Captive Insurance

What is a Captive

A captive insurance company is a private insurance company that is generally set up as a subsidiary of a parent operating company.  The captive accepts premiums that the parent company would have paid to a third-party insurance company, and in return the captive covers any claims made against the parent company.  The premiums paid to the captive are paid by the parent as a deductible expense.   For many years, only large companies were able to enjoy the benefits from operating their own captive insurance companies.  Most captives were established to provide coverage where insurance was unavailable or unreasonably expensive.  In recent years, however, the IRS has encouraged the formation of what is known as a small captive corporation, pursuant to Code Section 831(b).  Under Section 831(b), a captive insurance company can receive up to $1.2 million per year annually in premium payments free from federal taxation.  Otherwise, only the income generated by the investments of the captive’s premiums are subject to federal tax.   While it previously was not uncommon for captive insurance companies to be formed offshore in jurisdictions such as the British Virgin Islands, the Bahamas or Bermuda, recently, a number of states have adopted extremely favorable captive insurance company laws to encourage the formation of captive insurance companies within the United States.  Among those states are Vermont, South Carolina, Wyoming and Nevada.   The State of Nevada provides an ideal place to form a captive insurance company.  Not only does the State of Nevada not have a corporate income tax, but Nevada’s captive insurance company laws are among the most beneficial in the nation.  As a result of Nevada’s laws, captive insurance companies can be efficiently and cost-effectively formed within the State.
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Risk Management and Tax Benefits of Captives

Captive insurance companies not only provide attractive risk management elements, but a properly-structured and managed captive insurance company can provide the following tax and non-tax benefits:

  • $1.2 million federal and state tax deduction annually to the parent company for the insurance premiums paid to the captive;
  • Ability to remove the parent company’s earnings from creditors’ reach in a tax-favored nature;
  • Opportunity to accumulate and/or transfer wealth in a tax-favored vehicle;
  • Distributions to captive owners at favorable income tax rates (20% dividends tax rate);
  • Ability to insure risks that otherwise would be uninsurable or not economically viable to insure;
  • Reduction in the insurance premiums paid by the parent corporation; and
  • Ability to control settlement and payment of insurance claims.

An additional benefit of forming a captive insurance company within the United States is that insurance is one of the very few industries that are exclusively subject to the law of their state of incorporation.  They are not subject to federal law.  By way of example, a captive insurance that is set up within the State of Nevada is subject only to regulation by Nevada State insurance administrators.  Its status as an insurance company is not subjected to regulation by any federal laws.  A captive is a real insurance company with reserves, surplus, policies, policyholders, and claims.  It is licensed in the state of its formation, and it may later be licensed to conduct the business of insurance by other jurisdictions, including other states.
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Types of Captives

Captives primarily come in three varieties and are referred to either as a pure captive, a group captive, or as a series captive insurance company.

Pure Captives.  Pure Captives are either set up in a parent-child or a brother-sister relationship.  Examples of these types of captives are set forth in Figure 1.1 and 1.2 below. Parent-Child Relationship.  Figure 1 represents a simple pure parent-child captive, which has a common owner or parent, an operating subsidiary and a related captive insurance company.  The operating business pays insurance premiums to the captive insurance company in exchange for the captive’s issuance of policies insuring the risks of the operating business.

Figure 1.1  parent child

Brother-Sister Relationship. Alternatively, a more complex pure captive structure is set forth in Figure 1.2.  In this case, a parent company operates a number of subsidiary businesses.  Each of the subsidiary businesses then independently pays premiums to the captive insurance company for the acquisition of policies, independently insuring the risks of each of the subsidiaries.  For example, a real estate developer may have a number of projects, each of which are independently owned by separate limited liability companies.  The limited liability companies then purchase insurance policies from the captive to underwrite the risks of construction defects, completion of construction, failure of performance by subcontractors, deductibles under fire, casualty and commercial liability insurance, and other insurable risks.

Figure 1.2brother sister

Group Captive.  A second type of captive is a group captive.  A group captive underwrites the risk of a number of persons or businesses that are members of their organization or have similar interests.  For example, the American Automobile Association (AAA) is an example of a group captive. A group captive may share some risks of individuals and are usually formed to increase the members’ buying power.  An example of this would be a captive formed of a group of building companies that offers insurance to members of the group.  A captive that offers insurance primarily to businesses in the same or similar trades is known as an industry captive.  Due to the fact that group captives sell insurance to many people or businesses, they are much more tightly regulated than single parent pure captives.  

