What is a captive?

There are many possible ways to describe a captive insurance company, in part because such companies can take a variety of forms. But in general, a captive can be thought of as a wholly-owned subsidiary whose stated purpose is to provide insurance to the company or entity that owns it.

From this description, one can deduce that a captive is really a form of self-insurance. A captive, however, is more formal than what many may think of when they think of “self-insurance.” It has a corporate structure, clearly defined roles for officers and third parties, rules of governance, and operations that are documented and reported. Typically the insured company has significant influence in the

Captive’s creation and operations, although the captive legally remains a separate entity, and may also have slightly different ownership than the insured company. With some types of traditional captives, and to an even greater extent with mini-captives, the parent company or entity may be able to realize certain tax and/or estate planning benefits. These benefits can potentially be significant. What the parent business must bear in mind is that whatever the mix of benefits that a mini-captive may yield, the mini-captive must be constituted, and must operate, as an insurance-providing entity. One role of the mini-captive’s manager, working in tandem with the mini-captive’s CPA and legal counsel, is to help ensure that the mini-captive meets all of the structural tests and ongoing operating requirements that are required for a mini-captive to be recognized as a confide insurance company.

Micro-Captive Definition

A.M. Best’s Captive Directory uses this definition when deciding which insurance companies should be included in the “captive” section of its insurance rating directory:

“A captive is an insurance company that is wholly owned and controlled by its insureds; its primary purpose is to insure the risks of its owners; the primary beneficiaries of its underwriting profits are its insureds.”

Captive Benefits

There are numerous potential advantages to forming a captive insurance company. Captive insurance companies are formed for both economic and risk management purposes.

With a captive insurance company, a business owner can address their self-insured risks by paying tax deductible premium payments to their captive insurance company. To the extent the captive generates profits, those dollars belong to the owner of the captive.

Policy features, coverage and limits can be drafted to meet specific enterprise exposures. This allows for many risk-management advantages, including:

• Greater Control over Claims
• Risk Management
• Underwriting Flexibility
• Capture Underwriting Profits
• Improved Claims Review and Processing
• Tax Benefits
• Investment Income

In general, your captive insurance company will be capable of delivering better service to your operating company.

Internal Revenue Code Section 831(b) provides that captive insurance companies are taxed only on their investment income, and do not pay income taxes on the premiums they collect, providing premiums to the captive do not exceed $2.2m per year. Legislation signed into law on December 18, 2015, has increased the premium limitation from $1.2m to $2.2m per year for taxable years beginning after December 31, 2016. This new limit will be indexed for inflation annually.

Further, the captive may retain surplus from underwriting profits within reserve accounts, free from income tax

Over the years, profits and surplus may accumulate to sizeable amounts and may be distributed to the owner(s) of the captive company, under favorable income tax rates as either dividends or long-term capital gains.

Amounts set aside as reserves for potential claims payments, plus capital surplus, should be maintained in safe, liquid asset classes so that the captive has adequate solvency to pay claims when called upon. The formation of your Captive Insurance Company and eventual issuance of a certificate of authority to do business, are subject to approval by the insurance regulators in the jurisdiction where the insurance captive is formed. The insurance regulators will also oversee the organization and ongoing operation of the captive insurance company to assure ongoing compliance with the rules for that jurisdiction.

The new 2015 tax legislation adds diversification requirements to the 831(b) eligibility rules. A company can meet these rules in one of two ways – allowing for continued enjoyment of captive benefits and section 831(b) eligibility. Ownership options for your captive remain flexible but requires the support of competent advisors and an efficient captive structure to assure compliance with the new eligibility rules.

Section 831(b) and What It Means for Captives

Under the scenario of a single-parent captive, the essential business relationship between the captive and the parent is relatively straightforward: the parent pays premiums to the captive, and the captive provides insurance to the parent. For tax purposes, the premiums that the parent pays may be deductible by the parent as a business expense, while the captive would treat the premium as taxable income.

Under Section 831(b) of the Internal Revenue Code, however, captives that meet certain requirements do not have to count premiums as taxable income. Instead, the captive is only taxed on its net investment earnings.

What must a captive do to qualify for this special treatment as a mini-captive?

The most salient standard is the $2.2 million ceiling in premiums written. Any captive that receives more than $2.2 million in premium income in a given year — even a single dollar more — will fail to qualify under Section 831(b). It is also worth noting that the limit applies to all companies within an affiliated group (for instance, companies with common ownership). For all of these reasons, any captive that seeks mini-captive status must be designed so as to meet the $2.2 million limit.

