Closer Look at Captive Insurance
Greg Taylor and Scott Sobel
JUNE 2008 - Captive
structures have long been marketed by insurance brokers as a way
to control and stabilize the cost of insurance, but these brokers
often fail to maximize the benefits of a captive. Captive insurance
companies are often overlooked and misunderstood because their costs
and benefits are not simple to explain. By understanding the nuances
of captive transactions, insurance, economics, and taxation, CPAs
can improve the financial advice they offer.
its simplest form, a captive is a privately held insurance company
that insures a business. It issues policies, collects premiums,
and pays claims, just like a commercial insurer, but does not
offer insurance to the public. Historically, captive insurance
companies were only for large corporations: 80% of the S&P
500 use captive insurance programs. With
the enactment of favorable tax regulations and other legislation,
however, captives are no longer just for large corporations. Middle-market
and family businesses can take advantage of the same benefits.
of enterprise risk management has brought captives to the forefront
of risk management practices. As a business owner, the first step
is to take a look at the overall risk the business faces and examine
risks that are typically insured by commercial property and casualty
insurance. One should also consider risks that are already self-insured.
A good place to start is by reading property and casualty insurance
policies. In fact, most policies exclude the most severe types
of risk—those that are potentially catastrophic. Once a
business owner has taken inventory of the various risks, he must
assess each risk and determine a strategy to address it. When
facing a risk, the business can transfer the risk to a commercial
insurance company; it can avoid the risk by cancelling the operations
giving rise to the risk; or, it can look to alternative risk transfer
methods, such as a captive insurance company.
insurance companies can be a great financial tool, they are not
right for every business. In order to create and operate a successful
captive insurance program, the operating company must generally
have two or more of the following characteristics:
operations, with taxable income ranging from $1.5 to $100
or more self-insured or uninsured business risk;
- 100 or
more employees; and
or more in commercial insurance expenses.
a Captive Works
agents have historically marketed captive insurance to businesses
as a way of replacing conventional insurance. But captives can
offer even more. Instead of looking at the usual business risks,
savvy financial experts consider risks not covered by conventional
insurance policies. This raises the question of why a business
would want to insure additional risks that it wouldn’t otherwise
have to. Consider,
however, that those additional risks were always there; they were
simply risks that were self-insured. In reality, most businesses
knowingly—or unknowingly—self-insure an alarming amount
of risk, including the following kinds of items:
exclusions, such as mold and pollution
deductibles and self-insured retentions
risks, such as product recalls
of key customers and suppliers
of insurance unavailable in commercial markets
of this “self-insurance” outside of a valid and qualifying
captive structure is not tax-deductible. A properly formed and
operated captive may, however, deduct insurance premiums that
are paid into a privately owned insurance company. Claims are
paid with pre-tax dollars. If no claims are made, the captive
retains the premiums for future business risks or distribution.
(FIN) 48, Accounting for Uncertain Tax Positions, has
made it imperative for CPAs to determine if a transaction requires
disclosure in a company’s financial statements. Guidance
provided by qualified experts is the best way to avoid unwanted
disclosures that could serve as red flags for IRS auditors. In
the absence of private letter rulings or legal opinions from tax
professionals, captive owners must carefully analyze a proposed
program and view the deductibility of premiums to be paid objectively.
Ill-advised captive transactions can expose owners to significant
tax liabilities, penalties, and interest.
is costly. A business considering a captive can expect to invest
time, resources, and money when evaluating the feasibility of
such a program. The formation and start-up costs of a captive
insurance program mean that a business must be large enough to
have the required risk for the business plan to work, as quantified
of favorable captive tax provisions is IRC section 831(b). This
provision, designed to encourage the formation of new insurance
companies, provides for their alternative taxation (excluding
life insurance companies) if a company’s direct written
(or net written, if greater) premiums do not exceed $1.2 million.
A qualifying captive making a valid IRC section 831(b) election
can deduct premiums paid to its captive insurance company and
pay income tax only on the captive’s investment income.
the IRS, looking at parent-captive structures, consistently held
that if the insured risk were not transferred out of the “economic
family,” no risk shifting took place. Without risk shifting,
the insurance premiums were not deductible by the parent company.
This economic family position would disqualify an otherwise well-managed
captive insurance program. After consistently losing this position
in the courts, however, the IRS issued pronouncements that restated
the service’s position regarding captives and provided a
favorable basis for captive formation, operation, and management.
2002-89 provided one safe harbor in a captive insurance environment.
The IRS reiterated that if a parent’s premiums paid to the
captive insurer are 90% of the total premiums earned by the captive,
and the parent’s risks are 90% of the captive’s risks,
then there is insufficient risk shifting. This would mean that
none of the premiums paid by the company to the captive are deductible.
The IRS went further and stated that if the risks of the parent
were less than 50% of the captive’s total premiums and risks,
there would be sufficient risk shifting, and premiums would be
2002-90 created an additional safe harbor. The ruling involved
a domestic holding company with 12 operating subsidiaries, each
with a significant volume of independent, homogeneous risks. The
IRS stated that when each subsidiary has liability coverage for
less than 5% and no more than 15% of the total homogeneous risk
insured by the captive, the premiums would be deductible.
rulings, along with others, provide welcome guidance on risk-shifting
issues for captive insurers. The rulings constitute a trend, an
indication that the IRS recognizes that captive programs can be
properly structured for valid business reasons, and premium payments
to them can be deductible. The “safe harbors,” including
those described above, have eliminated many of the gray areas.
ago, a national battery manufacturer recalled more than 10,000
of its boat, golf cart, and recreational vehicle batteries because
they were found to be potentially dangerous. Product recall is
rarely covered under a general liability insurance policy; in
fact, it is often explicitly excluded, as had happened in this
case. The manufacturer paid for the recall out of its retained
time, the battery manufacturer has structured a captive to insure
product recall, product liability, and other related risks. In
order to comply with Revenue Ruling 2002-89, the manufacturer’s
captive is required to have greater than 50% of its risk from
independent third parties. The captive does this by participating
in a risk pool for a proportion of the risk it accepts from the
operating company. A risk pool helps its captive clients achieve
requisite compliance and risk distribution.
Ideas to Consider
to giving a business better control over its insurance costs,
a captive program can provide the following benefits:
- The deduction
of insurance premiums that flow tax-free to the captive, where
they accumulate on a pre-tax basis in anticipation of future
- The ability
to distribute underwriting profits to shareholders as dividends
or upon liquidation;
by a family trust, LLP, FLP, or other entity for the benefit
of future generations; and
- The ability
to give key employees restricted ownership in the captive, in
order to provide an increased incentive to manage risk effectively
and reward loyalty.
captive insurance companies can be a powerful year-end planning
tool because insurance premiums are deductible and insurance companies
receive favorable tax treatment.
Revenue Code, related IRS rulings, and case law all support the
use of captive insurance companies to manage risk. When properly
employed, the use of a captive insurance strategy can help businesses
better manage insurance costs, control claims, accumulate surplus
in anticipation of unforeseen risk, and allow for the accumulation
of wealth on a tax-deductible basis.
and their advisors must be thorough when exploring a captive program.
Programs vary greatly, are complex to understand, and can result
in significant tax and economic detriment. Any company considering
a captive should carefully analyze the risks and rewards with
Taylor is the chief technical officer, and Scott
Sobel is the managing director, both at Alta Holdings,
LLC, a risk management services firm, Costa Mesa, Calif.