Series Captives.  Often, businesses are too small to justify forming their own captive.  As an alternative, they can obtain the benefits of a captive insurance company by buying a cell of a series captive.  A series captive is comprised of a series LLC with numerous cells.  Structurally, a series LLC is like a parent holding company with a number of subsidiaries.  Series LLC’s are generally set up with up to 12 separate cells, and each participant buys a cell, which will allow him or his business to deduct up to $100,000 a year in premium payments.  If properly set up, the risks and the assets of each cell are segregated from each of the other cells, and under state series LLC law, the owner of one cell is not liable for the liabilities of another cell.  Nevada is one of 15 states that allows for the creation of series LLC’s and for the use of series LLC’s in setting up a captive insurance company.
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Procedures for Setting up Captives

The formation of a captive insurance company starts with the conducting of a feasibility study.  The main purpose of the feasibility study is to determine whether the formation and use of a captive would be economically viable and beneficial for a specific business.  The feasibility study will determine the amount of capital required to form the captive, and the cash flow necessary to support the captive, in order to make it economically viable.  In most cases, the attorneys or consultants who perform the analysis will refund a significant portion of the fee if the feasibility study leads to a negative recommendation as to whether it would be beneficial to proceed with the formation of the captive. After the feasibility study, the next step for setting up a captive is to have an actuarial study performed by an accredited actuary, which will examine the proposed risks to be underwritten by the captive, what range of premiums should be charged for that insurance, and what capital and reserves will be necessary to adequately back those risks.  The actuary will also develop detailed financial projections.

After the actuarial study is complete, the domicile and organizational structure for the captive will be determined.  The final step is the preparation and submittal of the application for an insurance license.  During the feasibility, actuarial and licensing stages, the need for a qualified insurance manager on the planning team is very important.

Business that Might Benefit from the use of Captives

The use of a captive should be considered by entities that meet the following criteria:

  • Profitable businesses seeking substantial annual adjustable tax deductions;
  • Businesses with multiple entities or those that can create multiple operating subsidiaries or affiliates;
  • Businesses with $300,000 or more in sustainable operating profits;
  • Businesses with requisite risk currently uninsured or underinsured;
  • Business owners interested in personal wealth accumulation and/or family wealth transfer strategies; and
  • Business owners that are looking for asset protection.

Examples of types of businesses that a captive would be helpful include the following:

(a) Doctors’ Group.  Medical groups have often used captive insurance companies to provide medical malpractice liability coverage for active physicians and practices that are underserved by the commercial professional malpractice insurance market, and tail or extended reporting endorsement coverage for retiring physicians and practices.

(b) Real Estate Developers and Investors.  Real estate developers and investors often have long-term construction defect liability risks that in most states extend up to ten years after the completion of a project.  They also have pollution, environmental remediation, liability for subcontractor work and other significant risks for which affordable coverage is often hard to obtain.

(c) Franchise Operator.  Captives can be owned by a group of franchises or owners of multiple franchise operations to provide coverage for commercial liability deductibles, crime professional liability, workers compensation, employment practices, cyber liability and umbrella policies.

(d) Manufacturing Company.  Manufacturers often have long-term products liability exposure, risk of loss of key vendors, employment practices, legal costs and other types of risk for which they are often underinsured or not insured due to exclusion in their commercial liability policies.  The use of a captive can be used to fill those gaps in coverage.

(e) Technology Company.  Often cybercrime patent infringement, loss of key vendors, and legal expenses coverages are only available to technology companies through the use of a captive.

(f) Small to Medium Size Company Subject to the Affordable Care Act.  Companies with over 50 employees are required to offer their employees’ health insurance coverage that fits specific affordability and coverage criteria as outlined in the Affordable Care Act.  Captive insurance companies are excluded from the Affordable Care Act.  Accordingly, captives are being used by companies subject to the Affordable Care Act to insure healthcare insurance deductibles.  Many companies are using “medical stop loss captives” to allow self-funded employees to pool part of their excess medical claims costs with other companies.
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Example of Tax Savings

The following example sets forth a situation in which the owners of a real estate investment and management company would find it advantageous to set up a captive insurance company:

John, Ted, and Bill are each one-third owners of a real estate investment company that acquires, manages, and improves apartment buildings (“Apartment Company”).  Apartment Company manages six separate apartment building complexes that have been purchased by limited liability companies set up by John, Ted, and Bill, which separately own each apartment complex.

