Captive Insurance Companies

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Rather than buying a policy from an existing property and casualty insurance company, many companies are increasingly choosing to start their own insurance companies for the purposes of managing their own risks. These “captive” insurance companies (CICs) may help, for example, manage risk of loss of business license, and financial loss due to regulatory changes or environmental losses. Today, most Fortune 1000 companies, as well as many smaller ones, have decided to go the captive route.

From a tax perspective, the key rule is IRC Section 831(b), which allows certain captive insurance companies to be taxed only on their investment income. This means that they do not pay income tax on the premiums they collect or on the earned underwriting profits, provided that net or direct premiums do not exceed $1.2 million per year. Furthermore, the captive may build surplus from underwriting profits free from income tax.

But tax breaks are not the only advantage, as the following list shows:

  • Investment Income—Could invest the captive’s reserves and surplus allowing the investment income to benefit the owner of the captive rather than a traditional commercial insurance carrier.
  • Tax Benefits—Underwriting profits are tax exempt under IRC 831(b) and are only taxed when distributed to the owner of the captive.
  • Incentive for Loss Control—A powerful incentive to implement loss control measures and reduce claims experience is provided because underwriting profits belong to the owner of the captive insurance company.
  • Increased Coverage Capabilities—Could provide coverage for risks that are only inherent to that specific enterprise, which is typically unavailable through traditional property and casualty carriers.
  • Greater Control Over Claims—Could have better control over the review process along with how claims are handled.
  • Underwriting Flexibility—Could create customized features, which better suit that enterprise’s needs.
  • Capture Underwriting Profit—Could capture underwriting profits by managing the underwriting risks of the captive effectively.

From a tax mitigation perspective, let’s assume that ABC Enterprise is in a combined federal and state income tax bracket of 45 percent and is paying $1.2 million per year in annual premiums to XYZ Captive. Effectively, ABC Enterprise is able to deduct $1.2 million from its taxable income, ultimately saving $540,000 (which would’ve gone to taxes if it had not integrated and coordinated a captive as part of its overall risk management strategy).

Further, the captive may retain surplus from underwriting profits within reserve accounts, free from income tax. For example, it can also generate profits by controlling or eliminating costs for overhead, marketing, advertising, agent commissions, and profits—items normally built into the premiums charged by traditional insurance companies. After adjustment for expenses and claim payments, net underwriting profits are retained within the captive insurance company. Over the years, profits and surplus may accumulate to sizeable amounts–and may be distributed to the owners of the captive company—under favorable income tax rates as either dividends or long-term capital gains.

From a wealth transfer perspective, a properly designed captive insurance company arrangement can provide significant wealth accumulation opportunities as well as allowing for efficient and tax-advantaged wealth transfer and asset protection strategies. A captive insurance company established as a standalone business entity can offer many additional planning advantages to the business owner, including:

  • Estate and Wealth Transfer Planning
  • Asset Protection
  • Wealth Accumulation
  • Business Succession Planning

As referenced above, a “CIC” can be utilized as an effective wealth transfer vehicle. For example, a high-net-worth individual may choose, with the assistance of estate planning counsel, to implement an irrevocable trust for the benefit of his children or grandchildren. The irrevocable trust may, in turn, own 100 percent of the captive’s shares, providing an effective mechanism to benefit trust beneficiaries via increases in the captive’s overall net worth, resulting from increases in its investment portfolio over time. When owned by an asset protection trust, capital and surplus of the captive insurance company can be protected from litigation risk. This arrangement can play an effective role in protecting assets from future creditors’ claims.