Captive insurance companies were created to enable corporations to establish subsidiaries that can insure the company’s own risks. The captive insurance industry has developed over the years and now includes a variety of forms and group structures.
Over the years, alternative forms of captive insurance have developed, including group structures that accommodate the needs of smaller companies. Here are the main types of captive insurance:
The pure (“single parent”) captive was the first and remains the most common type of captive today. A “pure” captive is where a corporation sets up a wholly owned subsidiary as a captive insurance company. The captive is established in a U.S. state or foreign jurisdiction that allows it to operate as a licensed insurer. The parent company informs the subsidiary captive insurance company of the various risks that it needs to underwrite for the parent and its other subsidiary companies. The captive then conducts risk evaluations, prepares the policies and sets premiums. Tax-deductible premium payments are made to the captive insurer, which invests those premiums in the event of a future claim.
Groups of insureds – usually from the same industry – may jointly own a captive to share costs and pool risks:
- “Homogeneous group captives” are shared by companies that are similarly situated (e.g., in the same industry or profession).
- “Heterogeneous group captives” are owned by companies that are dissimilar, and thus benefit from risk diversification.
“Association captives” are (usually homogeneous) captives that are sponsored by an industry association to underwrite only the risks of their owners or affiliates.
“Industry captives” or “industrial insured captives” are homogeneous captives created by companies in the same industry to deal with a specific insurance issue, e.g., the unavailability of a particular kind of insurance.
Establishing and managing a captive can be expensive, so a growing number of small businesses have been renting captive services (“sponsored captive,” “rental captive,” “rent-a-captive”), thereby receiving the benefits of captive insurance without the financial and administrative commitments. The renter pays a fee – usually a percentage of the premium – and the captive provides underwriting, rating, claims management, accounting, reinsurance, and financial expertise.
Note that the IRS has lately been challenging the deductibility of these premium payments.
Protected Cell Companies
A captive may operate like a rental captive yet keep separate underwriting accounts for each of its participants, segregating the assets and liabilities of each account in a “segregated cell captive,” or “protected cell captive.” In some jurisdictions these are known as “segregated portfolio companies” and “segregated account companies.”
A business that is too small to establish a conventional captive may create a micro-captive that pays tax only on its investment income. An election for special tax treatment under Section 831(b) may be made if the captive:
- Qualifies as an insurance company for tax purposes
- Has a bona fide business purpose, and isn’t set up merely to avoid tax
- Has annual written premiums of less than $2.3 million (subject to inflation adjustments)
Microcaptive abuse is under tremendous IRS scrutiny, to the point where nearly all are currently being audited.
Other types of captives
Other types of captive insurance include:
- “Agency captives” are captive insurers that are owned by one or more licensed insurance companies or agents.
- “Alien captives” are licensed in a foreign jurisdiction.
- “Branch captives” are U.S. domicile units of offshore (alien) captives that are licensed to transact insurance business on behalf of US policyholders and are typically used for employee benefits and terrorism insurance.
- “Diversified captives” underwrite risks both related and unrelated to the parent company’s business.
- “Special purpose captives”, also known as “special purpose vehicles” (SPVs) and “special purpose reinsurers” are companies that issue reinsurance contracts to the parent corporation and transfer specific insurance risks to investors in the capital markets (e.g., property-casualty or catastrophe risks).
Risk Retention Groups
A risk retention group (RRG) is a kind of liability insurance company that need not be licensed as a captive, although many are. Authorized under the Product Liability Risk Retention Act of 1981, RRGs enable individuals and organizations from the same industry to self-insure as a group. Here are a few of the requirements:
- RRG stock must be owned by its named insured
- All of the insured must be from the same industry
- The RRG may only write liability coverage, errors and omissions, commercial liability, and professional liability insurance. No workers compensation or personal lines insurance is allowed.
- An RRG must be licensed as an insurer within the United States
- RRGs are subject to regulation in every state in which they operate
Note that RRGs carry certain risks (e.g., they are not well regulated and may not be financial stable), and should be carefully scrutinized before use.
Captive insurance professionals in San Francisco
The full service tax firm of Moskowitz, LLP assist clients with captive insurance planning and litigation. Call our office today for a consultation.
In our next post in this series, we will discuss the benefits and risks of captive insurance companies, and who stands to benefit most from this planning vehicle.