If so, forming a captive insurance company may be a solution. Historically, captives have mainly been used by fortune 500 companies as a means to insure against potential losses arising from general liability claims, workers’ compensation, employee benefits, property and casualty losses, and other business risks. Over time, if claims are lower than the premiums earned by the captive for such coverage, the captive becomes another profit center. Today, more and more middle market private companies are discovering the benefits of forming their own private captive insurance company.
A captive is an insurance company formed by a business owner to insure or reinsure the risks of the operating/parent company. The captive writes insurance policies for the operating company at the business owner’s discretion. The business owner can determine policy terms and the types of risk to insure, which can vary from year to year. The only business that can file a claim is the parent company. If the operating company has years of good claims experience, the premiums that have been successfully deducted can later be taken as dividends or as liquidated capital at favorable tax rates.
Owning a captive has many operational benefits, such as the ability to tailor insurance coverage to fit your specific needs, more efficiently manage risk and liability exposure, and gain access to reinsurance markets. A captive also has the potential to provide many tax related benefits, such as pre-tax wealth accumulation, favorable distribution rules, asset protection, and estate planning opportunities. A captive can also be used as a tool to help retain key employees by giving those employees an ownership in the captive. Additionally, a captive can be a powerful tax planning tool because the insurance premiums are deductible to the parent and flow tax free to the captive under §831(b) of the Internal Revenue Code.
Captives will not work for every business. Most successful captives are formed by companies that are profitable (generally $1 million or more in taxable income) and have $250,000 of self-insured or uninsured business risk. In order for a captive to be cost effective, actuaries and underwriters generally must be able to quantify $500,000 or more in risk premiums from the parent company’s business operations.
Traditional insurance has become extremely expensive in some cases. As a result, many middle market companies have chosen to take on large deductibles and/or self-insure areas where they are currently exposed. The problem is that self-insurance without a captive is not tax deductible, nor are loss reserves set aside to finance future risk exposure. Businesses that have utilized a captive can finance risk using pretax dollars. Self-insured risk can be converted into tax-deductible premiums that are paid into a privately held insurance company. Risks can now be addressed with this pretax “nest egg,” provided the IRS rules are followed in designing the features of an insurance contract the captive may offer. If claims do not materialize, the captive can be a valuable wealth preservation tool for the business owner.