 Who May Want to Consider a Mini-Captive?

The factor that makes a mini-captive of little value to a Fortune 500 corporation — the $2.2 million premium limit — makes it ideal for many small- and mid-sized businesses. At the same time, a company can also be too small to benefit economically from establishing a mini-captive. Mini-captives often make sense for business owners whose companies have pre-tax earnings of at least $1 million a year

A mini-captive can be an especially good fit for private companies (in part because set-up and operation for these firms tend to be faster and easier), but public companies can benefit as well. Closely held private companies, especially family companies, may be in a position to utilize a mini-captive’s estate and gift tax benefits.

Whether the coverage a mini-captive writes is for a deductible/exclusion or for a specific type of risk, one important point to keep in mind is that typically, these are exposures that currently are being self-insured directly, with no attendant tax benefits. Shifting such coverage to the mini-captive allows the business to continue to self-insure, but now in a way that may include advantageous tax treatment.

Potential Insurance Benefits

As noted earlier, even though it may be the noninsurance benefits that ultimately yield the most value to a mini-captive’s owners, the mini-captive must first and foremost be a bona fide insurance company. This being the case, it is only logical to examine the possible insurance benefits that a properly designed mini-captive can provide.

Potential Income Tax Benefits

• Deductibility for self-insured reserves

A business typically can deduct as a business expense any payments it makes on commercial premiums as well as any actual losses incurred, whether for deductibles or for wholly uninsured losses. Both premiums and losses can be deducted at the time they are paid, but in practice, this means that while premium payments can essentially be deducted in advance of a loss, loss payments can only be deducted after the event has occurred and the costs have been determined. A company cannot take any deduction for cash that it sets aside as a reserve against potential future losses.

With a mini-captive, the business can change this situation to its advantage. Because a properly established captive is considered a separate insurance entity, even if ownership and control are identical or similar, the business can deduct the premium it pays to the mini-captive at the time it pays the premium. Meanwhile, the mini-captive, as discussed earlier, does not have to recognize the premium it has received as income; only its net investment earnings are taxable. Thus the common owners gain an immediate tax deduction for what used to be a non-deductible loss reserve.

The potential for lower effective tax rate:

A mini-captive can invest untaxed the entire premium it receives, and the premium can remain invested until a loss payment is due. As a rule of thumb, a captive may expect to invest premiums for six to eight years before paying any dividends. (The actual period of time depends on how long it takes for the captive to accumulate adequate reserves, and the value of claims paid out in the intervening years, among other factors.) Once a distribution is paid, there is still the potential for a further tax benefit: the distribution may be taxed as a long-term capital gain, which may be a lower rate than would otherwise apply.

“Even though insurance may not be the factor that initially prompted a firm to explore mini-captives, many firms end up being pleasantly surprised at the level of insurance benefits they can realize.”

Potential Estate and Gift Tax Benefits

• Intergenerational transfer of wealth:

Although the primary purpose of Section 831(b) is to stimulate competition among insurance firms and not to facilitate the tax-advantaged transfer of wealth, a mini-captive can be used to accomplish this. Under one common scenario, the owner of a private company or group of companies establishes a mini-captive that is owned by the entities or individuals to whom the business owner wishes to transfer wealth. The business owner may or may not also have partial ownership or control of the mini-captive (either directly or through irrevocable trusts, corporations, or other entities). To the extent that the business owner does have ownership or control of the mini-captive, a portion of the assets of the mini-captive will be treated as part of the business owner’s estate. So, for example, if the mini-captive is 90% controlled by the business owner’s family members and 10% controlled by the business owner, only 10% of the mini-captive’s assets would be counted as part of the owner’s estate. If the family controlled 100% of the mini-captive, then the entire mini-captive would be considered to be outside the owner’s estate, and therefore exempt from estate tax. In a similar fashion, such an ownership structure can play a role, in combination with other elements, in an overall program designed to manage exposure to Gift and Generation-Skipping Transfer Taxes. Types of Assets in which a Mini-Captive may Invest as an insurance company, a mini-captive needs to be prudent in its investments, and to avoid an undue level of risk. Accordingly, most types of aggressive or speculative assets, such as stocks, commodities, or futures, may not be appropriate. Most of the following types of investments are considered appropriate, either as individual securities or as mutual funds or other pooled investments:

– fixed income securities

– municipal securities (for tax-free income)

– Treasury Bills and other types of money market securities

KEY BENEFITS OF CAPTIVES

The following graph lists all key benefits of captive insurance companies compared to self-insurance and commercial insurance:

