For business owners paying taxes in the United States, captive insurance companies reduce taxes, build wealth and improve insurance protection. A captive insurance company (CIC) is similar in many ways to any other insurance company. It is referred to as “captive” because it generally provides insurance to one or more related operating businesses. With captive insurance, premiums paid by a business are retained in the same “economic family”, instead of being paid to an outsider.
Two key tax benefits enable a structure containing a CIC to build wealth efficiently: (1) insurance premiums paid by a business to the CIC are tax deductible; and (2) under IRC § 831(b), the CIC receives up to $1.2 million of premium payments annually income-tax-free. In other words, a business owner can shift taxable income out of an operating business into the low-tax captive insurer. An 831(b) CIC pays taxes only on income from its investments. The “dividends received deduction” under IRC § 243 provides additional tax efficiency for dividends received from its corporate stock investments.
Starting about 60 years ago, the first captive insurance companies were formed by large corporations to provide insurance that was either too expensive or unavailable in the conventional insurance market.
Over the years, a combination of US tax laws, court cases and IRS rulings has clearly defined the steps and procedures required for the establishment and operation of a CIC by one or more business owners or professionals.
To qualify as an insurance company for tax purposes, a captive insurance company must satisfy “risk shifting” and “risk distribution” requirements. This is easily done through routine CIC planning. The insurance provided by a CIC must really be insurance, that is, a genuine risk of loss must be shifted from the premium-paying operating business to the CIC that insures the risk.In addition to tax benefits, principal advantages of a CIC include increased control and increased flexibility, which improve insurance protection and lower cost. With conventional insurance, an outside carrier typically dictates all aspects of a policy. Often, certain risks cannot be insured conventionally, or can only be insured at a prohibitive price. Conventional insurance rates are often volatile and unpredictable, and conventional insurers are prone to deny valid claims by exaggerating petty technicalities. Also, although business insurance premiums are generally deductible, once they are paid to a conventional outside insurer, they are gone forever.
A captive insurance company efficiently insures risk in various ways, such as through customized insurance policies, favorable “wholesale” rates from reinsurers, and pooled risk. Captive companies are well suited for insuring risk that would otherwise be uninsurable. Most businesses have conventional “retail” insurance policies for obvious risks, but remain exposed and subject to damages and loss from numerous other risks (i.e., they “self insure” those risks). A captive company can write customized policies for a business’s peculiar insurance needs and negotiate directly with reinsurers. A CIC is particularly well-suited to issue business casualty policies, that is, policies that cover business losses claimed by a business and not involving third-party claimants. For example, a business might insure itself against losses incurred through business interruptions arising from weather, labor problems or computer failure.
As noted above, an 831(b) CIC is exempt from taxes on up to $1.2 million of premium income annually. As a practical matter, a CIC makes economic sense when its annual receipt of premiums is about $300,000 or more. Also, a business’s total payments of insurance premiums should not exceed 10 percent of its annual revenues. A group of businesses or professionals having similar or homogeneous risks can form a multiple-parent captive (or group captive) insurance company and/or join a risk retention group (RRG) to pool resources and risks.
A captive insurance company is a separate entity with its own identity, management, finances and capitalization requirements. It is organized as an insurance company, having procedures and personnel to administer insurance policies and claims. An initial feasibility study of a business, its finances and its risks determines if a CIC is appropriate for a particular economic family. An actuarial study identifies appropriate insurance policies, corresponding premium amounts and capitalization requirements. After selection of a suitable jurisdiction, application for an insurance license may proceed. Fortunately, competent service providers have developed “turnkey” solutions for conducting the initial evaluation, licensing, and ongoing management of captive insurance companies. The annual cost for such turnkey services is typically about $50,000 to $150,000, which is high but readily offset by reduced taxes and enhanced investment growth.
A captive insurance company may be organized under the laws of one of several offshore jurisdictions or in a domestic jurisdiction (i.e., in one of 39 US states). Some captives, such as a risk retention group (RRG), must be licensed domestically. Generally, offshore jurisdictions are more accommodating than domestic insurance regulators. As a practical matter, most offshore CICs owned by a US taxpayer elect to be treated under IRC § 953(d) as a domestic company for federal taxation. An offshore CIC, however, avoids state income taxes. The costs of licensing and managing an offshore CIC are comparable to or less than doing so domestically. More importantly, an offshore company offers better asset protection opportunities than a domestic company. For example, an offshore irrevocable trust owning an offshore captive insurance company provides asset protection against creditors of the business, grantor and other beneficiaries while allowing the grantor to enjoy benefits of the trust.For US business owners paying substantial insurance premiums every year, a captive insurance company efficiently reduces taxes and builds wealth and can be easily integrated into asset protection and estate planning structures. Up to $1.2 million of taxable income can be shifted as deductible insurance premiums from an operating business to a low-tax CIC.
Warning & Disclaimer: This is not legal or tax advice.
Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.
Copyright 2011 – Thomas Swenson
A big question that many insurance consumers ask is, “Do larger insurance companies offer cheaper insurance rates?” Let me answer this question by saying that just because the larger insurance companies may do business in multiple states, this doesn’t mean their share of the market is bigger, nor does it mean they can write lower premium policies for everyone in every state.
The amount of insurance that each company writes may vary from state to state based on their experience in that particular state, or even in a certain region of a state. Insurance consumers should also be aware that there may be smaller regional insurance companies that offer the same coverage at a lower rate. Although the regional companies may not be as big as the larger insurance companies, they still may be competitive and financially sound. Bigger is not always better. In my experience as an independent insurance agent, I have discovered that savings were available to some customers by writing the customer’s insurance with a smaller regional company.I would suggest that people who are looking for the lowest insurance rates consider requesting insurance quotes from the smaller regional companies, as well as a larger national company. Most smaller regional insurance companies do business through local independent agents. In order to request quotes from smaller companies, you will most likely have to use a local independent agent.
If using a smaller company is a concern, then I would also suggest that you request from the writing insurance agent the companies their AM Best rating and financial information. The AM Best rating can be a handy tool for consumers.
The A.M. Best Company is an independent, full-service credit rating organization. They assign a rating for each insurance company based on the insurance company’s financial strength. Based on the outcome, a company will receive a rating of Superior (A++, A+), Excellent (A, A-), or Good (B++, B+). Per AM Best, companies with a rating between A++ – B+ are considered to be financially secure. Other ratings include Fair (B, B-), Marginal (C++, C+), Poor (D), Under Regulatory Supervision (E), In Liquidation (F) and Suspended (S). According to AM Best, companies with a rating between B – S are considered to be financially vulnerable.By comparing multiple insurance quotes from both large and smaller regional companies who have B+ or better rating, consumers should be able to feel secure in finding the cheapest insurance rate.