Is a Captive Insurance Company Right for Your Business?October 02, 2017
Greg Cabral, CPA, MST
Rhode Island Managing Partner
A Captive Insurance Company (captive) is a property and casualty insurance company established to provide coverage primarily for a parent company. It can be a valuable risk management tool that allows businesses to more effectively manage corporate risks of all kinds. In many cases, the owner of the parent company is also the owner of the captive; however, the arrangement may be alternatively structured so the captive is owned directly by the operating company, another person, entity or trust. The captive must act as a legitimate business entity and must remain in compliance with all insurance regulatory provisions and Internal Revenue Service requirements.
A captive may be established to provide unique coverage or coverage not available through commercial property and casualty insurance companies. Coverage underwritten through and insured by a captive is often best utilized as a supplement to existing coverage, providing a more effective total risk management program for the business owner. The captive insurance arrangement may also be implemented in order to allow the captive owner to capture overhead, profit and other capital that would normally transfer to another insurance carrier.
A captive allows the business owner to reserve against property and casualty risks, as well as other enterprise risks. These are often the types of risk that keep business owners up at night and could result in business interruption, loss of revenue or even drive them out of business. These are risks that the business owner faces every day, but for which insurance coverage may not be available or may prove too costly to obtain. Examples of these risks include: loss of a business license or professional license, adverse financial impact of regulatory or legislative changes, loss of a key vendor or major client, loss of franchise license or lease, environmental losses, regulatory inspection failure, etc.
Small to mid-size privately held businesses can benefit from this risk management tool that can help them more effectively manage such enterprise risks and control their insurance costs. If properly structured and underwritten, premiums paid by the parent operating company to its captive for property and casualty coverage should be tax-deductible to the parent company as an ordinary and necessary business expense.
There are no firm rules regarding the minimum amount of gross revenue a company should have in order to benefit from implementation of a captive, nor is there a minimum amount of annual insurance premiums a company should be prepared to pay before it considers forming a captive.
Risk Management Advantages of Captives
In most cases, to the extent existing P&C coverage is reasonably priced, business owners will continue to maintain existing policies for their traditional coverage and supplement existing coverage by addressing their self-insured risks with their own captive. Policy features, coverage and limits can be drafted to meet specific enterprise exposures. This allows for many risk-management advantages, including:
- Greater control over claims
- Increased coverage
- Increased capacity
- Underwriting flexibility
- Access reinsurance market
- Incentive for loss control
- Reduced insurance costs
- Capture underwriting profit
- Pricing stability
- Improved claims review and processing
- Purchase based on need
- Tax benefits
- Investment income
- Additional profit center
Tax Advantages of Captives
Internal Revenue Code 831(b) provides significant tax advantages for small captive insurance companies. Captives may be taxed only on their investment income, and do not pay taxes on the premiums they collect, providing premiums to the captive do not exceed $1.2m annually. The PATH Act of 2015 increases the maximum premium amount to $2.2m and indexes this amount for inflation. These provisions are effective for taxable years beginning after December 31, 2016. Further, the captive may retain surplus from underwriting profits free of income tax. Investment income is taxable to the captive at graduated corporate rates, while dividends paid out of a captive, if any, should be taxed at long-term capital gains rates as a qualifying dividend.
In order to be eligible for the favorable taxation noted above, it is crucial that the captive conforms to Internal Revenue Code Section 7701(o) regarding economic substance, and be structured and managed as an insurance company, providing true risk, for appropriate premium levels. The IRS has frequently stated that an insurance contract must fall within the “commonly accepted sense of insurance” based upon a number of factual determinations. A captive must be organized and operated for bona fide business purposes and demonstrate both risk shifting and risk distribution in order for the arrangement to meet the requirements to qualify as insurance in the commonly accepted sense.
Amounts set aside as reserves for potential claims payments, plus capital surplus, should be maintained in safe, liquid asset classes so that the captive has adequate solvency to pay claims when called upon. The formation of your captive and eventual issuance of a certificate of authority to do business are subject to approval by the insurance regulators in the jurisdiction where the insurance captive is formed. The insurance regulators will also oversee the organization and ongoing operation of the captive to assure ongoing compliance with the rules for that jurisdiction. Additionally, the IRS has identified these structures along with similar ones as “transactions of interest” and require the filing of Form 8886, Reportable Transaction Disclosure Statement with the applicable tax returns.
A properly designed captive arrangement can provide many advantages for the insured enterprise and the owner(s) of the captive.
How BlumShapiro Can Help
BlumShapiro is the largest regional business advisory firm based in New England, with offices in Connecticut, Massachusetts and Rhode Island. The firm, with over 400 professionals and staff, offers a diversity of services which includes auditing, accounting, tax and business advisory services. In addition, BlumShapiro provides a variety of specialized consulting services such as succession and estate planning, business technology services, employee benefit plan audits and litigation support and valuation. The firm serves a wide range of privately held companies, government and non-profit organizations and provides non-audit services for publicly traded companies.
Disclaimer: Any written tax content, comments, or advice contained in this article is limited to the matters specifically set forth herein. Such content, comments, or advice may be based on tax statues, regulations, and administrative and judicial interpretations thereof and we have no obligation to update any content, comments or advice for retroactive or prospective changes to such authorities. This communication is not intended to address the potential application of penalties and interest, for which the taxpayer is responsible, that may be imposed for non-compliance with tax law.