Why Not Consider a Captive Insurance Arrangement? Part One

A business that does not have a captive insurance program or has not completed a feasibilty study to implement a captive insurance program may soon be in the minority: Insurance industry trends indicate that most businesses are looking at implementing a captive insurance program.

Captives have been used by Fortune 500 risk managers as a way to capture commercial insurance premiums. Large multinational companies self-insure several lines of coverage via a captive – general liability, workers' compensation, employee benefits and property insurance. With favorable claims experience, self-insurance and/or a captive can become a profit center.

Recent changes to Internal Revenue Service policies are allowing middle-market businesses to utilizing captives as another profit center. More than 10,000 businesses – representing industries ranging from finance to construction – have begun to accumulate vast amounts of pre-tax wealth through captive insurance programs, which use insurance subsidiaries formed to insure or reinsure their risks.

How does a captive work?

A captive writes policies at the business owner's discretion with negotiated terms and conditions. If the business has years of good claims experiences, the premiums that have been successfully deducted can later be taken as dividends or as liquidated capital at the capital gains tax rate.  A typical commercial business with taxable income of $10 million will pay 45 percent in federal and state income taxes, leaving it with 55 percent, or $5.5 million for claims or for distribution to shareholders. Instead of paying premiums to an insurance company the business funds $4 million in premiums to its wholly owned captive insurance company. It now has an additional $1.5 million available for expenses, claims or additional distributions to shareholders.

Captive insurance enables business owners to better manage insurance needs including cost, coverage, service and capacity. Additional benefits include:

• Pre-tax wealth accumulation. Insurance premiums are an expense to the parent company and flow tax-free to the insurance company, where they collect on a pre-tax basis in anticipation of future claims.
• Favorable distribution rules. In the event that claims do not materialize, underwriting profits can be distributed to shareholders as dividends.
• Asset protection. Because the captive is an independent corporate entity, creditors of the parent company may find it difficult to seize the captive's assets.
• Estate planning. A family trust or other entity can own the captive.
• Retention of key employees. Giving key employees restricted ownership in the captive can provide a foundation for retention.

The captive transaction is a powerful yearend planning tool because insurance premiums are deductible to the parent and flow tax-free to a captive qualifying under §831(b)of the Internal Revenue Code. At year end, a captive can provide nearly twice as much capital to the business as would have otherwise been paid in taxes. This makes the formation of a captive an attractive and viable option for middle-market companies.