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The Benefits—and Risks—of Captive Insurance

Captive insurance programs can be a great fit . . . for certain companies. Captive insurance is where a subsidiary insurer that is wholly owned by a parent company provides risk-mitigation services either for that parent company or for a group of related companies. Often, these captive insurance programs are put into place for companies that have difficulty securing risk management from outside firms or for specific and specialized business risks. Premiums for these services that are paid to the captive insurer can sometimes end up creating tax savings, making that insurance an affordable and attractive option while also creating better coverage for the risks of the parent company.

It bears saying, though it is probably obvious already, that these types of insurance programs are not the right fit for every company. Most companies would be much better served by going with more traditional risk management plans. For those who have sufficient capital and the right types of risks, however, captive insurance programs are a very good risk management solution. A better way to think of these companies (to put it in personal insurance terms) may be to consider them to be self-insured.

The concept may not seem familiar, but the reality is that many large corporations in the United States have operated these types of insurance companies for decades. Often, the subsidiaries that acted as the captives would be based offshore, especially in Bermuda or the Cayman Islands.

There is a slew of benefits which can be provided to companies which structure and manage their captives well:

· The management of risks which would otherwise be uninsurable

· Access to the reinsurance market (at a lower cost)

· Lower insurance premiums than those being paid by the operating company

· Favorable income tax rate distributions to captive owners

· The opportunity to create wealth via tax-favored vehicles

· Tax savings opportunities through gift and estate tax savings for shareholders

· Tax deduction for the parent company by way of the insurance premiums being paid to the captive

Since these types of companies have become more and more popular in the United States, a number of different types of captives have begun to spring up. These include pure captives, agency captives, association captives, and a number of others, all of which serve a unique role.

There are, of course, requirements that come along with these types of operations. For premium payments to be deductible as a business expense to the parent company, the captive entity has to be able to show that it is a valid insurance company. The proof, in this case, has to go beyond just obtaining an insurance license and into the proof of insurance provision itself. Insurance companies must be able to prove that they handle elements of risk distribution and risk shifting.

In order to meet the requirement of showing risk being shifted, the operating (parent) company has to be able to show that it has transferred risks to the insurance company in exchange for the premium that they pay for that service. In the case of captives, they need to be able to show the acceptance of risk from multiple entities in order to satisfy the requirement of risk shifting.

Tax aspects of captives are something that shouldn’t be overlooked either. Under Internal Revenue Code section 831(b) put in place by Congress in 1986, “if a property and casualty insurance company with gross premium income of $1.2 million or less makes an election, it avoids tax on premium income and only owes tax on investment income.” This provision alone makes captives a very attractive option for smaller companies, at least in terms of the tax benefit.

The way equity ownership of a captive is structured can also provide planning opportunities if shareholders are family members of the parent company as well. Any income to the capture would inevitably be a benefit to them. This transaction would come with no gift or estate tax since the money would be changing hands during part of regular business transactions between the parent company and the captive.

State taxation varies from state to state. It should be noted that the captive does not have to be domiciled in the same state as the operating company. The formation process of the entity determines where the proper domicile for the captive is.

There is still some risk involved with the formation of captives. The IRS, over the years, has shifted its approach when dealing with captives in the decades since they first began to appear. Instead of outright attacking the entire idea of a captive, they have begun to create “safe harbor” rules in order to keep those captives regulated while still maintaining their right to evaluate insurance requirements in individual cases. Captives, if following the rules in terms of risk shifting and risk distribution, should have nothing to worry about, but maintaining adherence to those rules is still essential.

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