Benefits and Risks of Captive Insurance Companies

A captive insurer is one that is typically wholly controlled and owned by its insureds. The primary purpose of captive insurance is to insure the risk of its owners, and the insureds reap the benefits of the captive insurer’s underwriting profits. Most large companies that operated captive insurance companies established the captive insurance company to provide insurance coverage where it wasn’t readily available or reasonably priced. However, over the past few years, some closely held and smaller businesses have also come up to speed about the significant benefits captive insurance businesses can provide.

The Benefits of Captive Insurance

A well-managed and structured captive insurance entity offers the possibility to receive the following nontax and tax benefits:

•            Covering risks that would otherwise not be insurable

•            Providing access to a lower-cost reinsurance market

•            Providing a tax-favored vehicle with the potential to accumulate wealth

•            Insurance premiums paid to the captive are tax deductible for the parent company

•            Distributions have favorable income tax rates for captive owners

•            Estate and gift tax savings available for the shareholders

•            Parent company and captive company income tax savings

•            Asset protection related to a personal creditor and business claims

•            Reducing the total insurance claims currently paid by the operating entity

•            Additional tax savings opportunities

Types of Captive Insurance Entities

There are three types of captives that have evolved in the United States. They are:

•            Pure captives

•            Association captives

•            Agency captives

With pure captives, the risks associated with a single group of related entities are insured by the insurance entity.

With association captives, the risks associated with the members of a specific association are covered by the insurance company.

With agency captives, the captive company is operated and owned by one or more insurance agents to insure their clients’ risks.

Pure captives carry the highest level of benefits compared to the other two, so the following content focuses on that type of captive insurance company.

Ideal Entities for the Use of Captives

As outlined in the Journal of Accountancy, certain criteria make companies an ideal candidate for the use of a captive, as outlined below:

•            Businesses where the owner(s) are seeking protection for assets.

•            Profitable organizations looking for opportunities for significant annual adjustable tax deductions.

•            Businesses that have multiple entities or are capable of creating various operating affiliates or subsidiaries.

•            Entities with sustainable operating profits of $500,000 or greater.

•            Entities with requisite risk currently underinsured or uninsured.

•            Business owner(s) interested in family-based wealth transfer strategies or personal wealth accumulation.

Requirements to Become and Be a Captive

A captive must show proof that it’s a valid insurance company for the premium payments to the captive to be tax deductible, which requires:

•            Obtaining an insurance license from a foreign jurisdiction or state

•            Providing insurance to the operating company or its affiliates

•            Over 50% of total revenue must be from the issuance of annuity or insurance policies

Note: Self-insurance payments typically aren’t tax deductible.

To qualify as “insurance,” the insurance must include risk distribution and shifting elements.

The risk-shifting requirement is met when the operating company proves it’s transferred certain risks to the insurance company in return for a premium that’s considered reasonable.

Regarding the risk-distribution component, in Kidde, 40 Fed. Cl. 42 (1997), the Court of Federal Claims described the risk-distribution concept 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 mathematical concept of the law of large numbers in that the ratio of actual to expected losses tends to approach one.

Based on this description, the captive needs to accept risks from various entities that are separate to meet the risk-distribution requirement. One avenue the IRS has taken is to issue private letter rulings on an entity’s risk sharing and risk distribution. The private letter also indicated whether the captives were truly insurance entities.

Possible Risks to Avoid with Captives

Captives first came on the scene in the 1950s, when the IRS’s approach towards them was rather aggressive, with captives coming under attack. In modern times, the IRS has modified its approach by implementing “safe harbor” rules to maintain regulations of captives while reserving the right to evaluate the captive arrangement based on each captive’s circumstances and facts.

As a result of the IRS’s approach, it’s essential for captives to correctly adhere to the principles of risk distribution and risk sharing. It’s also essential that the investment program is properly administered.

Appropriate levels of capitalization also need to be maintained.

On the flip side, the following risks need to be avoided to keep the captive in good standing with the IRS:

•            Excessive loan-back to the operating company

•            Attempts to offer life insurance arrangements

•            Excessive distributions to shareholders

Tax Considerations for Captive Insurance Companies

Congress implemented rules in 1986 that opened up planning opportunities for small insurance businesses.

If a casualty or property insurance company referred to as a mini-captive, meaning it has a gross premium income of $1.2 million or less, requests an election under section 831(b), it owes tax only on its investment income and avoids tax on its premium income. However, once made, the IRS must consent to the election being revoked. Also, the election is terminated automatically once an entity’s gross premium income goes beyond the prescribed limit. If the company’s premium income level goes to $1.2 million or below, the company can make another election.

In regards to business structure, an insurance company is taxed as a C corporation, and tax returns must be filed on a calendar-year basis. The exception to this is if it is included in a consolidated tax return. Insurance companies established as a partnership or an LLC must elect to be taxed under the check-the-box regulations of Sec. 7701 as a corporation, so C corporation tax rules apply. With the C corporation tax rules, captives can issue more than one classification of stock and pay out qualifying dividends. These dividends can receive preferential taxation. With that said, if liquidation were to occur, the corporation, along with its shareholders, might be subject to double taxation due to the entity being a C corporation.

Though the federal tax structure can fluctuate, the American Tax Relief Act of 2012, P.L. 112-240, increased the long-term capital gain and dividend income tax rate for high-income taxpayers from 15% to 20% beginning in 2013. Thus, the benefits of operating a captive insurance company were slightly reduced, though they still exist.

State taxation requirements of the captive insurance business are based on the state’s regulations in which the captive is domiciled. The domiciled location does not need to be the state in which the operating company is located.

Ownership Structure and Taxation

The captive’s equity ownership structure offers additional planning opportunities. According to the Journal of Accounting:

If the shareholders of the captive are family members of the owners of the parent company or trusts with family member beneficiaries, any income of the captive would inure to their benefit. Since this is a transaction in the ordinary course of business, no gift or estate tax would attach to the intrafamily transfer of wealth. Likewise, some shares of preferred stock of the captive might be distributed to key employees of the operating company and then redeemed upon retirement. The capital gains tax on the redeemed shares should be less than the tax on any other form of deferred compensation.

Using Multiple Captives to Maintain Tax Benefits

In cases where the shareholders desire to have a captive with the potential to accept more than $1.2 million in premiums without forfeiting their tax benefits of having a mini-captive, it’s possible for multiple captives to be created with different shareholders. Still, careful consideration should be taken to avoid Sec. 1563 attribution rules that could lead to captives being aggregated and exceeding the $1.2 million threshold limit. Having various captives could also benefit shareholders that have differing investment philosophies and retirement goals.

Operating a Captive as a True Insurance Company

It’s clear that the tax benefits associated with smaller, mini-captives are clear. With that said, it’s essential that businesses don’t forget that captives must operate like a true insurance entity. To support this requirement, the utilization of a reputable and experienced captive management company is essential to support the day-to-day operations of the captive company. Such a company can support the need for:

•            Annual financial statement audits

•            Annual actuarial reviews

•            Claims management

•            Tax compliance oversight

•            Support investment activities for planning to ensure liquidity needs are met

•            Additional legal and regulatory requirements

This list of requirements typically falls outside of the scope of experience or expertise of general business managers and owners, and even if they have the expertise, they might not have the time to conduct what’s required appropriately for captives.

It doesn’t make sense for all companies to create a captive insurance entity, though, for many, the benefits are numerous. Since it’s a complex endeavor, it’s best to consult captive experts to ensure compliance and that a true insurance company exists and is maintained.