Guide to Insurance Captives

What is a Captive Insurance Company?

A captive insurance company is generally a corporation that is formed in a legal jurisdiction (U.S. states or foreign countries) and subject to various industry regulations (federal, state, international governance) and income tax authorities for both the insurance company and the insured.

Insurance captives are a type of risk-financing tool. The term “captive” refers to the fact that the insurance company is owned and controlled by its insureds, in the form of a governing Board of Directors. The captive functions much the same as a regular insurance company, evaluating risks, writing policies, managing claims, and setting premium levels. The big difference is that it primarily insures the risks of its owners, and not outside parties.

The risks being insured are mostly risks available through traditional commercial insurance companies.  However, some risks insurable under a captive arrangement may generally be unavailable through the commercial insurance marketplace or otherwise fill “gaps” in a commercial insurance policy.  These risks can include general liability, E & O liability, employee benefits, workers compensation, product liability, cyber risk, environmental, property and more.

How Do They Work?

Most captive insurance companies are arranged through captive management companies that assist the insured business in identifying the benefits, costs and burdens of forming the captive insurance company.  This captive manager is critical in navigating the captive and the insured through the highly complex and burdensome regulatory environment, while staying current in a rapidly changing environment (for both industry and taxation policies).  The premium pricing and actuarial analysis are critical functions handled by the manager.

The captive entity is a standalone legal entity.  Our client captives are generally formed utilizing Internal Revenue Code § 831(b), which can provide substantial income tax benefits for the captive, while still giving rise to deductible insurance premiums for the insured business.

What are the Benefits of Insurance Captives?

Benefits of utilizing captives include potential cost savings, both short and long term, improving cash flow, centralization of investment policies, reducing risk management losses, enhanced control over policy design and claims management and removing commercial insured profit loading.

Who Can Use Insurance Captives?

For many small- and medium-sized businesses, captive insurance companies are a viable and productive tool. However, the complexities and costs involved certainly make it a “not for everyone” consideration. Generally, insurance captives are a good choice for companies that excel at risk management, are ready to make a long-term commitment, are financially sound, and have a reasonably predictable insurance risk. If your organization struggles with poor risk management, isn’t strong financially, or is too small to accept the risk of loss, then an insurance captive is probably not right for you.

What about the Internal Revenue Service?

The United States Treasury embraced the use of captives in 1986 by creating Internal Revenue Code § 831 and the § 831(b) election previously mentioned.  The genesis of the §831 tax incentives came about in a difficult U.S. economy, whereby small and medium sized businesses found it difficult to find affordable insurance.  The § 831(b) election was deemed to be an incentive to bring small and medium sized businesses into the captive arena. 

§ 831(b) allows certain small insurance companies (non-life policies) to exclude certain net insurance business income from federal taxation.  This exclusion is based on net premium income (gross receipts) of $2.2 million or less as of January 1, 2017 ($1.2 million prior to that).  This has the effect of federal taxes applying to only taxable investment income.

The § 831(b) provisions (and other insurance provisions) require that small captives enter shared risk pools (other insured risks are pooled with the insured that creates the captive) and is a critical area under IRS scrutiny.  This is relatively easy to navigate with a quality manager (but “other businesses risks are commingled with your business risks.”).  Even with the captive endorsement of Congress with the 2016 § 831(b) revenue expansion to $2.2 million, the IRS views all captives with a less than positive lens.  In 2016 the IRS issued a notice requiring all parties involved in certain captive insurance programs (micro-captive transactions) to file an annual form with IRS disclosing various details associated with the captive arrangements and the various parties involved in the captive arrangements.  The IRS used the term “Transaction of Interest” for this type of captive insurance transaction.  In and of itself, this required filing put these transactions in a highly visible and uncomfortable situation.

An IRS examination that identifies the existence of a captive insurance transaction will generally result in a referral to centralized IRS exam group.  It should be expected that an IRS exam that identifies a captive insurance transaction will intensify the examination process and create an initial disallowance of all premiums paid under the captive arrangement.  The IRS is generally not interested in auditing the core elements of the captive insurance arrangement nor the criteria established and set forth by the IRS as to “What makes a captive acceptable to the IRS?”.  Rather, it is an arbitrary and capricious attack on bona fide and lawful transactions.  It is… a bit of vigilante bullying.

The IRS is emboldened by general disdain for its statutory tax benefits and recent cases that have resulted in government victories in light of very problematic taxpayer facts and circumstances.   The insurance industry stands to fight a good and righteous fight.  The expectation is that substantial taxpayer victories will force the IRS to accept proper and legal captive insurance companies and their arrangements.

WNDE Insurance Captives Services

If you think that a captive strategy might be right for your business, and are interested in moving forward with creating an insurance captive, the first step is to commission a captive feasibility study. This study will make a detailed evaluation of your company’s specific circumstances and determine if an insurance captive is the right solution for you, given your needs and position.

WNDE provides a full range of strategic consulting and advisory services for entities seeking help with exploring, establishing and/or maintaining insurance captives. Our experienced tax specialists have the expertise needed to help you make key determinations in this area. To discuss your specific scenario and whether or not an insurance captive is right for your organization, please reach out to WNDE today. You may reach us at (714) 978-1300 or contact us via email at info@wndecpa.com.