As commercial insurance companies struggle to create the risk management services many businesses desire, captive insurance companies emerge as a strong and alluring alternative. If the captive complies with current law and exemplifies the characteristics of a bona fide insurance company, it stands to play a large role in supporting participating businesses across a variety of industries.
It may be time to figure out whether or not a captive insurance company is the right strategy for you and your business.
What’s in this article?
- What is a captive insurance company?
- What are some of the benefits of captive insurance?
- What are some of the tax-specific benefits of a captive insurance company?
- What types of captives are there?
- How does the IRS view captive insurance companies?
- Who should consider captive insurance?
- How can Squar Milner help?
What is a captive insurance company?
A captive insurance company (“captive”) is a subsidiary established by one or more commonly-owned businesses to insure the risks of the controlling entity and/or its affiliates or its individual owners.
More formally, it is a subsidiary formed by a company to finance its retained losses in a formal structure under the guidance of an appropriate state insurance department. Businesses use captives in hard and soft markets in order to obtain a wide range of property and/or casualty coverages.
Captive insurance companies are not a new phenomenon. After making their debut in the United States in the 1950s, the use of captives accelerated in the 1980s, when product liability, medical malpractice, and other liability coverages became difficult or impossible to obtain.
Today, nearly all Fortune 500 companies and thousands of mid-sized companies maintain captive insurance companies. There are thousands of captives established in various domiciles throughout the world for the benefit of all types of industries. However, according to the National Association of Insurance Commissioners (NAIC), the industries with the most captives are construction, real estate, manufacturing and finance.
What are some of the benefits of captive insurance?
Captive insurance entities offer a cost-efficient and tax-effective method of self-insurance. Despite the challenges associated with implementation and proper legal structure, the financial rewards are undeniably attractive.
One of the principle objectives of a captive insurance company is to provide improved risk management for an organization. Currently, commercial insurance companies lack both the ability to react to the rapidly-changing modern marketplace and the capacity to insure the wide array of risks most businesses face.
This is where a captive, an entity designed to give you control over your risk management, becomes an alluring option.
Captive insurance companies open up the possibility of organized risk management of a number of enterprise risks such as loss of key employees, suppliers or customers, failure to perform, or even reputational risk.
Some of the most notable benefits of a captive include:
- Increased financial efficiency of risk management
- Greater flexibility in responding to changes in risk retention and risk transfer strategies
- Minimized impact of marketplace pricing and volatility
- Coverage for risks traditionally not readily available or economically feasible in the commercial marketplace
- Access to reinsurance markets
- Control over claims analysis
- Centralized accountability for risk management of disparate operations, business units or insurance programs
- Access to government programs (e.g. terrorism insurance)
- Reduced insurance administration costs and recaptured underwriting profits
- Customization of insurance coverage to fit specific needs
What are the benefits for small and mid-sized businesses?
Following the enactment of Internal Revenue Code (IRC) Section 831(b) in 1986, captive insurance companies became especially alluring for small and mid-sized companies. Under Sec. 831(b) Congress allowed insurance premiums paid by a business to be 100% deductible to the sponsoring business while avoiding designation as income to the captive upon receipt of the premiums. This permitted captives of $1.2 million or less in annual premiums to exempt the premium received from their underwriting income when calculating income for taxation. (Note that the premium cap has since grown to $2.35 million in 2020 and will be further adjusted for inflation under the Protecting Americans from Tax Hikes (PATH) Act in 2015.) The captives privy to this Sec. 831(b) election are known as “micro-captives.”
While commercial insurance is an important component of business development, it often represents a cost that limits the growth of smaller businesses. The enactment of IRC Sec. 831(b) allowed mid-sized businesses to grow their balance sheets more quickly to support the risk of their owners and resulted in a rapid growth of captive insurance companies among mid-sized businesses.
What are some of the tax-specific benefits of a captive insurance company?
As noted above, captives have become increasingly popular in recent years, particularly among those in the Construction industry. Some of the tax-specific reasons include:
- The ability to distribute accumulated assets in a captive to the owners of the captive at favorable tax rates as either qualifying dividends or long term capital gain rates, upon liquidation.
- Premiums paid to the captives are not taxable income, but still provide a tax deduction to the parent company.
- Electing to domicile a captive in a favorable tax haven may result in little to no taxes on its income. In addition, a number of the states have made the formation of a captive here in the United States very favorable.
What types of captives are there?
The most common captives are single-parent, or “pure,” captives. In these cases, a single parent company owns the captive. It operates as a subsidiary to provide insurance and cover the loss exposures of the parent company. While the parent company does not transfer insurance risk out of the company (other than through reinsurance arrangements designed to protect the captive), a pure captive allows a company to monitor its operational risks, review its loss exposures and provide efficient claims management.
