For many years, large corporations in this country have enjoyed many benefits from operating their own captive insurance companies. Most were established to provide coverage where insurance was unavailable or unreasonably priced. These insurance subsidiaries or affiliates were often domiciled offshore, especially in Bermuda or the Cayman Islands. 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. These include the attractive risk management elements long appreciated by the larger companies, as well as some attractive tax planning opportunities. A properly structured and managed captive insurance company could provide the following tax and nontax benefits:
- Tax deduction for the parent company for the insurance premium paid to the captive;
- Greater transparency in annual premium development that reflect
insured’sexperience and not an array of external, market-driven factors out of the insured’s control;
- Opportunity to accumulate business wealth in a tax-favored vehicle;
- Asset protection from the claims of business;
- Reduction in the
amountof insurance premiums presently paid by the operating company;
- Use profits generated by good loss experience to offset new premium requirements in future policy years, allowing a multi-year strategy that can simplify budgeting
Since captives became accepted in the United States, a number of types have evolved. These include “pure captives,” where the insurance company insures the risks of one group of related entities; “association captives,” where the captive insurance company covers the risks of the members of a particular association; and “agency captives,” where the captive is owned and operated by one or more insurance agents to insure the risks of their clients.
For the premium payment to the captive to be deductible as an insurance expense, the captive must be able to prove that it is a valid insurance company (payments for self-insurance generally are not deductible. Besides obtaining an insurance license from a state or a foreign jurisdiction, the captive must provide insurance to the operating company or its affiliates. Insurance was defined for tax purposes is defined that it must include elements of risk shifting and risk distribution.
To meet the risk-shifting requirement, the operating company must show that it has transferred specific risks to the insurance company in exchange for a reasonable premium. Risk-distribution is generally defined as follows:
Risk distribution occurs when particular risks are combined in a pool with other, independently insured risks. By increasing the total number of independent, randomly occurring risks that a corporation faces (i.e., by placing risks in a larger pool), the corporation benefits from the law of large numbers in that the ratio of actual to expected losses tends to even out.
Thus, the captive must be accepting risks from multiple separate entities to satisfy this requirement.
FORMATION OF A CAPTIVE
Using a Captive Manager is one of the quickest ways and less time consuming ways for a captive to be formed. Often times Captive Managers have a process in place already and may already have a shared pool that a company can enter and shortens the headaches for companies coming into the Captive market for the first time.
The need for a qualified insurance manager on the planning team is very important, particularly in the formative stages. The formation of a captive insurance company can be a lengthy process including feasibility studies, financial projections, determining domicile, and, finally, preparing and submitting the application for an insurance license. If you are working through one these captive managers, the times it takes to form them is typically much shorter and less tedious.
The requirement for adequate initial capitalization of the captive is dependent in part on the level of risk projected to be assumed by the captive and the requirements of the particular domicile.
One critical function to be performed during the formative stages is the identification of the risks to be insured by the captive. The operating company is presently paying premiums to one or more commercial insurance companies to protect it from specific risks, some of which could be catastrophic if they were to occur without such insurance. The goal of smaller captives would be to maintain the transfer of the catastrophic risks to the commercial carriers, but to assume the underwriting associated with more “manageable” risks.
The policies that are written need to be for “real” insurance risks but with low probability of occurrence. Should the captive see a need to protect itself in the case of a higher-risk policy, it may be able to buy reinsurance at premiums that are less than the premiums that it has charged the parent company. On an annual basis, the premiums paid to the captive in excess of its claims and operating expenses can be transferred to a surplus account and be available for investment activities.
One of the risk management benefits that the captive may provide is the flexibility to opt for higher deductible levels on the existing property and casualty insurance policies. In keeping with the above desire to minimize, but not eliminate, claims experience, the selection of the risks that the captive is willing to assume should be prudent.
OPERATION OF THE CAPTIVE
The attractive tax benefits associated with the smaller captives can sometimes cause business owners to forget that the captive must operate as a true insurance company. The use of an experienced and capable captive management company is an essential element of the normal operations of such an entity.
The need for annual actuarial reviews, annual financial statement audits, continuing tax compliance oversight, claims management, and other regulatory compliance needs puts the day-to-day management of a captive insurance company beyond the skills of most general business people. Likewise, the involvement of a captive management company in the investment activities of the captive is essential from a planning perspective to assure that the captive’s liquidity needs are met.
In 1986, Congress inserted a provision into Sec. 831 that opened up a significant planning opportunity for small insurance companies. Under Sec. 831(b), if a property and casualty insurance company with gross premium income below a certain threshold amount, it has the potential to avoid tax on its premium income and owes tax only on its investment income. Once that premium income threshold is met, the captive may not be eligible for the tax benefit.
Speak with a Captive Manager about what the threshold may be for your company as care should be taken to ensure that a captive does not exceed that gross premium income threshold.
The state taxation of the captive depends on the state in which the captive is domiciled, which need not be the state in which the operating company is located. At inception, part of the entity formation process is determining the captive’s proper domicile. Selecting a domicile depends on a number of factors, including taxation.
Always consult with a certified accountant that is familiar with captives before making a final decision.
SERIES LLC OR CELL COMPANIES
Recent legislation in a number of states has created a new form of entity that is viewed as an attractive structure for captive insurance operations. The use of “series LLCs” or “cell companies” allows for the formation of a “master LLC” or “master cell,” which would procure the insurance license for the entire operation.
A number of “series” or “cells” would then be created that would function as autonomous units within the entity’s contractual structure. Each cell would have one or more owners, and each cell’s assets and liabilities would be insulated from the assets and liabilities of the other cells or master LLC. Proposed regulations would treat each cell as a separate entity for federal tax purposes if it is established under a state statute that would recognize the cell as a separate legal entity in that jurisdiction.
The attractiveness of this arrangement for captive insurance purposes is the ability to operate a captive insurance entity at lower costs and using much smaller levels of risk and premiums, making it available to a broader spectrum of companies.
The planning, formation and management of a captive can be complex undertakings, and compliance with the formalities of running a true insurance company is mandatory. The use of a Captive Manager that is more familiar with the matters at hand is crucial to establishing a captive insurance company is feasible. Where captives are appropriate, it can provide substantial tax and nontax benefits to successful shareholders with the right kinds of insurance risks.
Interested in finding out more about captives and how they can potentially help your business?
Write to Blake at firstname.lastname@example.org
This article was written by Phoenix Captive Solutions C.F.O. Blake Coats, any views or opinions do not necessarily reflect the opinions of either Phoenix Captive Solutions LLC, or any associated entities.