Captive insurance is a form of self-insurance where a subsidiary company is formed to provide property and casualty insurance for the parent company. It functions as a risk management tool, an investment vehicle, and a planning structure that allows for significant tax and asset protections opportunities. The purpose of the captive insurance company (“CIC”) is to provide unique coverage when not available through a third-party insurer. An example of such coverage is enterprise risk, which is typically not a commercially insurable risk available from third-party insurers. Often a CIC is best used as a supplement to existing coverage. Another benefit of Captives is that they afford the opportunity to capture costs that are normally lost to third-party insurers. As with other forms of self-insurance, a CIC allows the entity to better manage enterprise risk and control insurance costs. Premiums that are paid to the Captive are tax deductible, as they are treated as an ordinary and necessary business expenses for tax accounting purposes.
There are many potential advantages and benefits to forming a CIC, including: the opportunity to dramatically lower insurance costs, opportunity to enjoy additional risk protection when such protection would not be available in the third party commercial insurance market, and importantly, a number of risk management advantages. The specific risk management advantages that a CIC affords are: greater control over claims, increased risk coverage, increased capacity, underwriting flexibility, incentives for loss control, reduced insurance costs, capture of underwriting profits, pricing stability, improved claims review and processing, and customized ability to purchase based on unique insurance needs particular to a company. Additionally, it should be noted that the CIC provides tax benefits and potential investment income.
As a practical matter, a CIC coordinates coverage with traditional third-party coverage to best distribute and protect against risks. Important to note as part of a company’s financial planning is the consideration that, pursuant to IRC section 831(b), Captives’ appreciated assets are taxed as investment income. Entities funding a CIC do not pay tax on the premiums provided that annual premium contributions are below $1.2 million annually. Additionally, Captives may retain surplus from underwriting profits within a reserve account that is income tax exempt. The extra measure of control afforded by a CIC is an important and often overlooked consideration, while the more obvious benefit of cost capture from eliminating overhead costs associated with typical third-party insurance is a more obvious advantage.
After adjustment for claims payments and expenses, the net underwriting profits are retained within the CIC. Capital accumulated over years can be distributed as dividends or long-term capital gains. As a practical consideration, funds within the Captive that are set aside as reserves to satisfy potential claims payments should be maintained as liquid assets.
The CIC also offers significant wealth accumulation opportunities, specifically affording the ability to efficiently enjoy tax-advantaged wealth transfer and asset protection. An example of how the CIC functions as wealth transfer vehicle is as follows. A high net worth individual, with the assistance of estate planning counsel, could fund an irrevocable trust that benefits the children and grandchildren. In this situation the irrevocable trust would own 100% of the Captive’s shares. This strategy would be an effective mechanism to benefit the trust beneficiaries via an increase in the Captive’s overall net worth from portfolio appreciation. When owned as an asset protection trust, capital and surplus of the CIC are protected from litigation and creditor’s claims.
Another consideration is the fact that Captives are highly regulated by the Insurance Regulators. As a result, Captives’ investment portfolios tend to be conservative and provide significant liquidity. Investment plans for Captives are typically structured in a manner which reduces exposure to taxation from investment income. A common investment strategy used by captives is to hold assets that generate annual dividend income, as the Dividend Received deduction under US federal income tax law allows for the exclusion of 70% of dividends from taxable income.
Even though 90% of Captives are domiciled outside the US, we at Ruyle and Ruyle prefer anyone of the thirty domestic state jurisdictions. We do not favor the foreign domiciled CIC which has lower capital contributions, a broader of range of investment options and less consistent regulatory oversight. Creation and maintenance of the Captive requires the services of numerous professionals and often the services of a Captive management company, which is essential for coordinating services, providing claims review, and managing the day-to-day activities of the Captive.
Before forming a CIC it is an essential first step to perform a feasibility analysis, which examines the cost capture opportunities and tax and investment advantages from such an entity. Long-term planning is an essential component of Captives. As a practical matter, a minimum of 7 years should elapse before taking distributions or dividends from the CIC. If the insured maintains a favorable loss profile by succeeding in managing claims and expenses, then the investment portfolio should appreciate at an agreeable rate.
The CIC can also serve as part of an estate plan, with shares created in the name of children or grandchildren or with shares being placed in an irrevocable trust. There are also asset protection opportunities available with a CIC, as placing ownership of the CIC within an asset protection trust affords protection from judgment creditors.
There are a number of important tax and legal considerations that should be weighed. IRC 831(b) affords a significant tax advantage for small Captives, as they are taxed only on their investment income and do not pay tax on premiums as long as they are below an annual threshold of $1.2 million. Tax regulations also allow Captives to retain surplus from underwriting profits free from federal income tax. Investment income is taxable to Captives at graduated corporate rates, while dividends paid out should be taxed at long-term capital gains rate.
To obtain eligibility for favorable tax treatment it is crucial that the CIC be structured and managed as an insurance company, providing risk distribution and coverage for market rate premiums. The CIC must be organized and operated for a bona fide business purpose and demonstrate risk shifting and risk distribution in order to meet the requirements to qualify as an insurance company. Fortunately there is a long history of case law to guide Captive implementation, enabling planners to design a compliant CIC. With the application of the safe harbor provisions and revenue rulings, business owners have a clear path for Captive design with predictable business results. Characterization of the Captive entity as an insurance company allows for dividends paid to be treated as tax deductible under IRC 162.