Have you ever written a check for an insurance premium and wondered, “Isn’t there a better — or at least less expensive — way to insure against risk?”
For some manufacturers, that “better way” could involve forming a captive insurance company. A captive insurance company can recapture the profits that are currently going to your insurance carrier, customize coverage to meet your needs, achieve significant tax benefits, and create greater flexibility in estate planning. Indeed, the question I often get from clients after explaining the pros and cons of a captive is “Why wouldn’t I do that?”
What Is A Captive Insurance Company?
A captive insurance company or “captive,” is a legally licensed, limited-purpose property and casualty insurance company. A captive’s main business purpose is to insure the risks of its owners or the companies affiliated with its owners. Captives can be formed by any type of business — manufacturers, construction companies, and automobile dealerships, to name only a few of the most common ones.
Historically captives were thought to only make sense for companies with at least $100,000 in traditional insurance premiums and over $10,000,000 in revenue and at least 50 employees. Due to legal innovations and declining capital requirements and operating costs, this is no longer true. Additionally, some group, cell and series llc captive programs make financial sense for much even smaller companies. These smaller captives often take advantage of US Internal Revenue Code section 831 B which allows qualified small captive insurance companies to be exempt from federal income tax on operating income.
Types Of Risk Which A Captive Can Underwrite
Any type of definable and reasonably measured risk that can be protected against with insurance can be covered by a captive as well. Risks not coverable by commercial insurance can also be financed through a captive. One of the main benefits of a captive is custom tailoring insurance policies to cover your specific risks in ways not available in the general commercial insurance marketplace – and to cover risks where there is no commercial insurance available.
A captive can provide virtually any type of insurance, as long as the laws of the state or country in which it is domiciled (i.e., incorporated, licensed, managed, and operated) allow the line of business to be underwritten. Some of the most common types of insurance captives offer are:
- General and umbrella liability
- Workers’ compensation (reimbursement)
- Employment practices liability
- Contractors’ professional liability
- Directors’ and officers’ liability
- Property damage/business interruption
- Automobile liability
- Cyber security
- Professional liability/error and omissions
- Fiduciary liability
The types of coverage captives offer continue to evolve. For example, faced with rising employee health care costs, some companies have recently begun incorporating employee benefits programs into captive insurance companies.
Reasons For Forming A Captive
A common misconception about captive insurance companies is that they are formed primarily to secure certain tax benefits, particularly the ability to accelerate the deduction for losses. This advantage over self-insurance or a simple rainy-day fund is significant because the premiums paid to the captive insurance company generally are a deductible business expense to the company that formed it and thus accelerates the deduction of future losses.
While a substantial benefit, tax considerations alone, however, are not the sole reason for forming a captive. Below is a list of the advantages a business may enjoy as the result of the formation of a captive. While the application of the considerations below will vary from business to business, they should provide a basic framework to decide if a captive is an option for your company or not.
1. Improved Risk Management and Risk Financing
A captive insurance company can be a highly effective tool for gaining better control of an organization’s risk-management and risk-financing functions. A captive can enhance the overall organizational view of risk management and provide valuable ways to identify and quantify risks, both insured and uninsured. Forming a captive also can help management demonstrate to the board of directors, audit committee, and relevant regulators that the company is pursuing a prudent and transparent approach to risk management at various levels of the organization.
2. Lower First-Dollar Insurance Costs
Another common misconception about captives is the belief that their primary use is to replace existing commercial coverage. This is true in some situations, but more commonly, the captive is used to augment existing commercial insurance, especially by providing first-dollar coverage for losses. When a captive is available, most companies use it to provide coverage for selected commercial policy deductibles.
For many companies, a captive also offers the opportunity to reduce the cost of commercial policies by increasing deductibles to reduce premiums. Since the captive has the flexibility to insure any risk it chooses and to customize the terms and conditions of its policies, many companies are able to use a captive to take better advantage of their positive loss history or their relatively high tolerance for certain categories of risk.
3. Plugging Gaps in Commercial Insurance Coverage
Every company has gaps in its insurance coverage. Historically, many companies simply self-insured any risks that were excluded from commercial polices. Today, forming a captive allows businesses to plug gaps in their commercial policies by writing coverage the conventional market is unable to offer at an affordable rate or unwilling to offer at all.
4. Gaining Access to the Reinsurance Market
Because a captive is a fully licensed insurance carrier, it generally is able to gain direct access to reinsurance providers that underwrite the captive’s risk. This access spares the company commissions and profit margins that are built into the process when reinsurance is attained through a commercial carrier. The savings associated with eliminating these costs typically outweigh the incorporation fees, legal expenses, and other start-up costs involved in establishing a captive. This direct access to the reinsurance market is often the principal factor that induces companies to form a captive.
5. Added Estate Planning Flexibility
Another often-unrecognized benefit of a captive is the opportunity to transfer capital and value to a new generation of owners. This benefit cannot be understated, given the current state of the tax code. This transfer is possible because the ownership of the captive does not have to match exactly the ownership of the operating company. In fact, depending on the needs of the estate, a captive can be held by a completely different ownership structure – or even a family trust.
6. Creating a Profit Center
A captive can also offer a company the opportunity to generate additional profits by diversifying into the open market to offer insurance coverage to unrelated customers. For example, a tool manufacturer formed its own captive to insure the inventory maintained in the trucks of its independent distributors. Because they understood the risks better than other insurance carriers and could control them more effectively, the manufacturer and the captive insurance company were able to offer lower-cost coverage and eventually create a significant new profit center for the manufacturer.
Creation Of Your Captive
Captive insurance companies require specialized skills to form and manage. Most companies exploring the creation of a captive hire and rely on outside professional service firms to conduct a feasibility study to determine the appropriateness of a captive and the actuarial analysis required. Assuming good management, the greatest risk is experiencing claim losses and related claim management expenses greater than anticipated.
Captive programs can be implemented with under a $50,000 start-up budget, and operated with as little as $30,000 in annual fixed overhead expenses. Some protected/segregated cell captive and series LLC captive programs can be initiated and maintained much less expensively.
As with the creation of any new business, the formation of a captive insurance company requires a thorough analysis of the pros and cons involved. This analysis should be conducted with the help of legal and financial professionals that you trust, and that have knowledge of your company and the specific set of circumstances it faces, both currently and historically.