Group & Association Captives
Other types of captives include group captives and association captives. In these instances, a group/collection of companies with similar businesses and loss exposures, or a trade or professional association establish a group or association captive, respectively. It is a desirable option particularly when a single company does not have a large enough volume of premium to make a single-parent captive economically viable.
Often companies elect to use a group captive in order to:
- Reduce start-up costs;
- Pool their risks and claims experience; and
- Save time and money on underwriting talent.
Generally, captives with the ability to make a Sec. 831(b) election receive designation as a “micro-captive.” By design, micro-captive insurance companies play a useful role for relatively small businesses that need to insure risks they cannot purchase coverage for elsewhere. These companies have an annual written premium limit of $2.35 million or less, with the yearly cap determined by the IRS. Per the Sec. 831(b) election, micro-captive companies only pay tax on the income generated from investments. This results in premiums received, less claims paid and expenses incurred, and an overall underwriting profit taxed at 0%.
Following a number of tax court cases, the judicial system established four main criteria to determine whether or not a micro-captive insurance company is a bona fide insurance company. The criteria include:
- The arrangement involves insurance risk;
- The arrangement shifts risk of loss to the insurer;
- The insurer distributes risk among policy holders; and
- The arrangement meets commonly accepted notions of insurance.
Examples of insurance risk includes workers’ compensation, property and casualty loss, general liability, and other acceptable commercial risk relevant to the industry of the insured. Risk distribution occurs when an insurer pools a large enough collection of unrelated risks (i.e., risks that are generally unaffected by the same event or circumstances).
A rent-a-captive is an arrangement by which a third party accesses an existing captive’s capital. Typically, this third party business seeks to form a captive but without the cost or time involved in incorporating a separate entity. Often renting a captive is the first step towards the formation of a single parent, group or association captive. The benefits of a rent-a-captive include lower insurance costs, stable premiums, and better control over a company’s insurance program.
How does the IRS view captive insurance companies?
In the latter half of 2019, the IRS put the spotlight on captive insurance companies when they announced their settlement with certain owners of micro-captives. Unfortunately, this scrutiny is nothing new. The IRS scrutinizes captives very closely and is not afraid to challenge them. This does not pertain to all captive insurance companies, but mostly small captive insurance arrangements utilized as tax shelters. In fact, these arrangements are consistently listed on its “Dirty Dozen” list of tax-abusive transactions. The IRS continues to argue the legitimacy of the premiums paid in captive arrangements and often seeks to disallow the original tax deduction. More specifically, they suggest that certain taxpayers wrongfully claim tax benefits without properly establishing a bona fide captive insurance arrangement.
In Notice 2016-66, the IRS laid out the various factors that indicate potential tax-avoidance or tax-evasion purposes behind a micro-captive insurance arrangement. If the IRS determines the taxpayer is in the wrong, they will disallow the Sec. 162 ordinary and necessary business expense for the payment of the premium to the captive insurance company. Negligence penalties could also apply.
Later, on September 15, 2019, the IRS issued News Release IR-2019-157 entitled “IRS offers settlement for micro-captive insurance schemes; letters being mailed to groups under audit.” Again, we see the IRS continuing their relentless pursuit against captive insurance companies. However, this pertains only to a very small subset of captives that were marketed and sold as tax shelter.
It is very important to note that large corporate captives, bona fide group captives, and numerous other types of captives are not under any special scrutiny.
Who should consider captive insurance?
Captives may be especially beneficial to companies with the following characteristics:
- Financial stability
- Good risk management practices
- Substantial operations in high tax jurisdictions
- Multiple global operating entities with insurable risk dispersed throughout
- Sophisticated financial planning
- Existing balance sheet reserves for self-insured business risk exposures or large deductibles (i.e., worker’s compensation, general liability, professional liability, etc.)
Furthermore, the tax status of the captive insurance company for U.S. federal income tax purposes is important to consider. If the captive qualifies as an insurance company for U.S. federal income tax purposes, then premiums paid to the captive are tax deductible by the insured entity, and the captive is permitted favorable tax treatment under Subchapter L of the IRC.
How can Squar Milner help?
At the end of the day, given proper structure and careful attention to the details and rules associated with captives, they can yield significant tax savings to a number of businesses, as well as potential wealth accumulation to their owners. Squar Milner boasts a dynamic and detail-oriented tax department with the expertise to help you and your business capitalize on those tax savings while staying within the guidance of the IRS.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.