Captive Insurance

What is a Captive?

Captive insurance is an alternative to self insurance in which a parent company creates a licensed insurance company to provide coverage for itself. The main purpose for doing so is to avoid using traditional insurance companies, which have volatile pricing and may not meet the specific needs of the company. When a company creates a captive, they are indirectly able to evaluate the risks of the company and their subsidiaries, write policies, set premiums and, ultimately, either return unused funds in the form of profits or invest them for future claim payouts. Over 90 percent of Fortune 1000 companies and many successful middle market businesses have captives.

Benefits of forming a Captive

1. Greater Control

 

A captive insurance company gives a business the power to coordinate and improve their risk management program, turning it into a viable profit center for the business.

2. Customized Coverage

 

Captives have more flexibility in tailoring coverage to the specific needs of the insured business and providing coverage that is unavailable or prohibitively expensive in the commercial market. In addition, even when a business has insurance against certain types of risks, the business will still be exposed to certain exclusions. For example, the typical general liability policy may have exclusions for things like employment practices liability, which expose the business to claims of sexual harassment, age discrimination, wage and hour claims, etc.. The insurance provided by captives can fill those gaps.

3. Focus on Risk Management

 

A captive can be used to increase the visibility of a company’s risk management program. Senior managers and even operating managers can participate on the Board of the captive, which can raise the level of awareness of risk management at these levels and help create ownership of the risk management program. In addition, being financially responsible for paying claims under a captive program can provide a greater incentive to prevent losses than under regular programs of buying commercial insurance. The benefits of enterprise risk management, while sometimes hard to exactly quantify, are enormous. The focus shifts to analyzing the business so as to spot potential risks. Claims are thus prevented instead of just administered. In the end, the business owner gains a better understanding of the business and its limitations.

4. Save Money on Insurance

 

A primary purpose of a captive is to save money on insurance, and in this, captives have no equal. There are three main aspects to this:

 

First, commercial carriers have enormous costs that must be priced into their policies, such as the expense of compensating agents, marketing and advertising expenses, high executive compensation, etc. that have nothing to do with true risk in commercial policies, that can be saved through the use of a captive.

 

Second, even where the business decides to keep commercial insurance in place against particular risks, the captive can be used to reduce costs by any of raising deductibles, lowering coverage limits or increasing exclusions. The idea is to find where the commercial insurance is most economical and then use the captive to insure around that area.

 

Third, the mere existence of a captive and its ability to underwrite costs can save money even if the captive is never used for that purpose on a given policy. The insurance broker knows if the premium prices offered to the operating business are not extremely competitive, the operating business may decide to cover those policies in the captive.

5. Underwriting Profit and Investment Income

 

By underwriting the insurance needs of the business, the captive can capture and retain the underwriting profits that would ordinarily be lost to the commercial carrier. Premiums paid into the captive can be invested to grow the financial strength of the company and increase surplus. If the captive has good claims experience, it stands to generate a tremendous amount of underwriting profit for the captive owners.

6. Access to Risk Transfer Capacity (Reinsurance)

 

As a licensed insurer, a captive has the advantage of being able to access the reinsurance markets. This can increase the potential sources of risk transfer capacity and reduce the cost. Essentially, the captive can buy insurance at wholesale rates rather than the company buying commercial insurance at retail rates.

7. Control Over Claims Handling

 

A problem with commercial carriers is that they can allow a small claim to fester; either by not taking care of the claim early or by allowing it to drag on without resolution. Alternatively, the insurance company may settle a frivolous claim just to save defense costs, thus encouraging more such frivolous claims against the business. With a captive, the business owner can administer their own claims on their own terms and get on top of claims quickly before they spin into something much larger. The business owner can also choose not to settle frivolous claims, force the plaintiff’s attorney to incur time and expenses litigating the claim before dismissal and thus deter future lawsuits. Having a captive insurance program leads to improved control over claims; however, the extent to which this can be achieved will depend to a large degree on the reinsurance arrangements supporting the program.

8. Tax Advantages

 

Having a captive insurance program gives the business owner the opportunity to accumulate wealth in a tax favored vehicle and the distributions from the captive are at favorable income tax rates. The largest potential tax advantage is for those smaller captives that make the 831(b) election. This election avoids the payment of taxes on the underwriting profit of the captive. (See paragraph below for a more complete description of these captives.)

