Captive Insurance: A Closer Look

As stated in a previous article, a captive insurance company is first and foremost in the insurance business and should not be viewed as purely a tax planning vehicle. However, tax saving opportunities can exist with captive insurance companies and these benefits should be enjoyed when the arrangement is properly structured. The following is one example of how this might work.

A single-parent captive insurance company is formed to provide insurance coverage to Corporation A, an operating entity that is wholly-owned owned by Mr. Smith. Instead of having the stock in the captive be owned by Corporation A or by Mr. Smith personally, Mr. Smith makes gifts to his children (or to trusts established for the benefit of his children), and the gifted funds are used to provide the capital for the captive in exchange for the stock ownership of the captive.

Over the years, Corporation A makes insurance premium payments to the captive which are deductible against ordinary business income of the Company. The captive receives the insurance premium income, establishes appropriate loss reserves and pays claims on losses incurred by its insured parties. The captive operates successfully as an insurance company and builds equity value because the insurance premiums received over time exceed the claims paid out and the operating expenses of the captive.

After some period of time, say 10 years, a decision is made that the captive is no longer needed. The captive determines that if it still has any potential loss exposure for the insurance coverage it has provided, it can purchase 'tail' coverage in the reinsurance market to remove its responsibility. The goal is to have the captive with no further liabilities on its books and for the assets it accumulated over time for insurance reserves that were not needed to become equity available to be distributed to the captive's shareholders in liquidation of the captive. Depending on a number of factors, including premium volume, claims paid and number of years in existence, the captive could easily have accumulated a value in the millions of dollars.

The potential tax benefits from this arrangement are that Corporation A got ordinary tax deductions for its premiums paid for insurance coverage, and the value remaining at the liquidation of the captive is taxable to its shareholders upon receipt, but at long-term capital gains rates. In other words, ordinary deductions have been converted to long-term capital gains and there was also a deferral of tax for the years that the captive was in operation. Additionally, there is an estate planning benefit because Mr. Smith was able to move value out of Corporation A that he solely owns and have the value end up in the hands of his children, usually at a much higher value than the amount of the original gifts to fund the capitalization of the captive.

Of course, this type of transaction should only be undertaken with advice from competent advisors. Remember that the tax benefits are the icing on the cake, but should not be the primary reason for entering into a captive insurance company arrangement.

For more information on Captive Insurance Companies, please contact Tom Jollay or call 770.396.2200.