Features	Retail	Self	Captive
	Insurance	Insurance	Insurance
Asset Protection	Yes	No	Yes
Risk Protection	Yes	No	Yes
Warranty Design  Control	No	No	Yes
Claims Control	No	Yes	Yes
Improved Cash Flows	No	No	Yes
Tax Deductible Premiums	No	No	Yes
Income Tax Benefits	No	No	Yes
Underwriting Income	No	No	Yes
New Revenue Stream Options	No	No	Yes
Estate Planning Benefits	No	No	Yes

History of Captives

The term “captive” was coined in the 1950s by Fred Reiss, known as the father of captive insurance when in 1958 he formed American Risk Management. During this time, U.S. regulations made it prohibitively expensive to form and operate captives in the US. Bermuda in 1962 assisted Reiss in forming what is believed to be the first modern day captive.

By the end of the 1960s, there were approximately 100 captive insurance companies. Bermuda was the clear leading domicile and it and the Cayman Islands emerged as global financial centers accommodating these and other sophisticated hybrid legal vehicles.

By the end of the 80s, approximately 1000 captives were operating, nearly all formed and domiciled outside the USA.  As of 2011 over 30 US states authorize and regulate captive insurance companies. As of 2010, approximately 6,000 captives operated worldwide, responsible for more than $9 billion in annual premiums.

The captive industry is still, in many respects, in its infancy.

There are now nearly 100 domiciles that license and regulate captives today all around the world.  As of 2010, there were an estimated 6,000 captives globally.  831(b) Captive growth should continue as the nearly 100,000 mid-market sized companies become aware of the benefits of captive insurance programs.

Journal of Accountancy Article

www.journalofaccountancy.com

The benefits of captive insurance companies BY ROBERT E. BERTUCELLI, CPA MARCH 2013

For many years, large corporations in this country have enjoyed many benefits from operating their own captive insurance companies. Most were established to provide coverage where insurance was unavailable or unreasonably priced. These insurance subsidiaries or affiliates were often domiciled offshore, especially in Bermuda or the Cayman Islands. The risk management benefits of these captives were primary, but their tax advantages were also important. In recent years, smaller, closely held businesses have also learned that the captive insurance entities can provide them significant benefits. These include the attractive risk management elements long appreciated by the larger companies, as well as some attractive tax planning opportunities. A properly structured and managed captive insurance company could provide the following tax and nontax benefits: Tax deduction for the parent company for the insurance premium paid to the captive; Various other tax savings opportunities, including gift and estate tax savings for the shareholders and income tax savings for both the captive and the parent; Opportunity to accumulate wealth in a tax-favored vehicle; Distributions to captive owners at favorable income tax rates; Asset protection from the claims of business and personal creditors. Since captives became accepted in the United States, a number of types have evolved. These include “pure captives,” where the insurance company insures the risks of one group of related entities; “association captives,” where the captive insurance company covers the risks of the members of a particular association; and “agency captives,” where the captive is owned and operated by one or more insurance agents to insure the risks of their clients. Because the benefits of “pure captives” are much more significant, this article is limited to discussing that type of entity (see the sidebar “Case Study” for an example of situations in which it may be advantageous for a small business to set up a captive insurance company)

Ideal Candidates for Captives

The use of a captive should be considered for entities that meet the following criteria:

• Businesses with $500,000 or more in sustainable operating profits.
• Businesses with requisite risk currently uninsured or underinsured.
• Business owner(s) interested in personal wealth accumulation and/or family wealth transfer strategies.
• Businesses where the owner(s) are looking for asset protection.
• Profitable business entities seeking substantial annual adjustable tax deductions.

 

Conclusion

The planning, formation, and management of a captive are complex undertakings, and compliance with the formalities of running a true insurance company is mandatory. Establishing a captive insurance company is not feasible for all companies but, where appropriate, it can provide substantial tax and nontax benefits to successful shareholders and their families

Small, closely held companies can take advantage of a number of tax and business benefits if they set up their own captives. These captives can be set up in the jurisdiction that makes the most sense for the captive’s business.

Case law and the IRS require captive insurance companies to meet certain requirements. There must be actual risk shifting and risk distribution.

Small captive insurance companies that elect under Sec. 831(b) to be “mini-captives” are particularly tax favored. Their premium income is not subject to tax; only their investment income is.

Captive insurance companies can also be used for estate planning. A captive can be owned by family members of the parent corporation’s owners or a trust set

– Robert E. Bertucelli