9. Create a New Business

 

Many business owners who form captives think of it for what it does, but they don’t realize that they have just created a new business; an insurance company. The captive thus acts not just as an enterprise risk management tool, but also to segue into a whole new business opportunity. An existing captive with sufficient capital can be converted to a full insurance company that offers insurance to the general public by changing its license and business plan and meeting certain other state requirements. Not just a few business owners find insurance to be a better business than the successful business they are already in. The captive can underwrite customer or related party business and be an opportunity to sell a new service to an existing customer base; for example, extended warranty insurance or renter’s insurance.

Types of Captives

There are many types of captives, but the following are the most common:

 

Single Parent (or Pure) Captive

 

A company writing only the risks of its parent and/or affiliates.

 

Group Captive

 

A group captive is owned and controlled by multiple non-related organizations. It is formed as an independent entity and insures the risks of its owners.

Association Captives

 

An association captive is owned by members of a common industry or trade association and is designed to insure the risks of that industry among its members. Participation in the captive program is limited to members of the association. Association captives are a means to deliver added value to its membership.

Rent-A-Captive

 

A rent-a-captive is an insurance company that rents its capital and services to insureds who wish to create a captive program but do not want to invest in and own an insurance company. The owners of rent-a-captive facilities will usually require collateral from insureds to protect the aggregate participation in the captive program.

Sponsored Captives, Segregated Cells and Protected Cells

 

These entities are all forms of rent-a-captives. Their distinguishing feature is that the assets and liabilities of one captive program (cell) are legally separated from the assets and liabilities of other captive programs. Traditional rent-a-captive structures have no such legal separation, but require an indemnification from their insureds for liabilities from the captive programs. Most major captive domiciles have passed regulations creating the framework for the legal separation of cells within the rent-a-captive. Different terminology is used to refer to these new entities in different domiciles: Bermuda (segregated cell companies), Cayman Islands (segregated portfolio companies), South Carolina (protected cell companies) and Vermont (sponsored captives).

Risk Retention Groups

 

A risk retention group is an entity licensed under the Federal Liability Risk Retention Act. It is owned by its insureds and is authorized to underwrite the liability risks of its owners only. Owners must be from a homogenous industry group. A risk retention group is licensed as a captive insurance company in its domicile of choice and may operate throughout the U.S. provided it properly registers with each state that it does business in.

Microcaptives/Section 831(b) of the Internal Revenue Code

A microcaptive is a captive insurance company operating with annual premium of less than $2.2 million (was $1.2 million until January 1, 2017). In the United States, such captives are taxed under Internal Revenue Code 831(b), which provides that a captive qualifying to be taxed as a U.S. insurance company will pay tax only on its investment income.

 

Section 831(b) special tax rules can be used by all types of captives, whether single parent, group or rented, provided that the captive meets the following qualifications:

 

  1. The captive insurance company or the captive cell must qualify as an insurance company for tax purposes. Very briefly, this means it must have adequate risk shifting and sharing and operate and be regulated like a “real” insurance company, e.g., with adequate capital to allow it to take risk.
  2. The company must be a U.S. taxpayer, either domiciled in the United States or domiciled offshore, but having elected and qualified under tax code section 953(d) to be taxed as a U.S. insurer.
  3. The gross premium income for the tax year in question must be less than $2.2 million. This premium threshold applies to all insurers included in a single tax filing.

 

Microcaptives became popular because if a captive is taxed under section 831(b) of the tax code, it does not pay tax on its underwriting income. It pays income tax only on its investment income. If a captive with more than $2.2 million in annual premium issues policies and has no losses, the premiums paid, less operating expenses of the captive, will be taxed, as well as tax being paid on any investment income. However, if the gross premium is less than $2.2 million, only the investment income is taxed. The underwriting profit can either be returned as a shareholder dividend or remain in the captive as surplus.

 

One problem with 831(b) captives arises from the false premise that just meeting the limit of $2.2 million in premium is all that is required. The company must qualify as an insurance company and must have a business purpose, not merely a tax-reducing purpose, as the primary motivator for both the formation and the continued operation of the captive.

 

A second issue with 831(b) captives is that they have attracted attention through promoters touting tax deductions, wealth transfer tax advantages and tax deductible funding for life insurance. These promoters are pushing tax reasons for forming a captive. While these benefits can occur, they should not be the primary reason of forming a captive. Captives are regulated financial institutions. They should be handled with professionalism both in the formation and in the annual management and operations. The captive owners need to take the time necessary with experienced professionals to make sure the operations will stand up under Internal Revenue Service (IRS) or regulatory scrutiny.

 

On December 18, 2015, Congress passed the PATH Act, which includes two significant changes to section 831(b) that became effective January 1, 2017.