Apartment Company is an S corporation with 15 employees, and collectively Apartment Company, together with the LLC’s, has $1.2 million of taxable income taxed to each of John, Ted, and Bill at a 50% rate, including federal and state taxes.  John, Ted, and Bill would like to minimize the income tax liability associated with the funds earned by Apartment Company and each of the LLC’s and accumulate the monies received by Apartment Company and each of the LLC’s in a more tax-advantage basis, which will be beyond the reach of their personal, Apartment Company, and LLC creditors.

The shares of any captive insurance company set up by John, Ted, and Bill would be held in a separate LLC or asset protection trusts for the benefit of John, Ted, and Bill and their families.  John, Ted, and Bill retained a Nevada attorney and a captive insurance management company to perform a feasibility study analyzing Apartment Company’s and each of the LLC’s current insurance coverages to determine risks that are either self-insured or underinsured.  That feasibility study identified 15 risks and designated separate coverages for each of those risks, including employment practices, excess commercial liability, workmen’s compensation, zoning coverage, environmental liability, legal expenses, and other risks.

Results.  The premiums for the 15 separate polices were determined by applying usual and customary actuarial and insurance industry underwriting principles that provided a rational basis for calculating the premiums with respect to the benefits that would be insured.  The total premium paid for the 15 policy users totaled approximately $1,100,000.

Results.  The State of Nevada Insurance Commissioner approved the formation of a parent-child pure captive and issued the necessary licenses to form a captive insurance company taxed under Section 831(b). John, Ted and Bill realized a combination of significant tax and non-tax benefits in Exhibit A attached, which shows the tax benefits of using a captive versus not using a captive.  Those benefits include:

  •  The premiums paid by Apartment Company and each of the LLC’s to John, Ted, and Bill’s captive are fully deductible for income tax purposes.  The captive is not taxed on premium income, and the investment income is taxed as a result of Section 831(b).  Any eventual distributions by the captive to its shareholders qualify as dividends and are currently taxed at a 20% tax rate, and are not subject to the Net Investment Income surcharge.

 

  • The captive and its assets are not subject to the claims of Apartment Company’s creditors or to any creditor of each separate LLC or to claims of John, Ted, or Bill’s personal creditors for asset protection purposes.

 

EXHIBIT A CAPTIVE TAX BENEFITS OVER 10 YEARS

 

(Based on Preclaims) Year 1 Year 5 Year 10
No Captive
Net Business Income $ 1,100,000 $ 5,500,000 $11,000,000
Income Taxes (50%)      (550,000)  (2,750,000)    (5,500,000)
After-Tax Investment Income*         13,200      64,818        128,791
Total $    563,200 $ 2,814,818 $  5,628,791
With Captive
Captive Premiums $ 1,100,000 $ 5,500,000 $11,000,000
Operating Expenses        (65,000)      (325,000)      (650,000)
After-Tax Investment Income*         24,840      121,975       242,362
Total $ 1,059,840 $5,296,975 $10,592,362
After Tax Net Gain With Captive $    496,640 $2,484,157 $  4,963,571
Assumes a 3% gross rate of return on investments

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Exhibit A Captive Tax Benefits Over 10 Years

(Based on Preclaims) Year 1 Year 5 Year 10
No Captive
Net Business Income $ 1,100,000 $ 5,500,000 $11,000,000
Income Taxes (50%)      (550,000)  (2,750,000)    (5,500,000)
After-Tax Investment Income*         13,200      64,818        128,791
Total $    563,200 $ 2,814,818 $  5,628,791
With Captive
Captive Premiums $ 1,100,000 $ 5,500,000 $11,000,000
Operating Expenses        (65,000)      (325,000)      (650,000)
After-Tax Investment Income*         24,840      121,975       242,362
Total $ 1,059,840 $5,296,975 $10,592,362
After Tax Net Gain With Captive $    496,640 $2,484,157 $  4,963,571
Assumes a 3% gross rate of return on investments

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