Captives are typically used to reduce the cost of commercial insurance by:
- Avoiding the agent’s commission and the carrier’s overhead mark-ups
- Stabilizing the volatility of the commercial market’s pricing
- Providing direct access to the reinsurance markets
- Providing investment income within the captive to improve overall cash flow for covering future claims
- Providing customized coverages
- Improving claims handling and control
- Eventually providing the captive owners with either a tax advantaged profit distribution or an inexpensive financing vehicle for the future capital needs of the sponsoring insured business.
This is obviously a long-term strategy and sometimes referred to as a gift that keeps on giving.
In the second installment, we will explore who should create captives, the different types of captives available, and how to get started.If would like to learn more about captives to determine if they make sense for your business, visit our website at www.firsthorizon.com/captives.
