Over the past decade captive insurance companies have gained significant exposure both domestically and abroad, but lately it seems that everyone is talking about captives. It is likely that you have heard your colleagues or business associates discussing the pros and cons of forming a captive. If you have been considering whether a captive insurance company may be a viable alternative either to the traditional insurance market or to self-insuring, you are not alone. In making this decision, you do not need to be an expert in insurance. However, you do need to understand your own business risks and have a desire to gain some measure of control over them. There are plenty of service providers, ranging from captive managers and attorneys to actuaries and accounting professionals that can assist you in analyzing your business risks to determine if a captive is right for you. These same professionals will also be able to assist you in forming and running the captive.
Companies choose to form captives for a variety of reasons, but central to the discussion on whether or not to form a captive is creating a cost effective strategy to mitigate risk. It may be due to the rising cost of commercially available insurance during hard markets, or perhaps a company is looking for coverage for unusual or difficult-to-insure risks specific to their business or industry that are either unavailable or prohibitively expensive in the traditional insurance market. Others may be looking to control costs by gaining control over claims processing or obtaining access to the wholesale reinsurance market. All of these are compelling reasons to consider the formation of a captive.
Though captives have become a hot topic in recent years, captive insurance companies have been in existence for decades. Simply put, a captive is a wholly-owned insurance company (typically property and casualty) that is formed to insure the risks of its parent and related entities. It is essentially a form of self-insurance with one distinct difference. When a company self-insures its risks, it is not permitted to deduct insurance losses until they are paid; there is no tax deduction permitted for loss reserves when self-insuring. In contrast, premiums paid by a company to a properly formed captive are tax-deductible. In addition, under Section 831(b) of the Internal Revenue Code, there is an alternative tax for certain small non-life insurance companies where these insurance companies may elect to be taxed only on their taxable investment income. A small insurance company is defined in Section 831(b) as “all non-life insurance companies where net premiums (or, if greater, direct written premiums) do not exceed $1,200,000 for a taxable year.”
There may also be other tax advantages in forming a captive, though these should not be the primary motivation in the decision to form a captive. Nevertheless, these benefits can be significant, and if the captive has been formed based on a legitimate business need, is structured properly, and is operating as a true insurance company (which means that the captive has achieved both risk shifting and risk distribution), then companies may also be able to take advantage of these incidental tax savings in addition to the benefits that the will receive by gaining control over their risk management needs.
For more information on Captive Insurance Companies, please contact Anton Hayward or call 770.396.2200.