Captive Insurance

Alaina Schoonmaker (Dec, 2016)

Choosing insurance can be a frustrating and challenging decision for businesses. The process involves a lot of analyzation, research, and uncertainties. Commercial insurance can be very costly and may show little to no return for the insured. One insurance option that is becoming increasingly popular among businesses is captive insurance. While it may not be for everyone, it can be a very beneficial insurance option for certain companies.

Captive insurance companies have been around for decades, however, today there are more than 6,000 captives all over the world. Captive insurance companies are privately owned and operated by one or more businesses or business owners. The legal entity or entities that create the captive may be a corporation or partnership; however the captive itself must be taxed as a C Corporation. Captives are typically used as supplemental insurance for risks that are either too expensive or not regularly covered by commercial insurance. Similar to commercial insurance companies, a captive assesses the risks associated and the costs they could incur. A premium is charged based on the assessment and if the costs acquired from the risks are less than the premiums received, an underwriting profit is earned and then invested. However, the difference is that the profit received by the captive is being invested right back into the company directly, as opposed to being invested by the third party insurance company and having no benefit to the insured.

Depending on their situation, a business can either form their own captive or join a group captive with multiple other entities; both options including several steps for implementation. First, the entity should conduct a feasibility study, which analyzes a company from top to bottom to make sure a captive is really the best insurance choice for them. If the answer is yes, the next step to joining a group captive would be to research different captives and what their requirements are to join in order to find one that is most suitable for them. If the entity chooses to form a captive, their next step would be to appoint an underwriter to calculate premiums by identifying what risks they have and what needs to be capitalized. Once this critical information has been established, a detailed and well-developed business plan needs to be prepared. This business plan will be sent to the Insurance Commissioner along with the application to receive an insurance license, therefore it must include all significant aspects of the potential captive insurance company; such as strategies to manage risk, any coverage that will be offered, structure of management, etc. If and when an insurance license is issued, the newly formed captive will use their business plan to operate, while making investments that are advisable to the company. It is recommended to hire a third-party to conduct administrative tasks and keep the company on a successful track.

Captive insurance will not always make sense for every business. One downfall to captives is that they can be costly to join or create, with the idea that they will pay off significantly in the long run. Therefore, in order for a business to choose captive insurance they should possess $500,000 or more in operating profits. Along with being profitable, the entities are typically pursuing sizable annual tax deductions. Also, these businesses tend to have multiple entities and large uninsured risks that they are looking to protect. Not only is the business gaining benefits from captive insurance companies, but the owners are also; thus these individuals are hoping for additional personal wealth and security.

When a captive is formed and operated successfully, many benefits will arise. The premiums that are paid to the captive insurance company become a tax deduction as a business expense. Furthermore, the income that is received by the captive from premiums will either be reduced by loss reserves or considered nontaxable income under Sec.831 (b); the distinction is based on the amount of income. Small captives have premium limitations of $1.2 million or less (rising to $2.2 million in 2017), therefore they can use the election to deem income nontaxable. Large captives have no limitation on premiums so they can only protect that income with loss reserves. Another benefit is with the underwriting profit being invested right back into the company rather than a third-party; there can be an accumulation of personal wealth for the business owners. This also creates the opportunity for any family members that are shareholders of the business and have ownership in the captive, to transfer their wealth without any tax liabilities such as gift and estate taxes. In addition, assets that are typically considered uninsured are now protected from risks and creditors.

There are many complexities and difficulties that come with forming or joining a captive. However, those obstacles may be worth overcoming if you believe your business would benefit with captive insurance.  As always, please contact your Dermody, Burke, and Brown advisor if you have any questions.  

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