 

First, the $1.2 million premium limit was increased to $2.2 million and is indexed to the Consumer Price Index.

 

Second, to make and maintain an 831(b) election, an insurance company must meet one of two alternative tests for each year in which it is taxed under 831(b). The alternative tests are explained below:

 

  1. To meet the first test, a diversification test, no more than 20% of the insurance company’s premium can come from any one policyholder. A broad definition of ‘policyholder’ applies so that affiliated companies and individuals would be within the definition. Affiliates will be treated as one policyholder for this diversification test.
  2. The second test, an alternative to the first, essentially requires that ownership of insured businesses and assets mirror (within a 2% margin) ownership of the insurance company. One purpose of the second test is to prevent an irrevocable trust or other estate planning vehicle set up by the insured company’s owners from having an ownership interest in a captive, which can have the effect of transferring wealth from the company’s owners to their descendants without paying estate taxes.

There is no language in the legislation or amendments that grandfathers existing captives, and no such language is anticipated. Owners of existing 831(b) captives and businesses and assets insured by 831(b) captives should review their ownership structure to determine whether the captive and insured businesses meet the new “mirror ownership” requirement. If they do not, it’s very important to either restructure the ownership of the captive and/or the insured business to ensure continued eligibility under 831(b) or to withdraw the 831(b) election.

Risks Underwritten

Companies form captives to mitigate their exposure to a wide range of risks. Practically every risk underwritten by a commercial insurer can be provided by a captive. The majority of captives provide mainstream property/casualty insurance coverage such as general liability, product liability, workers’ compensation, director and officer (D&O) liability, auto liability and professional liability (e.g., medical malpractice). The medical stop loss portion (risks of serious medical problems) of medical insurance is another type of coverage that is becoming popular to put in captives as the cost of medical insurance continues to increase.

 

Captives also provide specialized coverage for unusual or hard-to-insure-risks (e.g., terrorism risk). Oil companies have used captives to guard against environmental claims related to infrequent, but potentially high-cost events. Other types of nontraditional insurance coverage that a captive could underwrite includes credit risk, pollution liability, equipment maintenance warranty and employee benefit risks.

Domicile of Captives

Captives can be formed in a wide number of domiciles, both onshore (located within the jurisdiction of the United States) and offshore (located outside the jurisdiction of the United States). A domicile is the jurisdiction in which a captive insurer is incorporated and regulated. Captives were originally formed in offshore tax haven jurisdictions such as Bermuda or the Cayman Islands. Over the years, however, these long-standing offshore domiciles have been joined by Vermont and many other U.S. states. The number of captive domiciles is growing and remains competitive. Bermuda and the Cayman Islands remain the largest offshore jurisdictions. In the United States, Vermont has more captive insurers than any other jurisdiction and is considered a leader in captive legislation.

 

There has been large growth in the number of states allowing captive formations with now over 35 states involved. California is the most conspicuous state that does not allow captive formations, but not allowing captive insurers to domicile in your state does not mean that businesses that reside within that state can’t form captives.

 

An important factor in establishing a captive is determining where it will be domiciled. U.S. companies have the option of domiciling offshore or onshore. The decision largely depends upon an organization’s analysis of a given domicile’s benefits and drawbacks. Key considerations for choice of domicile include: applicable taxes, operation costs and fee levels, permitted lines of business, experience, approval process and regulatory restrictions. In addition, restrictions on permissible investments and capital requirements are key considerations as well. The parent company’s industry also impacts the choice of domicile. Many captives are domiciled in jurisdictions that specialize in specific types of risk. Conversely, some jurisdictions have sought to tailor their captive legislation around certain types of coverage.

Regulation of Captives

The key purpose of insurance regulation is to protect policyholders first and foremost, as well as investors and other stakeholders. A captive is different from a commercial insurance company, because it just serves its parent company. Therefore, captives are regulated differently than traditional insurance companies that serve the public. Like traditional insurance companies, captives are regulated by the domicile in which its headquarters are located.

 

Each domiciliary regulator requires an annual audit by an independent CPA firm (or its equivalent) with industry specific experience in the insurance industry. In addition, many domiciliary regulators require a formal actuarial review of the captive’s policy on pricing and loss reserve methodology.

Captive Manager

Most captive management is usually outsourced to a captive manager located in the jurisdiction that holds the primary license for the captive. In the U.S., most captive managers are small administrative service providers. They don’t draft insurance policies, which is generally the function of a senior insurance or corporate lawyer; they don’t price policies, which is done by a property and casualty underwriter; and they don’t purport to be responsible for tax issues, which a tax lawyer handles.