Why Not Consider a Captive Insurance Arrangement? Part Two

Is your business a stand alone Captive candidate?

Captives will not work for every business. However, good candidates generally meet two or more criteria:

• Profitable operations, with taxable income ranging from $1.5 million to $100 million.
• $250,000 self-insured/uninsured business risk.
• 100 or more employees.
• $500,000 or more traditional third-party insurance expense.

The reason for these stringent qualifications is that a captive can be expensive to form and manage. In order for it to be a cost-effective option, actuaries and underwriters must be able to quantify $500,000 or more in risk premiums from the parent company's business operations. Hence, the parent company must be large enough and in a risky enough industry to qualify.

The owners, shareholders and executives must diligently study a captive's potential benefits and burdens. Such an analysis should extend considerably beyond the cost of existing insurance, and focus on net dollars to shareholders.

Traditional insurance has become extremely expensive for some types of coverage.  As a result, many middle-market companies have chosen to actively manage their insurance portfolios by taking on large deductibles and/or self-insuring areas where they are exposed.

Is your business a rent-a-captive candidate?

Where a business does not have enough of its own capital to start a captive, or where a license to sell a particular type of insurance is required, the business may enter into an arrangement with an existing and licensed captive to borrow the captive's facility so that the business can enter into a captive-like arrangement.

In a rent-a-captive arrangement, the captive usually issues a new class of preferred shares to the business owner. The business then purchases insurance from the captive and the business makes payments to the captive. The business owner may also be required to issue a letter of credit to the captive to protect the captive against any underwriting losses.

At the end of the policy period, any excess cash above underwriting losses is distributed to the business owner by way of dividends paid to the preferred stock shares, less of course whatever fee was charged by the captive to rent it. Thus, the business owner was able to realize the benefits of a captive in terms of the deduction within the business and to share in underwriting profits, but without having to bear the expense of creating a new captive. The trade-off is, of course, the fee paid to rent the captive.

Looking forward

Fortunately, the trend has been positive for captives, and the IRS has demonstrated the willingness to work with taxpayers by clarifying rules rather than by reversing them.  If you have not completed at the very least a captive feasibility study for your company, you should consier doing so sooner than later.