Captive insurance companies provide businesses with savings opportunities, tax benefits, and greater flexibility in managing insurance needs. However, they are subject to pricing fluctuations, require significant capital, and pose some administrative challenges, particularly for small enterprises.
As noted in Part I, a captive insurance company (“captive”) is a special purpose insurance company formed by a business owner to insure the risks of their related or affiliated businesses. In this post we discuss some captive insurance pros and cons, particularly for medium and small-size businesses.
Benefits of captive insurance companies
When established as part of a well-thought-out business plan, a captive insurance company can be a valuable risk management tool. Captives have many benefits, including the ability to:
- Insure risks that are otherwise unavailable for coverage.
- Benefit from increased cash flow through lower insurance costs.
- Ability to customize the terms and conditions of the insurance policies, including covering a particular risk and the claim processing time.
- Invest premiums that were not used to pay claims, instead of having to surrender them to a commercial insurer.
- Make loans from the captive’s reserves back to the operating company.
- Shield assets in a captive from claims against its parent company and other subsidiaries.
- Access the reinsurance market for additional savings and flexibility.
Although the Tax Cuts and Jobs Act of 2017 (TCJA) reduced many captive insurance tax benefits, it did not eliminate them. If structured properly, a captive insurance company can provide you with some tax benefits, such as the ability to:
- Deduct annual premiums for insurance that covers “reasonable” risks.
- Deduct unpaid losses as they are incurred, faster than in cases involving typical insurance.
- Accumulate underwriting and investment income.
- Distribute the captive’s net profits to shareholders as either dividends or long-term capital gains.
Small captives can make a tax election under IRC 831(b) and be taxed only on their investment income (premiums to an 831(b) captive are tax-exempt). Qualifying for the 831(b) election isn’t easy, though: (1) The captive must be licensed as an insurance company (in a U.S. state or a foreign jurisdiction),(2) premiums must not exceed $2.3 million, and (3) diversification requirements must be met (no more than 20% of the net written premiums may be attributable to any one policy holder).
Risks of captive insurance
Captive insurance isn’t for everyone. Here are some captive insurance risks:
- A substantial amount of capital is needed to establish and maintain a captive insurance company (note that although rent-a-captives are not as expensive, they are usually only worthwhile if utilized over a long period of time).
- In you underestimate the amount of funds needed for protection, or in the event of a catastrophic loss, the company may need to draw on other assets and its bottom line could be severely affected.
- The administration of a capital insurance company requires time, money and staffing – contracting out these services to capital management companies reduces the overall financial benefit, and if the chosen third-party provider is not top quality, the service may be inadequate.
- The captive must be licensed and is subject to state-based insurance regulation.
- The reinsurance market can be rather volatile – captives are susceptible to pricing fluctuations.
- Policies are becoming more stringent and there has been a reduction in some of the tax benefits as well.
- There are harsh penalties for noncompliance under IRC §953.
- There may be complications with mergers, acquisitions, and the closing of these entities.
- There is an increasing amount of scrutiny over small captives, and most 831(b) captives are being audited.
- Per IRC § 831(b)(2)(A)(iii), once an 831(b) election is made, it may be revoked only with the consent of the Secretary of the Treasury.
The tax considerations should never be the main factor in the decision of whether or not to form a captive insurance company. A captive may or may not be right for you, and action should not be taken before consulting with a qualified tax attorney.
Our final post in this series will cover captive insurance audit risks and the recent crackdown on captive insurance abuses.