An Overview of Captive Insurance Arrangements

A captive insurance company (CIC) is an insurance company that provides coverage for business entities within the same “economic family”.

  1. A CIC benefits its owner(s) through a combination of factors.

1.1 Similar to regular insurance, premiums paid from a business to the CIC are tax deductible expenses.

1.2 If a CIC elects treatment under IRC § 831(b), it is exempt from income taxation on premiums received up to $2.65 million per year. This provision aims to promote competition among insurers and provide more options for insurance consumers.

1.3 An 831(b) CIC only pays taxes on its investment income. The “dividends received deduction” under IRC § 243 provides additional tax benefits for dividends from corporate stock investments.

1.4 Unlike traditional insurance, premiums paid to a CIC stay within the economic family, reducing overhead, administration, and profit costs. Additionally, investment gains from the CIC’s own investment accounts benefit its owner(s).

1.5 A CIC tailors insurance policies to suit the specific needs and preferences of a business, improving coverage and potentially decreasing premiums.

1.6 A CIC can provide coverage for risks that are typically uninsurable or too expensive to insure through conventional means. It serves as a tax-efficient alternative to self-insurance, allowing the use of no-tax dollars as insurance premiums to the 831(b) CIC annually.

1.7 A CIC is well-suited for insuring “business loss” risks, such as revenue loss due to factors like key employee or customer loss, changes in regulations, or loss of operating license.

1.8 A CIC has access to reinsurers, allowing it to negotiate favorable “wholesale” insurance rates for high-premium policies.

1.9 A CIC formed in an offshore jurisdiction is not subject to state income tax.

1.10 Non-831(b) CICs must recognize premiums as income, but can benefit from deductions for IBNR loss reserves and the “dividends received deduction” under IRC § 243.

1.11 A CIC offers flexible premium financing and capitalization options to accommodate a business’s cash flow needs.

1.12 CIC reserves and surplus are protected from general creditors, allowing investment for maximum return.

1.13 Starting from 2017, a family trust cannot own an 831(b) CIC. However, a CIC can still play a valuable role in integrated wealth accumulation, asset protection, and generational wealth transfer plans.

  1. A well-designed CIC managed by a “turnkey” service provider can be operated and reinsured for about 12-16% of annual premium payments. This could result in a significant profit at the end of the year if there are minimal non-reinsured claims.

Typically, a CIC becomes economically advantageous when it receives around $250,000 or more in annual premium payments. The jurisdiction of formation requires initial capitalization, usually around 20% of the first year’s premiums.

Forming a CIC is generally less expensive in traditional foreign jurisdictions than in US states. However, an 831(b) CIC usually elects to be taxed as a domestic company under IRC § 953(d), with its operating and investment accounts located in the US.

Unrelated owners of businesses can form a multi-owner CIC, also known as a “group captive”, to insure their operating business entities collectively.

  1. CIC assets can be accessed through various means.

3.1 Dividends received by the CIC are taxed at different rates based on the taxpayer’s tax bracket.

3.2 The CIC can invest directly in new business ventures.

3.3 Shareholder loans can be transacted with strict formalities to avoid issues with the IRS and licensing agencies.

3.4 Liquidating the CIC would result in a long-term capital gain.

  1. In order for an insurance policy to be considered valid, it must transfer a genuine risk from the insured to the insurer. Actuaries typically use a rule of thumb that there should be a 10% chance of a 10% loss for the policy to qualify. A well-managed CIC uses underwriting and actuarial skills to provide sound coverage, meet statutory and IRS requirements, and maximize profits.

To ensure insurance premiums can be legitimately deducted under § 162, total annual premiums paid to an 831(b) CIC by a business entity should not exceed 10% of the business’s gross revenue. For example, if a business has annual gross revenues of $3 million, insurance premium payments should not exceed $300,000.

Risks can generally be categorized as follows:

4.1 Low-frequency/low severity risks can be efficiently covered by a CIC, avoiding the overhead costs of retail insurers.

4.2 High-frequency/low severity risks can be covered by a low-cost high-deductible conventional policy, with the CIC issuing an indemnification policy for the high deductible.

4.3 Low-frequency/high severity risks are well-suited for a CIC. Businesses often pay high insurance premiums for events that rarely occur, while others remain exposed to these risks due to lack of coverage. A CIC can provide cost-efficient coverage by combining a low-cost conventional stop-loss policy with an indemnification policy for rare, high-severity events.

4.4 There’s little benefit in conventional insurance if premiums are close to policy limits. A CIC can underwrite such risks more efficiently by reducing overhead costs and investing premiums in its own accounts.

4.5 Risks managed better than the industry average can be customized by a CIC to match the specific risk profile of the operating business, rather than subsidizing other companies with high claims histories.

  1.  Business Liability Policies. Liability policies cover claims made against the operating business by third-party claimants.

Direct policies involve paying claimants and legal fees, potentially creating an asset for plaintiffs. Indemnification policies reimburse the business for third-party claims it pays, without offering an asset for plaintiffs to pursue. Litigation expense policies cover only legal defense fees and expenses, making them suitable for a CIC as they don’t create rights for third-party claimants.

Common areas for business liability risks include vehicle use, construction and design defects, performance liability, structural defects, title insurance, environmental impacts, product liability, professional malpractice, advertising liability, copyright and trademark infringement, antitrust, unfair trade practices, director and officer liability, errors and omissions, Sarbanes-Oxley violations, employee relations, failure to investigate/control employees and agents, libel and slander, workers compensation, and employee health insurance (subject to limitations).

  1. Business Casualty Policies. Business casualty (or business loss) policies are suitable for a CIC as only the business can make a claim without involving third-party claimants. Many potential business casualty risks are often self-insured by businesses, knowingly or unknowingly.

Common business casualty risks include unforeseen administrative actions, changes in laws, judicial or administrative delays, extortion, market volatility, the inability of key individuals to work, loss of professional or business licenses, loss of key clients or investors, business credit issues, labor costs or strikes, property damage, unfair calling of guarantees, litigation costs, tax audit defense, business interruption, lawsuit interruptions, consequential damages, contract frustration, advertising and marketing failures, business reputation, commercial crimes, and currency risks.

  1. Bonds. CICs can underwrite surety, performance, and other types of bonds in certain circumstances.

Warning & Disclaimer: This is not legal or tax advice.

Internal Revenue Service Circular 230 Disclosure: Any advice related to federal taxes contained in this communication is not intended or written to be used for the purpose of avoiding tax penalties or promoting specific transactions or matters.

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